In the recent Tax Court case of Carson v. Commissioner (Docket No. 23086-25),[1] the IRS found itself in a challenging position due to a significant misunderstanding regarding the nature of the reported activity on Schedule F. This misunderstanding led the agency to claim that the activity was not conducted for profit, which would have resulted in severely restricted deductions under IRC §183 on the taxpayers’ returns.

The IRS suffered substantial repercussions due to the ensuing confusion. The Court's ruling concluded that the IRS had focused on the wrong issue, resulting in an unfavorable outcome for the agency regarding the profit motive aspect. Moreover, the Court emphasized that critical issues, which had the potential to give rise to additional tax obligations, were not properly brought before the Court for examination.

The Family Ranch

The case at hand centered on a ranch that had been originally owned by Ms. Carson’s grandmother and subsequently inherited by her mother. In a strategic move to facilitate the transfer of the ranch to her children, Ms. Carson’s mother established a trust.

In 2009, Mrs. Carson’s mother transferred most of her property, including the ranch, to a revocable trust that she controls during her life. Mrs. Carson’s mother is still alive. Under the revocable trust, if Mrs. Carson’s mother dies, and is predeceased by Mrs. Carson’s stepfather, the property of the trust is to be distributed to Mrs. Carson and her brother equally. If Mrs. Carson’s mother dies, and Mrs. Carson’s stepfather is still alive, the property of the trust will become a life estate of Mrs. Carson’s stepfather, and then at his death, will be distributed to Mrs. Carson and her brother equally.[2]

Ms. Carson and her mother subsequently entered into agreements related to the ranch:

In two successive agreements dated 2013 and 2016, respectively, Mrs. Carson agreed with her mother that she, Mrs. Carson, would contribute financially to the ranch; and that every year Mrs. Carson and her mother would jointly agree about how much, if any, cash distributions would be made from the ranch to Mrs. Carson.[3]

The Court subsequently provides details about the agreement between Mrs. Carson and her mother regarding the reporting of income and expenses tied to the ranch:

From 2014 to 2019, Mrs. Carson made substantial financial contributions to the ranch by paying its expenses. By then the ranch included land adjoining the quarter section. This land was owned by the trust. It served as pasture. The ranch made money mainly by selling cattle. The receipts from cattle sales were reported on the returns of Mrs. Carson's mother. The Carsons did not generally report the ranch's income on their returns because they did not receive any cash distributions from the ranch pursuant to the 2013 and 2016 agreements.[4]

One would naturally anticipate that the IRS would raise several questions and concerns regarding this arrangement. Was it considered a partnership? Given that the trust was revocable, allowing Ms. Carson’s mother to reclaim ownership of the ranch at any given time, it raises doubts about whether there was a genuine trade or business being conducted by the Carsons. Additionally, the expenses being paid by the Carsons—were they truly expenses of the trust, which appeared to be the entity conducting the trade or business?

Surprisingly, the IRS chose instead to focus solely on the activities of Ms. Carson’s children, particularly scrutinizing their involvement in rodeos:

The Carsons’ two children lived at the ranch helping in the ranch’s business of raising cattle for sale. For this purpose, the children used horses, some of which they also used to compete in cash-prize rodeos. The children also performed manual labor for neighbors of the ranch.[5]

The IRS’s decision to concentrate on the children’s rodeo activities appears to be influenced by the fact that, as per the agreements with Ms. Carson’s mother, all livestock income was reported on the mother’s return. Consequently, the only income recorded on Schedule F originated from the children’s activities.

For 2017, the Carsons filed a Schedule F for their “livestock” activity. The Schedule F reported gross income of $2,741, consisting of rodeo competition winnings of the Carsons’ children. The Schedule F claimed deductions for total expenses of $128,990.

The Schedule F for 2018 reported gross income of $8,063, consisting of $1,867 in compensation for labor performed by the Carsons’ children for local ranchers, and $6,196 in rodeo competition winnings of the children. The Schedule F claimed deductions for total expenses of $133,929.

For both tax years 2017 and 2018, the Schedules F reported no gross income from the ranch’s activities, except for the gross income amounts already discussed, because this gross income was reported on the returns of Mrs. Carson’s mother.[6]

The Schedule Fs filed for the years 2014 to 2019 undoubtedly served as the proverbial red flags that caught the IRS's attention:

During the six years 2014 to 2019, the Carsons reported cumulative losses of $502,742 on the Schedules F. For each year, these losses not only dwarfed the gross income reported on the Schedules F (consisting mainly of rodeo winnings), but they largely offset the Carsons’ ordinary income in the form of wages. It is perhaps no surprise that the deductions from the losses came under scrutiny by the IRS.[7]

The IRS Gets Distracted by the Rodeo

The taxpayers incurred significant losses as a result of an arrangement deliberately designed to prevent them from receiving any income. Moreover, they were continuously exposed to the risk of the party receiving the income reclaiming ownership of the ranch, which could potentially lead to its transfer to another individual, such as Ms. Carson’s brother. Given these circumstances, it is plausible for the IRS to argue that this arrangement may not qualify as a legitimate business activity or, at the very least, may lack a reasonable expectation of generating profit.

However, the IRS agent became fixated on the meager income disclosed on the Schedules, primarily stemming from the rodeo competitions in which the children participated.

The examining agent determined that the activity reported by the Schedules F was rodeo, not ranching. The main reason the examining agent determined that the activity reported on the Schedules F was rodeo, and not ranching, was that the only gross income reported on the Schedules F was from rodeo winnings (and from some compensation for the children’s work for neighbors) but not ranching income. The examining agent interviewed Mrs. Carson, but ignored her explanation that the Schedules F expenses mainly related to ranching activity through which Mrs. Carson participated through the agreements with her mother. He determined that the activity reported on the Schedules F was not an activity engaged in for profit under section 183. The determination was reflected in the notice of deficiency, which disallowed all deductions claimed on the Schedules F for 2017 and 2018.[8]

The crux of the matter lies in the government’s flawed assertion that the primary purpose of the business was to fund the children’s personal rodeo activities. This contention was clearly mistaken. As a result, the analysis pertaining to the absence of a reasonable profit motive from the rodeo work becomes irrelevant when considering the more significant issues: whether the taxpayers’ engagement in ranching constituted a legitimate trade or business, and if so, whether it was being conducted with the genuine intention of turning a profit.

As the opinion notes:

Mrs. Carson testified credibly at trial that the Schedules F expenses mainly related to the ranch rather than to rodeo. The Commissioner's litigating position is premised on the Schedule F expenses being related to the rodeo activity. For example, the litigating position supposes that the Carsons lost approximately $120,000 per year entering their children in rodeos. In reality, the Carsons lost this money primarily in ranching activities, the profit objective of which the Commissioner does not directly challenge. In summary, the Commissioner's position under section 183 makes no sense in light of our view that the deductions reported on the Schedules F mainly related to ranching.[9]

The IRS neglected to acquire and thoroughly analyze pertinent information concerning the nature of the ranching activity. Furthermore, during the trial, the judge was unwilling to permit the IRS to alter their approach and shift the focus towards examining the ranching activity based on the information available at trial.

The Court declines to refocus the Commissioner’s challenge to the Schedules F deductions by determining what relatively small part of the activities reported on the Schedules F consisted of rodeo activities rather than ranch activities. To do so would be difficult in this case. Although Mrs. Carson kept meticulous details of the expenses that were deducted on the Schedules F, and although these records would have allowed the Court to more precisely sort the expenses between ranching and rodeo, Mrs. Carson did not bring the records to trial. She believed — correctly — that the Commissioner did not challenge the substantiation behind the deductions. Without the substantiation, the Court cannot sort the deductions between ranch and rodeo without resorting to rough justice. Under these unique circumstances, I hold that the Commissioner has waived the right to refocus his challenge on the relatively narrow rodeo activities. I further hold that the activity or activities reported on the Schedules F for 2017 and 2018 were engaged in for profit.[10]

The IRS suffered substantial repercussions due to the ensuing confusion. The Court’s ruling concluded that the IRS had focused on the wrong issue, resulting in an unfavorable outcome for the agency regarding the profit motive aspect. Moreover, the Court emphasized that critical issues, which had the potential to give rise to additional tax obligations, were not properly brought before the Court for examination.

The Court recognizes the presence of possible concerns pertaining to the relationship in question. However, it is important to emphasize that the Government did not opt to delve into or raise those specific issues, resulting in their omission from the Court's deliberations and ultimate decision.[11]

[1] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/deductions-were-for-for-profit-ranching-activities%2c-not-rodeo/7gpl7 (retrieved May 20, 2023)

[2] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[3] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[4] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[5] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[6] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[7] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[8] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[9] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[10] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023

[11] Carson v. Commissioner, Tax Court Bench Opinion, Docket No. 23086-25, May 18, 2023