Question

Amy, a self employed US customs broker, obtained a customs broker’s license from US Customs and Border Protection in 1991. Since 2003 Amy has operated a customs brokerage business, Atlantic Air Express, LLC, (Atlantic Air), from her home. For 2004 Amy reported self employment income of $45,649. From this activity, Amy reported a net profit on Schedule C, Profit or Loss From Business, for each year from 2005 to 2011. For 2007 the year in issue, Amy reported a net profit of $130,872 on Schedule C.

Amy began breeding Great Pyrenees dogs in 1994 on a half acre of property in New York, where she sets up kenneling facilities. Amy incurred expenses to set up the kennel and to purchase dogs, food, grooming supplies and equipment, a vehicle to transport the animals, and advertising. From 1994 to 1999 Amy sought to build the prestige and reputation of the dog breeding operation, Impyrial Great Pyrenees (Impyrial), by producing a robust stock of Great Pyrenees dogs and showing the dogs at dog shows. She spoke with experienced Great Pyrenees breeders and visited various successful kennels to gather information for developing a breeding program. Amy’s dog breeding activity sustained losses every year until 2010, for which she reported a small net profit.

In 1999, when Amy owned five dogs, she moved Impyrial to a 15-acre farm in Orange County, New York. The purpose of the move was to accommodate a large breeding program. Amy also obtained a purbred dog license from the New York State Department of Agriculture and Markets, which is available only for kennels that maintain more than 10 dogs. By 2007 Amy owned 26 dogs.

Amy’s main source of income from the dog breeding activity is the sale of puppies. Amy typically charges $1,200 for a puppy but charges as much as $4,000 for a puppy sired from one of her top winning show dogs. Amy sold approximately six puppies between 1994 and 1999. During 2000 and 2001 Amy’s dogs produced six litters. In 2002 the dogs began to have fertility problems. Amy’s dogs had other health problems that also disrupted the breeding program, including Lyme disease, bacterial infections, and thyroid problems. From 2002 to 2009 Amy attempted to breed 46 female dogs, resulting in 17 pregnancies. The pregnancies produced 13 litters. In 2009 after consultations with veterinarians and fertility specialists Amy administered a month long antibiotic treatment to all of the dogs and treated some of the female dogs with thyroid medication. Amy’s dogs produced two litters shortly after the medical treatment. These were the first pregnancies in nearly 18 months. Amy sold 18 puppies in 2010.

In addition to selling puppies, Amy sells semen from the male dogs to breeders and charges stud fees ranging from $1,200 to $2,500 for top winning show dogs.

Amy reported profit or loss on Schedule C for Impyrial as follows:

Year             Income                   Expenses      Gain or (loss)

2005             $4,729                    $76,590        ($71,861)

2006             6,900                  96,996          (90,096)

2007             4,600                   71,116         (66,516)

2008             4,500                  69,340         (64,840)

2009             6,800                  30,790           (23,990)

2010             33,600                  30,120          3,480

2011                8,320                    27,369          (19,049)

Amy reported the income and expenses attributable to Impyrial on a Schedule C attached to her 2007 Federal income tax return. Amy asserts that (1) she engaged in the activity with the intent to make a profit and (2) that her return for taxable year 2002 was examined and that the Commissioner of Revenue allowed her to treat Impyrial as a trade or business.

Commissioner of Revenue determined that Amy did not engage in the dog breeding activity for profit and disallowed Amy’s expense deductions claimed in excess of the reported income.

Please note that Amy began Impyrial in 1994. Impyrial sustained losses every year from 1994 to 2009. The record does not reflect the amounts of Impyrial’s income, expenses, and losses between 1994 and 2004.

QUESTIONS

Based on the facts presented and information presented in chapter 6, do you believe that Amy's activity constitute a trade or business. EXPLAIN

Assume that you work as an agent of the IRS and you are challenging Amy's tax position. What argument will you present against Amy?

     3) Assume that Amy is your client and was audited by the IRS. What arguments will         

           you present to defend your Client?

Answer 1

Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business operates to make a profit.

The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services. It is not limited to integrated aggregates of assets, activities, and goodwill that comprise businesses for purposes of certain other provisions of the Internal Revenue Code. Activities of producing or distributing goods or performing services from which gross income is derived do not lose their identity as trades or businesses merely because they are carried on within a larger framework of other activities that may, or may not, be related to the organization's exempt purposes.

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to separate business expenses from the following expenses:

A taxpayer may deduct the ordinary and necessary expenses in carrying on a trade or business. Both self-employed taxpayers and employee taxpayers are considered to carry on a trade or business.

Those are a few of the rules related to individual tax losses, which greatly limit an individual’s ability to legally take a tax loss on their income tax returns.

• The expenses used to figure the cost of goods sold,

• Capital Expenses, and

• Personal Expenses.

These are difficult cases, the IRS and even the Tax Court analyze them with extreme subjectivity. Generally, the IRS regulations provide a list of factors that are applied to the facts and circumstances of any particular case to judge whether the activity was entered into for profit.

The non-inclusive list of factors are as follows.

Manner in which the taxpayer carries on the activity: This factor supports a for profit determination where the taxpayer carries on the activity in a business-like manner and maintains complete books and records.

The expertise of the taxpayer or his advisors: This factor supports a for profit determination where the taxpayer prepares for the activity by extensive study of its accepted business, economic, and scientific practices or consults with those that are experts.

The time and effort expended by the taxpayer in carrying on the activity: This factor supports a for profit determination where the taxpayer either devotes much of his personal time to the activity, withdraws from another occupation so that his energies may be devoted to the activity or the taxpayer devotes limited time to the activity but employs competent persons to carry on the activity

Expectation that assets used in the activity may appreciate in value: This factor supports a for profit determination where the taxpayer derives a profit from the appreciation of assets, as opposed to a profit derived from operations.

The success of the taxpayer in carrying on other similar or dissimilar activities: This factor supports a for profit determination, even if the activity has been unprofitable, if the taxpayer has engaged in similar unprofitable activities in the past, which the taxpayer    eventually converted to profitable activities.

The taxpayer’s history of income or losses with respect to the activity: This factor supports a for profit determination where the taxpayer takes a series of losses during the initial or start-up stage of the activity only. However, continuing losses sustained beyond a period of time that is customarily necessary to bring an operation profitable, will be indicative of an activity not engaged in for profit.

The amount of occasional profits, if any, which are earned: This factor supports a for profit determination where the taxpayer makes only an occasional substantial profit and the losses are comparatively small.

The financial status of the taxpayer: This factor supports a for profit determination when the taxpayer does not have substantial income from other sources.

Elements of personal pleasure or recreation: This factor supports a for profit determination where the activity lacks any appeal other than profit.

expects that if you start a business, you intend to make money at it. If you don't, your business is likely to be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:

• Do you put in the necessary time and effort to turn a profit?
• Have you made a profit in this activity in the past, or can you expect to make one in the future?
• Do you have the necessary knowledge to succeed in this field?
• Do you depend on income from this activity?
• Are your losses beyond your control?

Practical standard for business classification

The general rule is that if you have not turned a profit in at least three of the prior five years, the IRS will categorize your business as a hobby. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.

Consequences of hobby classification

Generally, the IRS classifies your business as a hobby, it won't allow you to take any losses. However, in certain limited situations you can use your hobby expenses to reduce your taxes.

If you have a hobby loss expense that you could otherwise claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full. Other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.

Preventing your business from being classified as a hobby

Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.

In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.