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T.C. Memo. 1997-408

UNITED STATES TAX COURT

CHARLES H. BUTLER AND JUDITH K. BUTLER, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24078-94.

Filed September 15, 1997.

Sandra G. Scott and Stephen M. Moskowitz, for petitioners.

Marion T. Robus, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

Respondent determined deficiencies in

petitioners' Federal income tax as follows:

Year

1991

1992

1993

Deficiency

$7,669

28,678

1,924

- 2 The principal issue presented for our consideration is whether

petitioners' operation of a farm was an activity not engaged in

for profit within the meaning of section 183.1

If we find the

activity was not engaged in for profit, then we must decide

whether legal expenses incurred by petitioners may be deducted

under section 162 or 212 as ordinary and necessary expenses

incurred with respect to property held for investment.2

FINDINGS OF FACT3

At the time of the filing of their petition, petitioners

Charles H. Butler and Judith K. Butler resided in Pescadero,

California.

Charles H. Butler (hereinafter referred to as

petitioner husband) was an engineer who designed power plants.

Petitioner husband possessed bachelor's and master's degrees in

engineering.

Judith K. Butler (hereinafter referred to as

petitioner wife) graduated from high school.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

Petitioners conceded adjustments in the amounts of $1,805

and $423 with respect to their real properties at Arnold Way,

Half Moon Bay, Cal., and Stage Road, Pescadero, Cal., and

respondent has conceded that in the 1993 taxable year petitioners

are entitled to an additional deduction of $4,859, which

represents a portion of a 1992 passive activity loss adjustment.

The parties' stipulation of facts and exhibits are

incorporated by this reference.

- 3 Petitioners spent approximately 1 year looking for real

property to acquire in northern California.

On July 25, 1979,

they purchased an 80-acre ranch in Pescadero (hereinafter

Pescadero property or ranch) for $275,876.80.

An artificial

8-acre pond, which also served as a reservoir, was located on the

ranch.

As part of a larger tract of land, the Pescadero property

had formerly been operated as a dairy farm.

The ranch had two

residences and several large barns and equipment sheds.

There

also was a granary that had been used as a cheese house.

When petitioners acquired the Pescadero property, they had

no prior experience as farmers.

Petitioner husband, at the time

of trial, owned a subchapter S corporation, Energy Design

Engineering Corp. (Energy Design), which provided consulting

services to the electric utility industry.

intermittently profitable.

Energy Design was

Petitioner husband also was part

owner of Cogeneration Acquisition & Development Corp.

(Cogeneration), which furnished consulting services to the

development of cogeneration projects as well as electric power

projects in the United States.

Cogeneration was regularly

profitable but eventually ceased business.

The Pescadero property was in a severely neglected condition

when petitioners purchased it.

Over a period of several years,

petitioner husband made substantial improvements to at least one

of the residences, such as installing a heating system and

- 4 electrical wiring and fixing the roof, which leaked.

plumbing system was also repaired.

The

Petitioner husband also made

structural repairs to the barns on the property.

The barns had

plumbing systems installed and were electrically rewired.

Petitioners also repaired and installed fences around the

property.

The reservoir added value and was important to the Pescadero

property because the land was otherwise "dry".

for irrigation and livestock purposes.

It was utilized

Other than the reservoir

itself, the Pescadero property did not have access to water which

would independently sustain livestock.

As part of a proposed aquaculture project, petitioner

husband seeded the reservoir with fish, such as catfish.

Petitioner husband intended to raise and sell fish from the

reservoir.

However, the project was never fully implemented

because a neighbor siphoned off water, causing an insufficient

oxygen supply to support aquatic life.

Petitioner husband

intended to raise fish at a later time.

In 1984, there were floods which affected the Pescadero

property, requiring repairs to the damage and cleanup of silt in

the reservoir.

Subsequently, from 1987 through 1989, there was a

drought in the area .

Sometime in 1989, petitioner husband commenced installing an

irrigation system on the Pescadero property, utilizing the

- 5 reservoir water.

The irrigation system had been recommended by

the San Mateo Farm Bureau and the U.S. Department of Soil

Conservation as the best method to maximize the productivity of

the land or livestock.

Subsequently, for the next several years,

petitioner husband spent significant amounts of money to extend

and maintain the irrigation system.

Petitioner husband expected that the Pescadero property

would appreciate over time, and he was prepared to invest

additional capital toward that end.

Petitioner husband believed

that the ranch was worth $1 million.

Farming Activity

Prior to the purchase of the Pescadero property, when

petitioners resided in Sonoma County, California, petitioner wife

worked for 2 years, without pay, for an individual who operated a

ranch that raised game birds for hunting purposes.

Early in

petitioners’ ownership of the Pescadero property, petitioner

wife, with the intention of starting a similar operation,

transported a number of chukars and quail to the Pescadero

property.

The game bird activity, however, was ultimately

unsuccessful.

Subsequently, petitioner wife ascertained that neighboring

farms were raising goats and sheep.

In turn, she purchased goats

and sheep as livestock for the Pescadero property.

During the

taxable years at issue, petitioners maintained approximately 25

- 6 cattle and 60 sheep.

At the time of trial, petitioners

maintained approximately 22 cattle and 65 sheep.

Petitioners may

also have raised some goats and horses on the Pescadero property

during the years at issue.

Petitioner husband worked on the Pescadero property after

his regular work hours and on weekends.

He spent, on average,

approximately 10 to 12 hours a day on weekends and about

2 hours on weeknights.

He repaired the fence around the ranch,

and he maintained and extended, as needed, the irrigation system.

Petitioner husband repaired the buildings, an activity which he

believed was necessary to increase or maintain the value of the

property so it would continue to appreciate and be attractive.

Petitioner wife spent approximately 60 to 70 hours per week

on the ranch.

property.

She handled daily operations on the Pescadero

In the mornings, she released the sheep locked up in

the pens, fed the sheep, filled up the watering troughs, and

ensured that none of the livestock were ill or missing.

She also

checked the structural integrity of the fences.

Petitioner wife

repaired and cleaned out the barns as necessary.

She performed

worming operations on the sheep twice a year.

Shearing in the

spring was not done by petitioners.

At the time of the purchase of the Pescadero property,

petitioners had two children.

They participated in the 4-H Club

program and helped raise the cattle and turkeys.

The animals

- 7 were judged and, eventually, sold at auction.

The children did

not reside on the ranch during the years at issue.

There were occasional sales only in 1992, through auctions,

of livestock (cattle and sheep) and a goat.

Petitioners were members of the San Mateo Farm Bureau.

This

organization provided literature and advice on farming as well as

farm-related supplies.

The Bureau also provided insurance for

buildings on the farm.

Petitioners also obtained information on

agriculture from local farmers as well as publications from the

University of California at Davis, the U.S. Soil Conservation

Agency, and the U.S. Department of Agriculture.

Dell'Oca Suit

Petitioners executed a water use agreement (agreement) with

the owner of an adjoining parcel of land, Conrad J. Dell'Oca

(Dell'Oca), in conjunction with the purchase of the Pescadero

property.

The agreement provided that petitioners and Dell'Oca

would have "exclusive dominion" over the reservoir water.

Additionally, the agreement stated that there would be

restrictions on withdrawals of water during times of shortage if

such withdrawals would interfere with the intended use of the

pond for protecting and sustaining livestock, fish, and wildlife.

On July 5, 1985, petitioners applied to the California State

Water Control Board (water control board) for a permit to divert

and store water from an outside stream into the reservoir on the

- 8 Pescadero property.

On June 22, 1988, the water control board

issued a permit granting petitioners the exclusive right to use

the water contained in the reservoir.

On August 22, 1988, petitioners initiated a lawsuit against

Dell'Oca in the Superior Court of the State of California, San

Mateo County (State court).

Petitioners alleged that they had

suffered damages in the form of loss of agricultural income and

damage to their livestock, wildlife, fish, and recreational use.

In a second amended complaint, petitioners alleged that

Dell'Oca's alleged overconsumption of the reservoir water limited

petitioners' ability to utilize the reservoir for fire

protection, fish and wildlife enhancement, stock watering,

recreation, domestic, and irrigation purposes or to entice

prospective lessees.

Petitioners also alleged that the value of

the Pescadero property had been diminished.

relief, among other things, through:

Petitioners sought

(1) A cause of action to

quiet title to interest in water; (2) a cause of action to quiet

title to interest in land; (3) a cause of action for declaratory

relief regarding interest in land (prescriptive easement).

On July 23, 1993, the State court entered final judgment

apportioning the parties' use of the water.

Petitioners received

the preponderance of the available water arising from the permit

issued by the water control board.

The parties were limited in

the amount of water they could procure although the legal

- 9 restriction did not apply to the incidental use of water by

livestock directly at the reservoir site.

Knauss Suit

On February 28, 1991, a lawsuit was filed in the State court

against petitioners by Lee R. Knauss and Joan F. Knauss (the

Knausses), and other associated parties, to obtain an easement in

a roadway bisecting the Pescadero property.

The Knauss suit

alleged, among other things, that the Knausses had been deprived

of access to their adjoining property.

On June 28, 1993, a judgment was filed in the Knauss suit,

whereby the State court determined that petitioners had acquired

by the doctrine of adverse possession or prescriptive

extinguishment all right, title, and interest in the Pescadero

ranch roadway.

In that regard, the Knausses were found to have

no right-of-way or easement in petitioners' property.

Expenses and Other Items

Petitioner husband kept a series of separate folders in a

file cabinet for each line item on Schedule F.

As each expense

was incurred, he obtained a receipt and placed it in the proper

folder.

Petitioner husband segregated receipts for expenses

connected with the farm from those for expenses that were not

farm related.

No separate checking account was maintained for

farm-related expenses because checks relating to the property

were infrequent.

Petitioner husband believed that he was able to

- 10 maintain and retrieve proper records when required to do so.

records of the number of livestock were maintained.

Petitioner

husband intended to go into the farming business so that he could

leave the engineering profession.

once his herd doubled in size.

He expected to make a profit

Petitioners believed the main

obstacle to profitability to be availability of water for the

livestock.

Petitioners believed that this factor prevented the

number of livestock from expanding.

Petitioners, on their joint Federal income tax returns,

reported the following items:

1987

19891

1990

Wages

$82,107 $76,000 $88,300

Interest income

4,542

11,510

14,936

Farm gross income

198

N/A

Farm expenses

(23,470) (37,538) (32,613)

Net farm income or (loss) (23,272) (36,989) (32,613)

1991

$65,678

21,478

715

(64,086)

(63,371)

1992

$105,344

9,019

1,919

(164,566)

(162,647)

1993

$52,532

9,568

(600)

(61,111)

(61,711)

The record does not provide information regarding the 1988 taxable year.

Petitioners apparently added the loss of $600 to the total expenses of

$61,111 for a net loss of $61,711.

Petitioners reported that the principal product of their farming

activity was "General Livestock".

Petitioners, on their 1991,

1992, and 1993 Schedules F (Profit or Loss from Farming), claimed

attorney’s fees as "Labor hired",

in the amounts of $45,961,

$139,397, and $43,004, respectively.

- 11 OPINION

We must decide whether petitioners' activities were "not

engaged in for profit" within the meaning of section 183(c).

Section 183(a) provides that, if an activity engaged in by an

individual is not engaged in for profit, no deduction

attributable to that activity shall be allowed except as provided

in section 183(b).4

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."

Sec. 183(c).

Section 162 allows a deduction for all ordinary and

necessary expenses paid or incurred in carrying on a business.

Section 212 allows a deduction for all the ordinary and necessary

expenses paid or incurred for the production or collection of

income, or for the management, conservation, or maintenance of

property held for the production of income.

Whether deductions are allowable under section 162 or 212

depends on whether the taxpayer engaged in the activity with the

objective of making a profit.

Elliott v. Commissioner, 90 T.C.

960, 970 (1988), affd. without published opinion 899 F.2d 18 (9th

In the case of an activity not engaged in for profit, sec.

183(b)(1) allows a deduction for expenses that are otherwise

deductible without regard to whether the activity is engaged in

for profit. Sec. 183(b)(2) allows a deduction for expenses that

would be deductible if the activity were engaged in for profit

but only to the extent the total gross income derived from the

activity exceeds the deductions allowed by sec. 183(b)(1).

- 12 Cir. 1990); Ronnen v. Commissioner, 90 T.C. 74, 91 (1988);

Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without

published opinion 702 F.2d 1205 (D.C. Cir. 1983).

While a

reasonable expectation of profit is not required, petitioners'

profit objective must have been bona fide.

Hulter v.

Commissioner, 91 T.C. 371, 393 (1988); Taube v. Commissioner, 88

T.C. 464, 478-479 (1987); Beck v. Commissioner, 85 T.C. 557, 569

(1985); Dunn v. Commissioner, 70 T.C. 715, 720 (1978), affd. 615

F.2d 578 (2d Cir. 1980).

Whether petitioners possessed the necessary profit objective

is a question of fact to be resolved on the basis of all the

facts and circumstances of the particular case at hand.

Golanty

v. Commissioner, 72 T.C. 411, 426 (1979), affd. without published

opinion 647 F.2d 170 (9th Cir. 1981); Dunn v. Commissioner, supra

at 720.

Petitioners here bear the burden of proof on this issue.

Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).

Greater

weight is given to objective facts than a taxpayer's statement of

intent.

Independent Elec. Supply, Inc. v. Commissioner, 781 F.2d

724 (9th Cir. 1986), affg. Lahr v. Commissioner, T.C. Memo. 1984472; Beck v. Commissioner, supra at 570; Thomas v. Commissioner,

84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256 (4th Cir. 1986);

Dreicer v. Commissioner, supra.

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

nonexclusive list of factors to consider in determining whether

- 13 an activity is engaged in for profit.

These factors are:

(1)

The manner in which the taxpayers carry on the activity; (2) the

expertise of the taxpayers or their advisers; (3) the time and

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

the expectation that assets used in the activity may appreciate

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

activities; (6) the taxpayers' history of income or losses with

respect to the activity; (7) the amount of occasional profit, if

any, which is earned; (8) the financial status of the taxpayers;

(9) whether elements of personal pleasure or recreation are

involved.

every case.

Not all of these factors are necessarily applicable in

Brannen v. Commissioner, 722 F.2d 695, 704 (11th

Cir. 1984), affg. 78 T.C. 471 (1982); Taube v. Commissioner,

supra; Abramson v. Commissioner, 86 T.C. 360, 371 (1986); Allen

v. Commissioner, 72 T.C. 28, 34 (1979).

No one factor nor a

majority of the factors is necessarily determinative, nor do we

reach our conclusion by simply counting the factors that support

each party's position.

Keanini v. Commissioner, 94 T.C. 41, 47

(1990); Taube v. Commissioner, supra at 480; Dunn v.

Commissioner, supra at 720.

The Manner in Which the Taxpayers Carry On the Activity.

The fact that a taxpayer generally carries on an activity, in a

businesslike manner and maintains complete and accurate books and

records may be indicative of a profit motive.

Similarly, where

- 14 an activity was conducted in a manner substantially similar to

comparable businesses that are profitable, and where changes were

attempted in order to improve profitability, a profit motive may

be indicated.

Engdahl v. Commissioner, 72 T.C. 659, 666 (1979);

sec. 1.183-2(b)(1), Income Tax Regs.

There is little evidence that petitioners operated their

farm with the expectation of profitability.

Petitioner husband

argues that he has maintained records for his activities.

Petitioner husband kept records consisting of receipts that were

segregated in folders according to each Schedule F line item.

Petitioners did not maintain a separate checking account or a

system of ledgers which would have provided a basis for

ascertaining revenue and expenses.

Significantly, there is

nothing in the record showing that petitioners conducted an

analysis or investigation of the profitability of farming in

their area.

Finally, and more significantly, petitioners did not

prepare an analysis of the revenues and expenses that their

property could achieve with more livestock (either cattle or

sheep) to determine whether it could then be operated in a

profitable manner.

Petitioners did not demonstrate that the manner in which

they conducted the farming operation was reasonably calculated to

produce a profitable return.

Although petitioners reported their

farming activity as "General Livestock", there was no inventory

- 15 of the livestock.

There were intermittent sales, through

auctions, of livestock (cattle and sheep), but only during 1992.

Also, there was a 1992 sale of a goat for $35.

Petitioners did

not engage in a sustained practice of purchasing, culling, or

selling the livestock.

Petitioners assert that they were limited in the amount of

cash they could infuse into the Pescadero property in order to

make the farming activity profitable, repairing the existing

structures, and building the irrigation system, as well as

attempting to manage and expand the livestock.

Petitioners,

however, did not attempt to obtain financing to expand the

farming activity.

In that regard, the irrigation system was not

installed until 10 years after the purchase of the Pescadero

property.

Petitioner husband contended that he repaired farm buildings

to "add value and maintain the value of the property so it will

continue to appreciate and be attractive."

Petitioners also

initiated a lawsuit against Dell'Oca to protect the value of the

property from any diminution that would result from the alleged

overuse of the water in the reservoir.

Petitioners' major focus

was on the possibility that the Pescadero property might

appreciate in value.

Although petitioner husband contended that he wanted to

raise fish in the reservoir as a business activity, he also

- 16 contended that he was unable to implement that project because of

disputes concerning the water usage.

Other than a drought in

1987, the litigation concerning the reservoir apparently was not

an impediment to petitioners' use of the reservoir for raising

fish.

Petitioners testified that significantly increasing the size

of their livestock herd would result in profitability for their

farming venture; however, their herd remained approximately the

same during the years at issue (25 cattle and 60 sheep) and at

the time of trial (22 cattle and 65 sheep).

The Expertise of the Taxpayers or Their Advisers.

Petitioners were not experienced farmers, and although petitioner

wife had some experience in raising game birds, she did not

demonstrate that she took steps to successfully operate a farm.

Petitioners attempted to become knowledgeable about the market

for cattle and sheep; they sought advice from local farmers, read

farming materials from the San Mateo Farm Bureau, and consulted

with various institutions such as the University of California at

Davis, as well as the U.S. Department of Soil Conservation.

Time and Effort Expended by the Taxpayers in Carrying On the

Activity.

Petitioners expended significant time in the farming

activity.

Petitioner husband worked full time as an engineer,

and he also worked approximately 30 hours a week (10-12 hours per

- 17 day for 2 days on the weekend and 2 hours each weeknight) on the

Pescadero property.

Sec. 1.183-2(b)(3), Income Tax Regs.

The Taxpayers’ History of Income and Losses With Respect to

the Activity.

Under section 1.183-2(b)(6), Income Tax Regs.,

losses in the initial stages of an activity are not necessarily

indicative of a lack of profit motive.

However, when unexplained

losses have continued for an extended period of time, they may be

probative that an activity is not engaged in for profit.

v. Commissioner, supra at 34.

Allen

Specifically, the presence of

losses in the formative years of a business is not inconsistent

with an intention to achieve a later profitable level of

operation.

The goal must be to realize a profit on the entire

operation, which presupposes recouping past losses in addition to

current expenses.

Bessenyey v. Commissioner, 45 T.C. 261, 274

(1965), affd. 379 F.2d 252 (2d Cir. 1967).

Petitioners did not take steps to address the continuous and

substantial losses incurred in connection with the Pescadero

property.

Petitioners' main argument is that their farm could not be

profitable due to ongoing legal disputes.

They assert that they

were precluded from expanding their farming operations because of

the uncertainty regarding the water supply.

Petitioners did not,

however, show that the herd size was maximized to comport with

the amount of water available in the reservoir.

Petitioners'

- 18 claims are further undermined by the fact that for several years

after the purchase of the ranch, and prior to the water use

dispute in 1988, they were not limited in utilizing the water in

the reservoir (other than by the agreement and the 1987 drought).

After the conclusion of the litigation with Dell'Oca, petitioners

did not augment or increase the size of their livestock herd even

though they were legally guaranteed a significant portion of the

reservoir water.

Expectations That Assets Used in the Activity May Appreciate

in Value.

Section 1.183-2(b)(4), Income Tax Regs., provides that

profit includes expected appreciation in assets such as land.

Appreciation may explain a taxpayer's willingness to continue to

sustain losses.

Allen v. Commissioner, 72 T.C. at 36; see also

Fields v. Commissioner, T.C. Memo. 1981-550.

Unrealized

appreciation is relevant to deciding whether the taxpayer has a

profit objective.

Lemmen v. Commissioner, 77 T.C. 1326, 1342-

1343 n.22 (1981).

Section 1.183-1(d)(1), Income Tax Regs., provides that in

order to determine to what extent section 183 and the regulations

thereunder apply, the activity or activities of the taxpayer must

be ascertained from all the facts and circumstances.5

(d) Activity defined--(1) Ascertainment of

activity. In order to determine whether, and

to what extent, section 183 and the

(continued...)

- 19 Petitioners assert that the sustained losses were offset by the

appreciation in value of the Pescadero property.

Respondent

counters that petitioners' farming activity and holding of the

Pescadero property were separate activities and the assets used

in each activity must be separately considered with respect to

this element.

Petitioners estimated that from 1979 to the time of trial,

on the basis of the sale prices of neighboring parcels of land,

their farm appreciated at least $724,124 ($1 million, the

estimated real estate value, less the $275,876.80 purchase price)

and that the appreciation indicates a profit objective.

In that

regard, petitioners made substantial improvements to the

residence(s), the barns, and other buildings, as well as

installing an irrigation system.

Petitioners made these

improvements with the intention of "add[ing] value and

maintain[ing] the value of the property so it will continue to

appreciate and be attractive."

The circumstances are different with respect to their

farming activity.

Petitioners stated that once their livestock

(...continued)

regulations thereunder apply, the activity or

activities of the taxpayer must be

ascertained. * * * In ascertaining the

activity or activities of the taxpayer, all

the facts and circumstances of the case must

be taken into account. * * * [Sec. 1.1831(d)(1), Income Tax Regs.]

- 20 had sufficiently increased in weight, they would be sold at

auction.

Petitioners also asserted that their livestock would

increase in size and value through breeding.

The record does not

support petitioners' assertions.

Section 1.183-1(d)(1), Income Tax Regs., provides that

Where land is purchased or held primarily with the

intent to profit from increase in its value, and the

taxpayer also engages in farming on such land, the

farming and the holding of the land will ordinarily be

considered a single activity only if the farming

activity reduces the net cost of carrying the land for

its appreciation in value. Thus, the farming and

holding of the land will be considered a single

activity only if the income derived from farming

exceeds the deductions attributable to the farming

activity which are not directly attributable to the

holding of the land (that is, deductions other than

those directly attributable to the holding of the land

such as interest on a mortgage secured by the land,

annual property taxes attributable to the land and

improvements, and depreciation of improvements to the

land).

In that regard, petitioners' gross income derived from their

farming activity for the taxable years 1991, 1992, and 1993, was

$715, $1,919, and zero, respectively.6

Petitioners' car and

truck expenses for the taxable years, 1991, 1992, and 1993, were

$2,601, $7,124, and $3,724, respectively.

The nominal income

from the farming activity fell far short of the deductions

attributable to the farming activity (e.g., the car and truck

expenses).

Sec. 1.183-1(d)(1), Income Tax Regs.

Accordingly,

Petitioners entered a loss of $600 for gross income

derived from their farming activity for the 1993 taxable year.

- 21 the farming activity and the holding of the land cannot be

construed to be a single activity.

Petitioners may not utilize

the appreciation of the land to support their argument that it

should offset the farming losses.