Faulconer v. C.I.R.

• Decision Date: 20 November 1984
• Docket Number: No. 83-2014,83-2014
• Citation: 748 F.2d 890,55 A.F.T.R.2d 85
• Parties: -302, 84-2 USTC P 9955 Hunter FAULCONER, Sr. and Mary T. Faulconer, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 890

748 F.2d 890

55 A.F.T.R.2d 85-302, 84-2 USTC P 9955

Hunter FAULCONER, Sr. and Mary T. Faulconer, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 83-2014.

United States Court of Appeals, Fourth Circuit.

Argued March 6, 1984.

Decided Nov. 20, 1984.

V.R. Shackelford, Jr., Orange, Va. (Shackelford & Robertson, Orange, Va., Thomas A. Davis, Davis & McLeod, Washington, D.C., on brief), for appellants.

Jo-Ann Horn, Tax Div., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Ann Belanger Durney, Tax Div., Dept. of Justice, Washington, D.C., on brief), for appellee.

Before WIDENER and HALL, Circuit Judges, and HAYNSWORTH, Senior Circuit Judge.

WIDENER, Circuit Judge:

Hunter and Mary Faulconer (taxpayers) appeal the judgment of the Tax Court, 1983 T.C.M. (P-H) p 83,165, which disallowed certain tax deductions and credits attributable to their farming activity on the ground that this activity was not engaged in for profit. The Tax Court thus found deficiencies in income taxes due from the taxpayers in the aggregate amount of $60,635.49 for the years 1970, 1972, 1973, and 1975. We reverse.

I

Hunter Faulconer, age 75 at the time of the Tax Court hearing, has operated two farms in Albemarle County, Virginia, since 1950. From the age of 9 he grew up on one of the farms and operated the same as his father's executor during 1947-50. For all the time since 1950, he has actively engaged in horse breeding, racing, and selling, as well as cattle raising and selling (collectively referred to as the farming activity ¹ ) on these farms. Mary Faulconer is a party to this § action solely because she filed tax returns jointly with Hunter Faulconer, her husband. The taxpayers incurred a net loss in their farming activity in five out of the seven tax years 1970 to 1976, and realized a net profit in two of those seven years, specifically, 1971 and 1975. A summary of the income and expenses of this farming activity follows: ²

The details of the farming activity and the gains and losses therefrom are referred to with more particularity below.

After an audit of the taxpayers' returns, the IRS determined that taxpayers' farming activity was not engaged in for profit under the standards of I.R.C. Sec. 183, ³ a determination that had several tax consequences. The IRS disallowed deduction of the net farm losses from the taxpayers' other income, see I.R.C. Sec. 183(a)-(b); disallowed an investment credit; disallowed farm-fuel credits under I.R.C. Secs. 39, 6420; and assessed against the taxpayers additional self-employment tax. The taxpayers challenged this determination in the Tax Court, and claimed further that they were entitled to an additional refund of $1,144 because their loss in 1972 was greater than they had originally calculated. See supra note 2. The Tax Court rejected the taxpayers' claims, finding that the farming activity was not engaged in for profit.

II

A survey of the statutory and regulatory framework is in order, particularly because the Tax Court focused exclusively on the issue of profit motive under the so-called hobby-loss provision, I.R.C. Sec. 183, and failed to mention the inseparable issue of whether the taxpayers' farming activity was a trade or business.

Taxpayers are allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on a "trade or business" under I.R.C. Sec. 162(a). We have required that a business be undertaken "in good faith for the purpose of making a profit" in order for its expenses to be deductible under I.R.C. Sec. 162. Malmstedt v. Commissioner, 578 F.2d 520, 527 (4th Cir.1978); Cecil v. Commissioner, 100 F.2d 896, 899 (4th Cir.1939). Particularly relevant to this case is the regulation under section 162 that allows a farmer who operates a farm "for profit" to deduct as necessary expenses all amounts actually expended in the carrying on of the business of farming. 26 C.F.R. Sec. 1.162-12(a).

Related to section 162 is I.R.C. Sec. 212, which generally allows an individual to deduct ordinary and necessary expenses paid or incurred in profit seeking activities that do not rise to the level of a "trade or business." ⁴ If an individual incurs a loss in a trade or business, or in any transaction entered into for profit unconnected with a trade or business, I.R.C. Sec. 165(c) permits the individual to deduct the loss.

Congress supplemented these provisions in the Tax Reform Act of 1969, Pub.L. No. 91-172, Sec. 213(a), 83 Stat. 487, 571-72, by enacting I.R.C. Sec. 183 out of concern about the ineffectiveness of a prior provision ⁵ in reaching taxpayers who were not carrying on a business to realize a profit but who were merely attempting to utilize losses from an operation to offset other income. H.R.Rep. No. 413, 91st Cong., 1st Sess., Leg.Hist., U.S.Code Cong. & Admin.News 1969, pp. 1645, 1717; S.Rep. No. 552, 91st Cong., 1st Sess., Leg.Hist. at 2027, 2133.

Section 183 generally allows deductions only to the extent of gross income in an activity "not engaged in for profit." ⁶ This provision plainly defines an activity not engaged in for profit as an activity other than one with respect to which deductions are allowable under sections 162 and 212(1) and (2). I.R.C. Sec. 183(c). Section 183, therefore, does not come into play unless there has been a determination that an activity is not a trade or business under section 162 or not actively related to the production or collection of income under section 212. See Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir.1984).

In the legislative history of the Tax Reform Act of 1976, the committee reports explain that "the rules for determining whether an activity is a trade or business or engaged in for the production of income are the same as those used for determining whether an activity is engaged in for profit (i.e. under I.R.C. Sec. 183)." H.R.Rep. No. 658, 94th Cong., 2d Sess. 163, 1976 U.S.Code Cong. & Ad.News 2897, 3057; S.Rep. No. 938, 94th Cong., 2d Sess., pt. I, at 151, 1976 U.S.Code Cong. & Ad.News 3439, 3583. ⁷ The regulations under section 183, therefore, explicate the profit-motive requirements of sections 162 and 212, and courts have properly relied on the section 183 factors in making the profit-motive analysis under sections 162 and 212. See Brannen v. Commissioner, 722 F.2d at 704.

Under I.R.C. Sec. 183, a taxpayer ordinarily has the burden of persuasion to show that he is engaged in an activity for profit. See Nickerson v. Commissioner, 700 F.2d 402, 404 (7th Cir.1983). This is merely a corollary to the general rule that an assessment of the Commissioner is presumptively correct and the taxpayer has the burden of proving it wrong. E.g., Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933). But that is not the end of the analysis; section 183 provides that an activity "shall be presumed" to be engaged in for profit if a taxpayer can establish that his gross income from the activity exceeded the deductions attributable thereto in two out of five consecutive taxable years. I.R.C. Sec. 183(d). In the case of an activity "which consists in major part of the breeding, training, showing, or racing of horses," the presumption arises if gross income exceeds deductions in two out of seven consecutive years. ⁸ This special treatment for horse breeding activities was added by amendment on the Senate floor out of recognition that "the breeder ... is engaged in a long-cycle operation of recognized uncertainty, often requiring investment over several years of funds from other sources." 115 Cong.Rec. 38,295 (1969) (amendment of Sen. Cooper). If the relevant number of profit years is met, an activity is presumed to be engaged in for profit "unless the Secretary establishes to the contrary." I.R.C. Sec. 183(d).

We find little assistance in the case law for determining the effect of this presumption. ⁹ The only comment in the committee reports on the effect of the presumption was made by Senator Gore. In his individual views appended to S.Rep. No. 552, Leg.Hist. at 2349, 2377, he complained:

[T]he Committee rule creates a highly undesirable precedent in placing the burden on the IRS of overcoming the presumption. The taxpayer is the one who has the facts and he should carry the burden of showing he intends to make a profit. While the IRS has the burden of proof in cases involving fraud, it does not and should not in ordinary tax cases.

Unless the statutory language is ignored, and we do not think that it can be, we believe Senator Gore's comments accurately reflect what Congress did in enacting section 183. Once the taxpayer has established that the requisite number of profit years has been met, the burden of proof shifts to the Secretary to "establish[ ] to the contrary." Not only is the wording of the statute clear, a literal construction is supported by the only legislative history on the subject. Thus, we see no reason to treat the presumption any differently than others; if nothing else appears, the presumption requires a fact finder to accept the fact presumed, in this case that the activity is engaged in for profit. Wigmore on Evidence, Chadbourne Rev. (1981) Sec. 2490, 2491. The inquiry in which we then engage is whether or not the Secretary has met his burden of proof, whether he has "establishe[d] to the contrary" in the words of the statute.

The ultimate determination of whether an activity is engaged in for profit is to be made, according to the legislative history and the regulations, by reference to objective standards, taking into account all of the facts and circumstances of each case. A taxpayer's mere statement of intent is given less weight than objective facts. A reasonable expectation of profit is not required, but the facts and circumstances must indicate that the taxpayer entered into or continued the activity with the objective of making a profit. 26 C.F.R. Sec. 1.183-2(a); S.Rep. No. 552, Leg.Hist. ...