Eight Circuit Sympathetic to Taxpayer's Arguments that Cattery Was a Trade or Business, but Still Denies Deductions (Parker's Federal Tax Bulletin: August 2012)

A recent decision is a cautionary tale of what can happen when a taxpayer tries to turn a hobby into an actual business and what additional steps a taxpayer may want to take to prove the business is genuine. In DKD v. Comm'r, 2012 PTC 191 (8th Cir. 7/17/12), the taxpayer alleged that her kitten business was a legitimate trade or business. In fact, the taxpayer's cattery had won four national championships. While the Tax Court concluded the enterprise was no more than a hobby, the Eight Circuit was not so quick. It found some legitimacy in the taxpayer's argument that her corporation was operating a trade or business with respect to the kitten activities. Had the taxpayer taken a few extra steps to prove she had a good-faith, subjective intention to make a profit, the outcome might have been different. In the end, however, the Eighth Circuit affirmed the Tax Court's decision and held that the taxpayer couldn't deduct the cattery expenses.

Background

DKD is an Iowa corporation wholly owned and managed by Debra Dursky. Debra ran DKD out of her home in West Des Moines, Iowa. DKD's principal source of income was information technology consulting. Debra was DKD's only employee engaged in the consulting business. DKD also operated a cattery to breed, show, and sell pedigree show kittens. Before 2003, Debra and Elizabeth Watkins operated the cattery as an informal, unincorporated business. When Debra and Elizabeth decided to expand the cattery operation, to enhance its national reputation and to increase profits, DKD assumed responsibility for the cattery. Debra and Elizabeth continued to manage the cattery from Debra's home.

To enhance the cattery's national reputation, DKD entered its kittens in national competitions. Debra and Elizabeth anticipated that breeding national champions would increase the value of DKD's premium show-quality kittens to between $1,000 and $5,000 per kitten. Between 2003 and 2005, DKD's cattery won four national championships. For tax years 2003, 2004, and 2005, DKD reported a total income of approximately $198,000, $235,000, and $214,000, respectively.

DKD paid Debra an annual salary of $80,400 plus other compensation, including healthcare benefits and a profit-sharing plan. DKD paid Debra $1,000 per month to rent office space in her home for DKD's consulting and cattery operations. During 2003-2005, DKD reimbursed approximately $61,000, $67,000, and $68,000, respectively, to Elizabeth and Debra for out-of-pocket expenses associated with the cattery, such as travel and competition costs, veterinary bills, cat food, grooming, and supplies. DKD also paid Elizabeth an annual salary of $7,700 for the approximately 1,700 hours Elizabeth devoted to the cattery's operation each year. The cattery produced no revenue in 2003, $250 in 2004 from the sale of three cats, and $1,525 in 2005 from the sale of eight cats.

Due to the substantial costs associated with competing on the national circuit, unexpected expenses and market forces, breeding problems, and inadequate revenues from kitten sales, DKD could not afford to continue operating the cattery. Also, in 2006, Debra and DKD were informed that the IRS was going to audit their 2003 and 2004 tax returns. Around August 2006, Debra and Elizabeth discontinued operating DKD's cattery activity, but continued operating the cattery activity as individuals (i.e., a separate unincorporated venture).

Tax Court's Decision

The IRS audited DKD's and Debra's tax returns from 2003 to 2005 and found substantial tax deficiencies. DKD and Debra appealed the IRS's assessment to the Tax Court. In T.C. Memo. 2011-29, the Tax Court disallowed DKD's claimed deductions for:

(1) operational expenses of the cattery, finding the activity was a personal hobby of Debra rather than a genuine trade or business of DKD;

(2) payments toward the profit-sharing plan that benefitted Debra, deciding that the plan was ineligible for deductions because it discriminated in favor of Debra, a highly paid employee; and

(3) medical benefits paid by DKD for Debra's benefit, determining the payments were not made pursuant to a qualifying plan.

According to the Tax Court, Debra and Elizabeth were just looking for a way to deduct expenses, and there was no evidence they ever intended to make a profit.

With respect to Debra's returns, the Tax Court held that DKD's payments in support of the cattery and to fund the pension plan were constructive dividends to Debra and thus taxable income. The Tax Court also agreed with the IRS that Debra was liable for income taxes on the medical benefit payments made by DKD on her behalf. DKD and Debra appealed to the Eighth Circuit.

Trade or Business Issue

The Eighth Circuit noted that the most important criterion for determining if a trade or business exists is the existence of a genuine profit motive. The court found some legitimacy in the argument that DKD was operating a trade or business with respect to the kitten activities. The court noted that DKD: •operated a website marketing its kittens; •successfully raised four national champion kittens; and •earned some income in 2004 and 2005 from kitten sales.

The mere fact that DKD's cattery expenses vastly exceeded its income, the Eighth Circuit stated, was insufficient to disprove the existence of a genuine profit motive. Additionally, the Eighth Circuit said it would be incorrect for the Tax Court to disallow a trade or business deduction merely because, in the court's view, the business venture was unlikely to produce the desired profits. According to the Eighth Circuit, the rule is clearthe Tax Court should find the trade or business venture lacked a genuine profit motive only if the court finds, as a factual matter, that the taxpayer lacked a good-faith, subjective intention to make a profit and was engaged in the activity for wholly different reasons.

However, the Eighth Circuit said that while it disagreed with some of the Tax Court's reasoning, it could not say the Tax Court clearly erred in finding DKD failed to carry its burden of establishing that for each of the years at issue, DKD's cattery activity constituted a trade or business within the meaning of Code Sec. 162(a). As a result, the Eighth Circuit affirmed the Tax Court on this issue.

Practice Tip: The Tax Court honed in on the fact that Debra and Elizabeth had operated the cattery as an unincorporated venture before and after DKD was involved. And the court noted that they both spent large amounts of time and money and had never made a profit. Had Debra and Elizabeth put together a marketing or business plan showing how they were going to change things so they could make a profit and consulted with experts, they might have had a different outcome.

Constructive Dividend Issue

The Eighth Circuit agreed with Debra that a shareholder does not receive a constructive dividend merely because the shareholder derives personal pleasure or satisfaction from the operation of a business. However, the court disagreed with Debra's interpretation of the Tax Court's findings. The Tax Court's constructive dividend findings, the court stated, had to be considered in light of its determination that DKD lacked a genuine profit motive to operate the cattery. Because DKD lacked a legitimate business purpose to operate the cattery, the Tax Court reasonably inferred DKD operated the cattery for no other reason than to finance Debra's personal hobby.

Debra also argued that the Tax Court erred by calculating the constructive dividend in terms of the cost to DKD rather than explicitly determining the financial benefit to Debra. What Debra failed to recognize, the court stated, was that, in certain circumstances, the value of a constructive dividend may be measured by the cost to the corporation. DKD financed the cattery solely for the personal benefit of Debra, the court stated, thereby relieving Debra of the substantial hobby costs associated with the cattery's operation. According to the Eighth Circuit, it was not clear error for the Tax Court to find, as a matter of fact, that the economic benefit conferred on Debra was equal to the costs incurred by the corporation. Thus, the Eighth Circuit affirmed on the constructive dividend issue.

Profit-Sharing Plan Issue

In 2003, DKD contributed $10,000 to a profit-sharing fund established by DKD and managed by Fidelity Brokerage Service, LLC. In 2004, DKD contributed $20,000 to the plan. DKD claimed contribution deductions under Code Sec. 404. The notices of deficiency provided to DKD asserted that these payments were not an ordinary and necessary business expense and that the deductions were therefore improper. Before the Tax Court, the IRS raised a different argument, alleging the pension plan discriminated in favor of Debra, a highly compensated employee, because Elizabeth was not included in the plan. The Tax Court agreed and denied DKD's claimed deductions and included the contributions in Debra's taxable income as constructive dividends.

The Eighth Circuit reversed on this issue, finding that because the IRS raised a new issue at trial, it had the burden of proof. The court concluded that the IRS clearly failed to establish DKD's pension plan discriminated in favor of Debra. Further, the court said, because funds properly allocated to a qualifying pension plan are taxable to the beneficiary only when they are actually distributed, DKD's contributions to the pension plan did not constitute taxable income to Debra. The court concluded that DKD was entitled to deduct contributions to the plan, and those contributions are not taxable to Debra as a constructive dividend.

DKD and Debra also argued that DKD was entitled to deduct a $5,000 contribution made to the profit-sharing fund in 2006, which DKD attempted to deduct on its 2005 tax return. The Tax Court found DKD bore the burden of proof on this matter, because DKD raised the issue for the first time before the Tax Court. DKD and Debra did not challenge the Tax Court's conclusion with respect to the burden of proof.

The Eight Circuit remanded to the Tax Court for further consideration the questions of (1) whether DKD's 2006 contribution to the profit-sharing plan qualified for deduction in tax year 2005; and (2) whether that distribution was taxable to Debra as a constructive dividend.

Health Insurance Issue

Finally, DKD and Debra asserted that the Tax Court erred in deciding payments made by DKD to provide health insurance for Debra were neither an ordinary and necessary business expense nor an accident or health plan excludable from Debra's income. However, the Eighth Circuit affirmed the Tax Court on this issue because the Tax Court permissibly found that DKD failed to prove the payments were made pursuant to a pre-determined plan for the benefit of employees.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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