Taxable Talk

One of the vexing matters for tax professionals are side businesses. If they’re profitable, it’s usually not an issue. It’s another Schedule C for the return. However, when they are unprofitable problems can arise if the IRS scrutinizes the return.

The Tax Court looked at this again on Thursday when the decided the case of a Kansas couple who had an exotic animal breeding business. The husband is a successful physician, with a medical practice that brought in $750,000 or more annually. Starting in 1989, the began to breed exotic birds. They then expanded into all sorts of exotic animals, including (but not limited to) “Watusi cattle, miniature donkeys, miniature horses, elk, reindeer, zebras, African antelope, kangaroos, Clydesdale horses, and primates.”

The Kansas couple did some things right: They did keep a separate set of books and a separate bank account. But they didn’t bother with sales receipts to customers. They did treat the employees of their business as employees. They withheld taxes, offered health insurance, etc.

However, they never turned a profit. And when the IRS audited the couple’s tax return for 2001 and 2002, the IRS ruled that the couple could not deduct the losses at the business. The case was then appealed to the Tax Court.

The Court looked at their records, and found them deficient.

“Although we are satisfied that petitioners kept financial records of their breeding activity, we are not convinced that petitioners’ record keeping represented anything other than an effort to substantiate expenses claimed on their return…Petitioners presented no evidence that their books and records were used to review profitability or to implement cost-saving measures. While a taxpayer need not maintain a sophisticated cost accounting system, the taxpayer should keep records that enable the taxpayer to make informed business decisions…Although petitioners kept extensive financial records, they were not used to review and reduce expenses or to enhance the possibility of generating income…Petitioners did not introduce any evidence that they used their financial and breeding records to determine whether a specific breed was profitable…Because petitioners failed to use the existing books and records to minimize their expenses or otherwise foster profitability, the fact that they maintained records does not indicate that the activity was carried on with a profit motive.”

And that basically was the case. Yes, the couple kept records. But the records appeared incomplete, and were apparently not utilized completely. The couple couldn’t show that they expanded breeding of profitable exotic animals because they couldn’t show which animals were profitable. Add to that 16 years of large losses, and the case flew the coop.

Case: Knudsen v. Commissioner, T.C. Memo 2007-340