KAHLA v. COMMISSIONER

T.C. Memo. 2000-127

UNITED STATES TAX COURT

HAROLD W. AND JULIA A. KAHLA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12318-97. Filed April 10, 2000.

Daniel S. Parks and W. McNab Miller III, for petitioners.

Roberta L. Shumway, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: Respondent determined deficiencies in

petitioners’ Federal income taxes as follows:

Year Deficiency

1992 $41,815
1993 83,435
1994 79,173
 - 2 -

These deficiencies stem from respondent’s disallowance of certain

deductions and losses attributable to petitioners’ cattle-raising

and deer operations (sometimes referred to as petitioners’ Schedule

F activities)1 conducted during the years in issue. Petitioners’

Schedule F activities were conducted at two different locations:

Buckview Ranch (the North Ranch), which is located in Leon County,

near Centerville, Texas, and El Squato Ranch (the South Ranch),

which is located in Wells County, near Encinal, Texas.

The issue for decision is whether petitioners’ Schedule F

activities were activities engaged in for profit. We hold they

were not.2

All section references are to the Internal Revenue Code as in

effect for the years in issue.

1
The parties stipulated that the cattle-raising and deer
operations constitute one activity.
2
During the course of trial preparation, respondent’s
counsel discovered that certain labor and fuel costs claimed on
petitioners’ 1992-94 returns as expenses were capital in nature
and should have been depreciated rather than expensed.
Thereafter, respondent filed an amendment to answer asserting
that if petitioners should prevail in their position that the
cattle-raising and deer operations were activities engaged in for
profit, then deficiencies would still be due, but in lesser
amounts, for the years in issue as a result of petitioners’
misclassification of the labor and fuel costs. Petitioners
apparently do not dispute respondent’s assertion in this regard.
In any event, in view of our holding that petitioners’ Schedule F
activities were not activities engaged in for profit, this matter
goes by the wayside.
 - 3 -

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

stipulations of facts and the exhibits submitted therewith are

incorporated herein by this reference.

Background

Petitioners, husband and wife, resided in Tomball, Texas, at

the time they filed their petition.

Harold Kahla (petitioner) received a bachelor of business

administration degree in marketing and management in 1961; he

subsequently attended law school but did not graduate. Julia Kahla

(Mrs. Kahla) received a bachelor of arts degree in speech

communication; she later earned a master’s degree in education.

During the years in issue, petitioners were the sole

shareholders of United Galvanizing, Inc. (United), a Texas

corporation. For Federal income tax purposes, United is an S

corporation. Since its inception in 1970, United has operated at

a profit. For the years in issue, United’s income was as follows:

Year Amount

1992 $45,174
1993 235,410
1994 224,221

The North Ranch

The North Ranch is approximately 100 miles from petitioners’

home in Tomball. It comprises approximately 1,223 acres. The land

was acquired, in substantially undeveloped condition, as follows:
 - 4 -

Date Acres Acquisition Price

5/73 188.070 $52,659.60
4/75 142.000 117,000.00
1977 7.000 By adverse possession
12/77 150.000 67,500.00
12/78 530.000 198,750.00
4/83 44.487 By exchange
9/86 161.380 116,647.93

Total 1,222.937 552,557.53

The ranch has 507 acres of improved coastal Bermuda grass

pastures for hay production and cattle grazing, and approximately

100 acres of open native pasture land. The balance of the ranch is

dense-to-scattered woods. The ranch is fenced into separate

pasture areas, allowing for pasture rotation for either cattle

grazing or hay production. When fully operational, the North Ranch

can sustain up to 400 cows at any given time. Several buildings,

including a 4,792-square-foot home, an equipment shed, and ranch

offices, are located on the property. The value of the acreage

making up the North Ranch during 1992, 1993, and 1994 was

$1,225,000. The value of the house and improvements on the North

Ranch during 1992, 1993, and 1994 was $85,000.

In order to receive cost-sharing payments from the U.S.

Department of Agriculture (USDA), petitioners consulted with the

Soil Conservation Service for technical assistance regarding land

management matters on the North Ranch. Between 1976 and 1996,

petitioners received payments from USDA totaling approximately

$22,000.
 - 5 -

Petitioners spent a considerable amount of time on the North

Ranch each year. Besides using the North Ranch for their cattle

ranching, petitioners regularly entertained family members on

holiday occasions, and petitioner frequently hunted on the

property.

The South Ranch

The South Ranch is located approximately 320 miles from

petitioners’ home. During the years in issue, it comprised

approximately 3,578 acres.3 The land was acquired as follows:

Date Acres Acquisition Price

9/88 1,073.47 $354,245.10
11/88 648.14 213,886.20
1
2/89 (31.57) (10,418.00)
4/89 1,169.54 409,339.00
10/89 500.00 200,000.00
12/92 218.00 65,400.00
1
Total 3,577.58 1,232,452.30
1
Petitioners sold 31.57 acres in February 1989.

The South Ranch is essentially a large pasture suitable for

cattle grazing and is located in an area that is subject to

drought. In addition to its large open grazing areas, the South

Ranch contains several buildings and fixtures, including a large

residence and two “outbuildings”. The residence is often used by

petitioners both as a personal retreat and as lodging for visiting

guests. The outbuildings are primarily used to house farm

3
An additional 438.66 acres was acquired on Feb. 13,
1997, for $153,673.
 - 6 -

equipment and supplies. The value of the acreage making up the

South Ranch as of May 11, 1992, was $1,270,500. The value of the

house and improvements on the South Ranch as of May 11, 1992, was

$70,000. The value of the acreage making up the South Ranch in

1993 and 1994 was $1,442,000. The value of the house and

improvements on the South Ranch in 1993 and 1994 was $90,000.

During the years in issue, petitioners spent a considerable

amount of time on the South Ranch. They fished and hunted on the

property. In addition, since 1987, they escorted family members

across the South Ranch on guided hunts.

Petitioners’ Cattle-Raising Operations

Petitioner had a lifelong interest in cattle ranching. He was

raised on his parents’ cattle ranch, where he gained practical

knowledge in raising and breeding cattle. Petitioner began his own

cattle-ranching activities when he purchased nine cows and one bull

in 1973; by 1994, petitioners owned over 300 head of cattle.

Petitioners bred and raised cattle. Cattle deemed surplus

were sold at biannual cattle auctions. The following numbers and

types of cattle were sold at auction:

Year Calves Cows Bulls

1992 75 0 4
1993 280 68 7
1994 28 6 1
1995 119 35 3
1996 255 133 0
1997 98 6 0
 - 7 -

Initially, petitioner did most of the chores around the North

Ranch. As their operations grew, petitioners hired contract labor.

In addition, during the years in issue, two employees of United

(Jerry Scott and Perfecto Delgado) worked as caretakers on both

ranches. Although paid by United, petitioners claimed Messrs.

Scott’s and Delgado’s salaries as Schedule F expenses.

From the inception of their cattle-raising operations,

petitioners’ Schedule F expenses exceeded income; this result is

expected to continue for the foreseeable future. (Petitioners

incur a net loss of approximately $11.85 for every head of cattle

sold.) Petitioners attribute these continued losses to fluctuating

cattle and feed prices due in large part to increased competition

in the industry as well as a prolonged drought.4

Deer Operations

In 1988, petitioner decided to raise and manage deer so that

he could eventually develop a herd suitable for trophy game

hunting. For this purpose, petitioners acquired the South Ranch

and enclosed the property with deer-proof fencing. In addition,

petitioners installed a water and feed system across the South

Ranch in order to ensure a constant supply of food for the deer.

Although petitioner had an extensive knowledge of deer from

previous hunting trips, he sought advice from the Texas Parks and

4
We note that during 1992 through 1994, prolonged
drought conditions did not exist in the areas surrounding the
North and South Ranches.
 - 8 -

Wildlife Department on how to manage and feed herds of deer.

Additionally, petitioner had aerial surveys made of roaming deer

herds in order to observe the herds’ development. Petitioners’

son, Byron, was employed full time to manage their deer operations;

his salary was paid by United.5

Petitioner initially planned to conduct guided trophy hunting

expeditions on the South Ranch. Petitioner estimated that when

fully operational, these hunts would generate a net income stream

of $38,600 per year. During the years in issue, petitioner had not

begun conducting these guided hunting expeditions on the South

Ranch because of the lack of trophy bucks on the property.

According to petitioner, it takes on average 4-1/2 years from the

beginning of a breeding program for a fawn to develop into a mature

trophy buck.

Petitioners’ General Financing and Accounting Practices

Petitioners’ cattle-raising and deer operations are

leveraged. At the time of trial, petitioners owed between $130,000

and $150,000 of debt incurred in operating both ranches.

During the years in issue, petitioners did not maintain

5
During the years in issue, Byron Kahla was paid the
following amounts by United:

1992 $33,837
1993 226,969
1994 205,825

Petitioners did not claim Byron Kahla’s salary as a Schedule F
expense.
 - 9 -

accounting books and records for their Schedule F activities. Nor

did they keep formal business plans, forecasts, budgets, or “herd”

books for the cattle-raising or deer operations.

For purposes of calculating their Schedule F income or loss,

petitioners did not allocate revenue and expenditures between the

two ranches. Petitioners reported the following Schedule F income

and deductions from their activities conducted at the North and

South Ranches:

Year Revenues Sales of Property Deductions Gain/Loss

1976 $192 -0- $33,261 $(33,069)
1977 4,949 -0- 27,448 (22,499)
1978 9,414 -0- 34,419 (25,005)
1979 15,353 -0- 35,139 (19,786)
1980 -0- -0- 43,393 (43,393)
1981 33,737 -0- 67,398 (33,661)
1982 1,873 -0- 55,116 (53,243)
1983 21,394 $1,337 86,032 (63,301)
1984 40,368 -0- 64,025 (23,657)
1985 -0- -0- 77,811 (77,811)
1986 41,107 -0- 76,636 (35,529)
1987 53,110 17,538 66,775 3,873
1988 49,462 839 74,973 (24,672)
1989 49,795 -0- 195,063 (145,268)
1990 54,752 -0- 258,441 (203,689)
1991 7,475 16,648 310,548 (286,425)
1
1992 33,451 3,366 245,319 (210,894)
1993 100,835 4,074 263,289 (158,380)
1994 14,599 3,414 202,550 (184,537)
1995 46,567 13,501 192,036 (131,968)
1996 80,294 15,598 152,295 (56,403)
1997 41,021 2,419 96,807 (53,367)
699,748 78,734 2,658,774 (1,882,684)
1
A computational error was made in determining petitioners’
net loss for 1992.
 - 10 -

Petitioners’ 1992-94 Federal Income Tax Returns

Petitioners timely filed their 1992, 1993, and 1994 Federal

income tax returns. On their returns, petitioners reported income

from various sources, as follows:

Year Compensation Interest Schedule C United

1992 $97,089 $300,035 $126,500 $45,174
1993 409,596 162,391 --- 235,410
1994 387,786 6,007 --- 224,221

Petitioners offset this income with the following Schedule F losses

attributable to their cattle-raising and deer operations:

Year Schedule F Net Loss

1992 $211,868
1993 162,454
1994 187,951

OPINION

The issue we must decide is one of fact: whether petitioners

entered into or carried on their Schedule F activities with an

intent to make a profit. If petitioners did not have the requisite

profit motive, as respondent maintains, then all deductions

exceeding the revenue attributable to those activities would be

disallowed pursuant to section 183(a).

Respondent contends that petitioners lacked the requisite

intent to make a profit in carrying out their Schedule F

activities. In support of this position, respondent maintains (1)

petitioners failed to carry on the activities in a businesslike

manner, (2) the activities generated substantial losses over an
 - 11 -

extended period of time (26 years), and (3) there was no realistic

expectation that petitioners’ Schedule F activities would be

profitable.

On the other hand, petitioners maintain that they entered into

their Schedule F activities with the intent of making a profit.

Petitioners dispute respondent’s assertion that they failed to

execute their Schedule F activities in a businesslike manner.

Further, they assert that despite decades of losses from their

Schedule F activities, these losses represent startup period losses

and were attributable to unforeseen circumstances (i.e., drought

and fluctuating cattle prices). For the reasons set forth below,

we agree with respondent.

We begin our analysis with the applicable statutory

provisions. Generally, under section 183(a), individuals are

disallowed deductions attributable to an activity “not engaged in

for profit” except to the extent of any gross income generated by

such activity. Section 183(c) defines an activity not engaged in

for profit as “any activity other than one with respect to which

deductions are allowable for the taxable year under section 162 or

under paragraph (1) or (2) of section 212”. Accordingly, section

183 is considered in pari materia with sections 162 and 212. See

sec. 1.183-2(a), Income Tax Regs.

The standard for determining whether an expense is deductible

under sections 162 and 212 (and thus section 183) is identical: a
 - 12 -

taxpayer must show that he or she engaged in or carried on the

activity with an actual and honest objective of making a profit.

See Antonides v. Commissioner, 893 F.2d 656, 659 (4th Cir. 1990),

affg. 91 T.C. 686 (1988); Ronnen v. Commissioner, 90 T.C. 74, 91

(1988); sec. 1.183-2(a), Income Tax Regs. Although a reasonable

expectation of profit is not required, the taxpayer’s profit

objective must be bona fide. See Hulter v. Commissioner, 91 T.C.

371, 393 (1988); Beck v. Commissioner, 85 T.C. 557, 569 (1985).

“Profit” for purposes of section 183(a) means “economic profit,

independent of tax savings”. Ronnen v. Commissioner, supra at 92;

Hillman v. Commissioner, T.C. Memo. 1999-255.

Section 1.183-2(b), Income Tax Regs., sets forth a

nonexclusive list of factors to be considered in determining

whether an activity is engaged in for profit. These factors are:

(1) The manner in which the taxpayer carried on the activity; (2)

the expertise of the taxpayer or his advisers; (3) the time and

effort expended by the taxpayer in carrying on the activity; (4)

the expectation that assets used in the activity may appreciate in

value; (5) the success of the taxpayer in carrying on other similar

or dissimilar activities; (6) the taxpayer’s history of income or

losses with respect to the activity; (7) the amount of occasional

profits, if any, which are earned; (8) the financial status of the

taxpayer; and (9) whether elements of personal pleasure or

recreation are controlling. No single factor is necessarily
 - 13 -

dispositive; rather, the facts and circumstances of the case

ultimately control. See Keanini v. Commissioner, 94 T.C. 41, 47

(1990).

We now apply each of these factors to the facts in this case.

1. Manner of Carrying on the Activity

The fact that a taxpayer carries on an activity in a

businesslike manner and maintains complete and accurate books and

records may indicate that the activity was engaged in for profit.

See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-

2(b)(1), Income Tax Regs. Adapting new techniques and abandoning

methods that are economically inefficient may also support the

conclusion that the taxpayer possessed the requisite profit motive.

See Allen v. Commissioner, 72 T.C. 28, 35 (1979).

Here, the record is replete with instances where petitioners

did not conduct their cattle-raising and deer operations in a

businesslike manner. Petitioners had no formal business plan,

budgets, or accounting records. Petitioners’ records and expense

ledgers consisted primarily of canceled checks, invoices, and Forms

1099. These records were often inaccurate and incomplete. For

instance, petitioner often “forgot to put a couple thousand dollars

worth of cattle in his balance sheets”. Moreover, petitioners were

unable to allocate specific costs between their two ranches because

of their practice of aggregating expenses from both ranches.

Petitioners also failed to keep separate bank accounts; they
 - 14 -

intermingled personal funds with those from their Schedule F

activities. Additionally, despite the industry custom of

maintaining yearly “herd books” for cattle, petitioners often

failed to record and maintain accurate documentation of their

inventory.

Despite experiencing losses in 24 of the first 25 years of

operation (1973-97), there is no convincing evidence in the record

indicating that petitioners undertook substantial action to rectify

this situation. In fact, petitioner testified that he anticipates

petitioners’ cattle-raising activities will not be profitable for

the foreseeable future. Even with this stark economic reality

facing them, petitioners have not seriously investigated the

possibility of changing or abandoning any of their current methods

of operation. Suffice it to say, we believe that petitioners’

failure to take affirmative measures to mitigate continual and

substantial losses is inconsistent with operating an activity with

a profit motive.

2. Expertise of Taxpayer or Advisers

Preparation and execution of an activity after conducting an

extensive study or consultation with experts regarding the accepted

business practices of the activity may indicate a profit motive

where the taxpayer conducts the activity in accordance with such

study or advice. See sec. 1.183-2(b)(2), Income Tax Regs.

Conversely, a taxpayer’s failure to obtain expertise in the
 - 15 -

activity may indicate a lack of profit motive. See Burger v.

Commissioner, 809 F.2d 355, 359 (7th Cir. 1987), affg. T.C. Memo.

1985-523.

Petitioner grew up on his parents’ cattle ranch; he learned

firsthand the basics of raising and breeding cattle. He spent

considerable time consulting with the USDA Soil Conservation

Service, as well as State game and wildlife agencies. In addition,

he is an experienced deer hunter. Consequently, he possessed a

substantial level of expertise regarding cattle and deer.

However, the fact that petitioner had knowledge of cattle and

deer, and that technical noneconomic experts were consulted, does

not indicate that petitioners engaged in their cattle-raising and

deer operations for profit. See Hillman v. Commissioner, supra.

Considering all the years of losses, petitioners did little to

demonstrate an expertise for the economics of these operations.

3. Time and Effort Expended in the Activity

The fact that a taxpayer devotes much of his or her personal

time and effort in carrying on an activity, particularly if the

activity does not have substantial recreational aspects, may

indicate a profit motive. See sec. 1.183-2(b)(3), Income Tax Regs.

Petitioner spent approximately 40 percent of each year on both

ranches; Mrs. Kahla spent approximately 10 percent. The record

does not indicate the proportion of time spent on each ranch during

the years in issue or the amount of personal effort each expended
 - 16 -

in carrying out the Schedule F activities. However, we are mindful

that initially petitioner performed many of the required chores

around the North Ranch. At the same time, however, petitioners

used the property for hunting and fishing trips, as well as to

entertain guests during the holiday season. As a result, we are

unable to draw an inference regarding the existence of a profit

motive solely from how much time and effort petitioners may have

expended working on their Schedule F activities.

4. Expectation That Assets May Appreciate

An expectation that assets used in the activity will

appreciate may indicate a profit objective. See sec. 1.183-

2(b)(4), Income Tax Regs. Accordingly, a profit motive may be

inferred where there are no operating profits, so long as the

appreciation in value of the activity’s assets exceeds its

operating expenses of the current year and its accumulated losses

from prior years. See Golanty v. Commissioner, 72 T.C. 411, 427-

228 (1979), affd. 647 F.2d 170 (9th Cir. 1981); Sullivan v.

Commissioner, T.C. Memo. 1998-367, affd. 202 F.3d 264 (5th Cir.

1999); sec. 1.183-2(b)(4), Income Tax Regs.

Between 1976 and 1997, the amount of accumulated losses from

petitioners’ Schedule F activities exceeded $1.8 million.

Petitioners anticipate that they will continue to incur operating

losses from these activities in the near future.

During the years in issue, the value of the North Ranch
 - 17 -

exceeded its acquisition costs by $672,443, and the value of the

South Ranch exceeded its acquisition costs by $38,048 in 1992 and

by $209,948 in 1993 and 1994. However, the appreciation to date in

the North and South Ranches, if and when realized, is substantially

less than the cumulative losses from petitioners’ Schedule F

activities. Moreover, the parties stipulated that both the North

and South Ranches were not acquired for speculative appreciation.

5. Past Success in Other Activities

We have recognized that a taxpayer’s success in other business

activities may indicate a profit motive. See Eldridge v.

Commissioner, T.C. Memo. 1995-384; Hoyle v. Commissioner, T.C.

Memo. 1994-592. Here, concurrent with the cattle-raising and deer

operations, petitioners operated United, a highly profitable

business. When asked at trial what he would have done had United

not shown a profit, petitioner candidly responded: “I would have

just fixed it.” Yet, with respect to the Schedule F activities,

petitioner made little attempt to “fix” the continuation of losses.

Petitioner’s apparent tolerance of losses from his Schedule F

activities is thus contrary to the position he would have permitted

at United and suggests a lack of a profit motive with respect to

his cattle-raising and deer operations.

6. History of Income or Losses From the Activity

A history of losses over an extended period of time may

indicate the absence of a profit objective. See Allen v.
 - 18 -

Commissioner, supra at 34. Although a long history of losses is an

important criterion, it is not necessarily determinative. See

Engdahl v. Commissioner, 72 T.C. at 669; Allen v. Commissioner,

supra. For instance, a series of startup losses or losses

sustained because of unforeseen circumstances beyond the control of

the taxpayer may not indicate a lack of profit motive. See Engdahl

v. Commissioner, supra; sec. 1.183-2(b)(6), Income Tax Regs.

Petitioners were engaged in cattle raising for nearly 20

years, sustaining losses well past the length of time that can be

called the “startup” period.

Petitioners maintain that severe drought and large

fluctuations in the price of cattle caused most of their losses.

We do not agree with this claim. On the basis of climate and

meteorological data from the years in issue, it is apparent that no

drought existed in those years. These losses were not unforeseen.

Even if it were assumed that drought or fluctuations in the market

price of cattle contributed to the losses, petitioner was raised on

a cattle ranch in that region of Texas and on the basis of his

personal experiences, as well as the advice he received from

experts, knew that the region was susceptible to drought and that

the price of beef often fluctuated. Petitioners failed to take

substantial remedial action to compensate for these conditions

which, petitioners apparently claim, existed for nearly 20 years.
 - 19 -

Consequently, petitioners’ long stream of losses with regard to

their cattle-raising and deer operations militates against a

finding of profit motive.6

7. The Amount of Occasional Profits Earned, If Any

If an activity generates only small, infrequent profits and

typically generates large losses, the taxpayer conducting the

activity may not have a profit objective. See Golanty v.

Commissioner, supra at 427; sec. 1.183-2(b)(7), Income Tax Regs.

In this context, profit means economic profit, independent of tax

savings. See Seaman v. Commissioner, 84 T.C. 564, 588 (1985).

Petitioners’ cattle-raising and deer operations achieved a

profit only once in more than 20 years. And the record indicates

that losses from these operations will continue for the foreseeable

future.

8. Taxpayer’s Financial Status

Substantial income from sources other than the activity in

question, particularly if the losses from the activity generate

substantial tax benefits, may indicate that the activity is not

engaged in for profit. See Hillman v. Commissioner, T.C. Memo.

1999-255; sec. 1.183-2(b)(8), Income Tax Regs.

For 1992, 1993, and 1994, petitioners had $572,164, $839,000,

6
We note that during the years in issue, Byron Kahla’s
salary was paid by United but not deducted on petitioners’
Schedule F. Had Byron Kahla’s salary been deducted as a Schedule
F expense, petitioners’ Schedule F losses would have been
greater.
 - 20 -

and $619,611, respectively, in unrelated gross income. During the

same years, petitioners claimed $211,868, $162,454, and $187,951,

respectively, in Schedule F losses. Petitioners used these losses

to reduce their gross income by 37 percent for 1992, 19 percent for

1993, and 30 percent for 1994. These reductions led to substantial

tax savings.7

9. Elements of Personal Pleasure or Recreation

The existence of recreational elements in an activity may

indicate that the activity is not engaged in for profit; on the

other hand, where an activity lacks any appeal other than profit,

a profit motive may be indicated. See Hillman v. Commissioner,

supra; sec. 1.183-2(b)(9), Income Tax Regs.

Petitioners’ recreational objectives were a significant

component of their cattle-raising and deer operations. Petitioner

grew up on his parents’ cattle ranch, where he often enjoyed the

hunting of deer, a passion he was able to continue on his own

ranches. Moreover, petitioners entertained friends and families on

both ranches during holiday seasons and other special occasions.

7
Petitioners’ cattle-raising activities also enabled
them to reduce their State property taxes by as much as 90
percent. According to one of petitioners’ expert witnesses, this
tax benefit was available to taxpayers who made land “look like a
ranch” solely by placing “a few cows [on the property] whether it
is run profitably or not”.
 - 21 -

Conclusion

Giving due consideration to the record as a whole, we conclude

that during the years in issue petitioners did not enter into or

carry on their cattle-raising and deer operations with an intent to

make a profit. Accordingly, we sustain respondent’s disallowance

of petitioners’ Schedule F losses.

In reaching our conclusions herein, we have considered all

arguments presented and, to the extent not discussed above, find

them to be without merit.

To reflect the foregoing,

Decision will be

entered for respondent.