Vineyard Hobby or Business?
We regularly get this question from our clients. This is a very important question, and one that should be asked as early as possible because; it will affect the way you run your vineyard, how you keep records, the taxes you pay, and the amount of enjoyment you derive from your farming activities.
First off, it is very important to understand that the amount of taxes you are expected to pay, or save, does not determine whether your vineyard is a business or a hobby. The IRS presents nine factors in Reg. Sec. 1.183-2(b)(1)–(9) that needs to be applied to each case’s unique facts and circumstances. CPAs and their clients should record their evaluation based on these factors, and re-evaluate it regularly. If the IRS audits you fifteen years down the line after ten years of losses due to bad weather and disease, they need to be convinced that you and your advisers truly believed that that this was going to be a profitable business. Although profit expectation is an important factor, it is by no means exclusive evidence of a business endeavor.
Let’s look at two examples and run them through the nine factors. We will look at Jennifer and Peter.
Jennifer is a Cal Poly graduate, has a degree in organic farming, and earns $25,000 a year from working part-time as an acupuncturist. She and her husband inherited 10 acres of land in Paso Robles, where they now live in a modest house.
Peter is an urologist, works full-time, and owns a medical clinic. He earns $800,000 a year. His gardening skills are limited to raking leaves and flinging the watering hose in the direction of dry patches. He bought a 10 acres property in Paso Robles where he built himself a weekend cottage worth $900,000.
What is the same for Jennifer and Peter? Both Jennifer and Peter are planting four acres of grape vines, and both hope that their grapes will one day be used in a vineyard designate wine. Both expect the value of their property (plantable vineyard land) to grow. They also both make use of a vineyard management team because the small scale of their vineyards does not justify buying all the equipment needed. They also need the vineyard management team’s expertise and advice.
Running the numbers for Peter and Jennifer–both expect to make an operating loss before tax of about $300,000 on the grapes over a 25-year period (establishment plus life of vineyard). Both expect the value of their plantable vineyard land to increase by about $500,000 over the 25 year period, providing them each with a positive net return of about $200,000.
Let’s now look objectively at the 9 factors in Reg. Sec. 1.183-2(b)(1)–(9) to determine if a profit objective exists:
“(1) Manner in which the taxpayer carries on the activity.”
Jennifer is constantly trying new farming methods, implementing cost cutting measures, and maintains detailed records of each penny she is spending on the farm. (business)
Peter is also meticulous in his record keeping. He contracted his CPA to keep track of all farming expenses, calculate when each deduction can be taken, and to measure actual performance against a detailed business plan annually. (business)
“(2) The expertise of the taxpayer or his advisors.”
Jennifer attended a two-week grape growing course at UCDavis. She also plans to attend more courses in the future. Her degree in organic farming is coming in handy. She consults regularly with her vineyard management company, and reads up on new farming techniques and practices. (business)
Peter compensates for his lack in expertise by regularly consulting with his vineyard management company. He appointed them after doing thorough research. He also consults regularly with other farming consultants to be sure that he is implementing only the best farming practices. (business)
“(3) The time and effort expended by the taxpayer in carrying on the activity.”
Jennifer spends every minute she gets in her vineyard. (business)
Peter does not have as much time to spend on the farm as he would have liked. He has a full-time job and other business responsibilities to attend to as well. He is only on his farm about every second weekend. For this reason, he employed a very competent and qualified vineyard management company, after extensive research and due diligence. (business)
“(4) Expectation that assets used in activity may appreciate in value.”
“The term profit encompasses appreciation in the value of assets, such as land, used in the activity.”
Even though both Jennifer and Peter expect a loss on the grapes, they expect a bigger profit on the appreciation in value of the land used for business purposes. The overall effect is a net profit. (business)
“(5) The success of the taxpayer in carrying on other similar or dissimilar activities.”
Jennifer has never owned a vineyard before. She has never been involved with any other business ventures either. (hobby)
Peter previously owned a share in some land with a vineyard on it. He and his business partner used a vineyard management company to improve the yield of the vineyard, and they sold the established vineyard five years ago at a significant profit. Peter also owns a medical clinic that is making healthy profits. He is a well respected businessman in the community. (business)
(6) “The taxpayer’s history of income or losses with respect to the activity.
A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit.”
Jennifer and Peter are just starting their vineyards now, so past income or losses does not apply in our example.
However, the above illustrates an excellent reason to create a professional business plan from day one. A vineyard takes longer than most businesses to be profitable, and if things go wrong ten years down the line, you deserve at least to be able to get the tax write-offs (if it was genuinely a business). We will get back to this point in the next article when we compare the tax consequences of a vineyard business with a vineyard hobby.
In a recent court case, Samer Mikhail and Mariana Mikhail v. Commissioner, the court disallowed losses under the hobby loss rules of §183. One of the arguments of the court was that although the taxpayers kept records of their expenses, they did not use the records to analyze their business performance or to prepare profit projections, an analysis, or a budget. They did not change their strategy or tactics to increase the likelihood of earning a profit. If it was genuinely a business, the taxpayers would have been concerned when losses were being incurred and would have taken corrective action.
“(7) The amount of occasional profits, if any, which are earned.”
If both Jennifer and Peter allocated to their vineyard operations only 4 of the 10 acres of their land, their expected net return over the investment would be the same. For Jennifer, there is an opportunity cost because she could have sold the inherited land but decided to keep it. For Peter, it was an out-of pocket expense.
For both of them, the overall net return is rather small- about $200,000 over a 25 year period. This is from about $500,000 for the initial investment in land and establishment costs, $100,000 in preproductive period costs, plus annual field period costs of about $30,000. It is a small return.
Factor #7, however, actually refers to the size of profits expected in some years compared to the size of losses in others. It also refers to the potential for an extremely big return, even if the odds are low.
A vineyard of this size that depreciates capital costs and recognizes unrealized gains on the land’s appreciation in value is expected to make small losses for about 10-15 years, followed by small profits for the remainder. It is not a venture capital investment.
This factor does not place Jennifer or Peter in either hobby or business categories.
“(8) The financial status of the taxpayer.”
This is an extremely important factor, and often the deal breaker in combination with the next factor.
Jennifer does not have other material sources of income. Her financial success or ruin is dependent on the success of her vineyard (business).
Peter has significant other sources of income (hobby).
“Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit, especially if there are personal or recreational elements involved.”
This is a deal breaker for Peter and puts him solidly in the hobby category. The $200,000 profit over a 25 year period compared to his annual income of $800,000 shows that his financial success is not dependent on the success or failure of this endeavor. The $900,000 weekend cottage on the property also counts against him because of the obvious independence from the vineyard’s profits (hobby).
In a recent court case, Merrill C. Roberts v. Commissioner, the court actually found that, even though the taxpayer had significant other sources of income, he was not an excessively wealthy individual. His house was mortgaged and he continued to work long hours at physically demanding endeavors. If Peter were in the same court, the judge probably would have found this factor to be neutral.
“(9) Elements of personal pleasure or recreation.”
Recreational enjoyment is not always an indication of a hobby. Many of us enjoy and even choose our careers based on our personal interests.
“[…] the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit. An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit […]”
As discussed under factor 7 above, both Jennifer and Peter expect a very small return from the vineyard. Even though other investment opportunities are available that are expected to provide higher returns, their motives could still be seen as for-profit. The other distinguishing factors are therefore more important than the size of the expected profit or the amount of personal enjoyment expected.
Jennifer is in the vineyard most every day, getting her hands dirty. (business)
Peter, on the other hand, is happy to leave all the hard work to the vineyard management company, and will only check in with them once a month. Peter does not know much about farming practices, and prefers to stay out of the vineyard management company’s way. He is also not planning to attend any training courses in the wine industry. He is more concerned with hosting elaborate parties at his vineyard residence. (hobby)
Similar conduct got the taxpayer in trouble in the Merrill C. Roberts v. Commissioner case.
Based on the above evaluation, Peter has a hobby and Jennifer has a business.
If Peter (in addition to what he was doing correct above) attend some farming courses, actively pursue cost cutting measures, truly attempt to find the highest selling price for his grapes, and balance out the elaborate social events on his vineyard with spending some time with his hands in the dirt, he could have possibly also had a business. Having to do all these things might, however, ruin the recreational enjoyment for Peter.
How big a deal is having your vineyard designated a hobby, rather than a business? In the next article we will look at the tax consequences. It might not be as bad as you’d expect. Both scenarios, however, require some tax planning and good record keeping. The last thing you want is to be paying taxes on your hobby, or not be able to write off losses on a business that went south.