By John Alan Cohan, Attorney at Law
Often enough, the IRS will “trick” taxpayers by questioning whether they satisfy the Material Participation Test. This happens if the IRS concedes that your farm, livestock or horse activity is conducted for profit under the hobby loss rule. That in itself is usually a big victory, but it can turn into a dark victory if the IRS then says that your losses are “passive” and cannot be deducted against your main source of income because you do not materially participate in the venture.
Under the Material Participation Test, you are permitted to deduct losses relating to a venture against your other income only if, among other things, you “materially participate” in the activity.
The IRS applies the test to individuals operating as partners, as well as sole proprietors. In one case, it was applied to a horse syndicate. Joseph Machado, of Long Beach, Calif., entered into a partnership with four other partners to purchase a broodmare named La Barbara. One partner was the managing partner and was responsible for maintaining the books and records of the partnership and for paying all expenses. The partnership made decisions by majority vote of all six partners. The broodmare was bred to a number of stallions, but the partnership generated losses over a period of seven years.
The Tax Court denied Machado the right to write off these losses against his income from a trucking business he owned because it held he did not materially participate in the partnership. Accordingly, his losses were limited by the passive income rules of Section 469 of the IRS Code and could not be used to offset his other income.
As mentioned, the rule is applied both to partnerships, as well as individuals operating as sole proprietors. Under the test, a taxpayer materially participates if he is involved in the operation of the activity on a “regular, continuous, and substantial” basis. Most people seek to prove compliance with evidence that they have spent 500 hours or more participating in the activity in each year at issue. There are other tests as well, but that is the main one.
Travel time to and from the farm or ranch is not counted. A taxpayer can establish the extent of his participation by any reasonable means including “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”
It is best to keep a detailed, contemporaneous time log, identifying what you did and when you did it. Phone records of calls to the farm manager should be maintained. Records of research you have conducted should be kept. Time records of seminars and auctions or other events you attended, as well time spent studying journals and other research you conducted, should also be kept.
The kind of activities that a taxpayer should be able to document during each year may include the following:
—consulting with advisers or other experts in the industry
—attending industry events, auctions or other sales
—keeping business records
—discussing matters with one’s spouse and other partners
—implementing or formulating business plans and revising them
—reviewing finances, making cost projections or making disbursements
—speaking with vendors on the telephone or in person
—talking to potential customers
—general duties of animal husbandry or harvesting of crops
—planning and making improvements (such as building fences)
—tending to the physical labor on the farm or ranch, supervising others hired to work for you and performing other tasks and decision-making functions.
Remember, it is imperative that records be kept to reflect the number of hours involved.
In the above case involving Mr. Machado, the only evidence he presented regarding participation in the partnership was his uncorroborated testimony that he spent hundreds of hours researching potential stallions to breed with La Barbara, and a calendar log that reflected l5 entries for phone calls he made relating to the partnership.
It is also important to keep in mind that the material participation test is supplemental to IRS Regulations on the hobby loss rule. Even if you can prove material participation in your ranch or farm, the IRS could still find the venture was merely a hobby unless you can prove the overall elements of the hobby loss rule.
Many duties are often delegated to a farm manager or, in the case of horse activities, to trainers or other qualified experts. Sometimes the IRS will question the validity of your own participation in decision-making, in an effort to say you have failed to meet the Material Participation Test. Their argument will be that you were not really in control, that decisions were made by those to whom you delegated various duties.
It is important to obtain advance legal guidance whenever you enter into a partnership if you intend to write off possible losses against other income sources. The Material Participation Test is something you must plan on meeting and complying with, and is not something to be treated lightly.
John Alan Cohan is an attorney who has served the livestock, farming and horse industries since 1981. He can be reached at: (310) 278-0203, by e-mail at [email protected], or visit his website at JohnAlanCohan.com.