Businesses fail. That’s a feature of capitalism, not a bug. Mark Twain discovered that when he lost his first fortune investing in a business that failed, the Paige Compositor. He not only lost his fortune but some say he also lost his sense of humor. Certainly his later works become more dystopian. See e.g. The Mysterious Stranger, or A Connecticut Yankee in King Author's Court.
But sometimes businesses just go through a rough patch, netting a loss from operations in one year, but having profitable years before and/or after. Section 172 permits taxpayers to take those Net Operating Losses (NOLs) as a deduction against the income earned in prior and later years.
But the key word in Net Operating Loss is “Operating.” To get the NOL, the taxpayer must be able to show the loss arose from an existing business, one that was actually operating. And it is not always easy to tell when a business actually starts operating. That is the lesson we learn in James M. Root and Valerie K. Root v. Commissioner, T.C. Memo. 2025-51 (May 22, 2025) (Judge Toro). There the taxpayers lost a lot of money in 2014 in what they later claimed was a recreational ranch business and attempted to take a §172 deduction on their 2017 and 2018 returns. Judge Toro explains why their activities in 2014 did not amount to operating a business in that year.
Details below the fold.
Law: To Get a §172 Deduction, You Need a §165(c)(1) Deduction
Section 172 permits all taxpayers to deduct in one tax year the Net Operating Losses (NOLs) they incurred in both prior and subsequent years. An NOL is defined as the excess of deductions over gross income. §172(b). However, for individual taxpayers, that basic definition is modified to require that the losses arise from the conduct of a trade or business. §172(d). See Laney v. Commissioner, T.C. Memo. 1997-403 at p. 13 (“As a result of subsections (c) and (d) of section 172, the basic category of an individual’s losses that may constitute net operating losses is losses from the conduct of a trade or business.”) (sorry, I can find no free link to this opinion).
One other feature of §172 bears mention: timing. Generally, each tax year stands alone. Section 172 permits taxpayers to cross years. The details are somewhat gnarly but the basic idea is that an NOL can be carried forward into later years. As Judge Toro points out, the purpose of §172 is to allow a business “to set off its lean years against its lush years.” Op. at 13. And that is true even if the lean year generating the NOL occurred has become a closed year. In such case a NOL properly claimed in that year can still be applied to the current year under the rules in §172.
Law: To Get a §165(c)(1) Deduction, You Need An Operating Business
Section 165(c) authorizes a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” For individual taxpayers, however, that general rule applies only to three types of losses, spelled out in §165(c):
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from.
A taxpayer who seeks to deduct a loss has the burden to show that the loss falls within the scope of §165(c). For example, a taxpayer claiming a §165(c)(2) deduction must identify the transaction which produced a loss rather than the intended profit. See Dominie v. Commissioner, T.C. Memo. 1975-94 (1975) (again I cannot find a free link—damn this monetization of the internet!).
Today’s case concerns a taxpayer who, in order to get the §172 NOL deduction, needs to identify a loss deductible under §165(c)(1). To get that deduction, a taxpayer must properly connect the loss to an existing trade or business. As Judge Toro explains, the determination of whether a taxpayer has a trade or business is the same for §165(c)(1) purposes as it is for §162 purposes. Op. at 6 (“The Supreme Court and our Court have applied the same standard under both section 162(a) and section 165(c)(1) to determine whether a trade or business exists.”)
So let’s take a look. First, there must be a trade or business and, second, the taxpayer must be “carrying on” the business: it must be operating.
- Test for Trade of Business
Until 1987 the received wisdom was that a “trade or business” must be an activity where a taxpayer offers goods or services to the public. Deputy v. du Pont, 308 U.S. 488, 499 (1940) (Frankfurter, J., concurring) (“carrying on any trade or business, within the contemplation of [the predecessor to §162], involves holding one's self out to others as engaged in the selling of goods or services.”) (internal quotes omitted). If you were not doing that, you were either a hobbyist or an investor.
In 1987 the Supreme Court abandoned the "holding out goods or services" test and substituted a Wobbly Table of Factors (WTF) test. There the taxpayer was an unemployed salesman who spent some 60-80 hours a week in 1978 betting on dog races. He had gross winnings of over $70,000 which looks pretty good until you realize his losing bets amounted to over $72,000. If his losing bets were attributable to a trade or business he would have avoided the Alternative Minimum Tax (AMT) as it applied in 1978. If the losing bets were not so attributable—if they were just hobby losses, for example—they would have been considered items of tax preference, largely ignored for AMT purposes. Thus he really wanted his gambling activity to amount to a trade or business!
The Supreme Court held he was in a trade or business, using this test: “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). Importantly, however, the Court deliberately declined to give any really helpful general rule to use. Indeed, the Court explicitly left the rule vague, to be resolved by the facts of each future case. It did so from a “concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code.” 480 U.S. at 36.
Courts distinguish a trade or business activity from two other types of income producing activities.
First, certain investment activities produce income and yet may not amount to a trade or business. Higgins v. Commissioner, 312 U.S. 212 (1941). I explored this distinction in Lesson From the Tax Court: Distinguishing Investment from Business Activity, TaxProf Blog (Apr. 22, 2019). Expenses associated with investment activities may be deducted under §212. And losses from investments are deductible under §165(c)(2). But §172 does not piggyback on net investment losses.
Second, sometimes an activity that is engaged in primarily for pleasure—we call those hobbies—also throws off some income. Expenses associated with hobby activities may be deducted under §183 but only up to the amount of the income from the hobby. See Lesson From The Tax Court: Freedom, Taxes, And Hobbies, TaxProf Blog (July 3, 2023). So, by definition, a hobby activity can produce no tax losses at all.
Bottom line: to be a trade or business activity, the taxpayer must show the activity is pursued regularly and continuously for profit and not as an investment or hobby activity.
- Test for “Carrying On”
Even if one can point to a trade or business activity, there are no deductions allowable under §165(c)(1) unless the losses are incurred “in” that trade or business. That means that the business must be in actual operation. This again parallels §162’s requirement that limits deductions to those expenses incurred in “carrying on” a trade or business.
When a taxpayer is actually “carrying on” a trade or business is, once again, a WTF test: a question of fact that depends on the circumstances of each particular case. See United States v. Manor Care, 490 F. Supp. 355, 361-62 (D. Md. 1980) (“[I]ssues of when a business begins … are issues to be determined on the facts of each case.”). As the Fourth Circuit explained after reviewing the case law:
“The uniform teaching of these several cases is that, even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not ‘engaged in carrying on any trade or business' within the intendment of section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. U.S., 345 F.2d 901, 907 (4th Cir.), vacated and remanded to consider additional claims, 382 U.S. 68 (1965) (footnotes omitted) (emphasis supplied).
The Tax Court has also long followed Richmond Television, noting that the Fourth Circuit included Tax Court cases in its review of case law. See Madison Gas & Elec. Co. v. Commissioner, 72 T.C. 521, 566 n.18 (1979).
With this background, let’s look at the facts of the case, recognizing the importance of the fact-finder, here Judge Toro. That is especially important in today’s case. Typically, Chief Counsel attorneys and taxpayers will stipulate the relevant facts and argue the law. However, here the legal test really depends on the facts. Was profit really the taxpayers’ “primary purpose” for the claimed business activity? That may depend on the credibility of the taxpayer’s testimony in the eyes of the factfinder.
Facts
Mr. and Ms. Root owned and operated a highly successful business in Medford, OR, that created and sold fruit puree around the world. This laudatory Los Angeles Time article noted that in 1996 their company, Sabroso, earned the Governor’s Achievement Award in international business. “Over the last decade, Sabroso emerged from being one of many producers of purees and concentrates to status as world leader and premier marketer of these healthy products, said Gov. John Kitzhaber in presenting the award in Portland.” They sold the business in 2008 to Tree Top Inc. for an undisclosed sum.
So they knew how to run a business.
The Roots also had a love of outdoors. In the 1990’s they bought a total of 86 acres in Klamath County “to develop ideas for a recreational ranch.” Op. at 2. Apparently it’s easy to enjoy the outdoors in Klamath County, at least per this Reddit thread. Between 2000 and 2006, the Roots contracted with an architect, builder, and interior designer to build a “Lodge/Residence (including a semi-attached guest wing and a simi-attached council house).” Op. at 3.
In 2006, the Roots discovered they had been had. Judge Toro explains:
“By the end of 2006, snow and rain caused the lodge to flood, revealing defects in its windows, roofing, and weatherproofing. In 2007 the Roots discovered hundreds of bats living in the walls of the lodge, along with rats and mice. The infestations caused a foul odor within the lodge. Later, it also became clear that the foundation of the lodge was defective.”
It gets worse. Turns out the foundation was so defective that Klamath County condemned the building in 2010. The Roots eventually tore it all down.
The poor Roots! They never got to use their lodge. They barely got to use their property. Judge Toro finds that “between 2002 and 2009, the Roots held about a dozen events on the property, none of which involved stays at the lodge. These events were by invitation only. The record reflects no payments to the Roots for these events.” Op. at 6.
Naturally, the Roots did what any red-blooded American would do: they sued everyone they could think of! In 2014 “the Roots recovered approximately $3 million through arbitration and litigation but paid approximately $4 million in legal fees.” Op. at 5.
On their original 2014 tax returns the Roots did not report any income or loss from a commercial recreational ranch business. They did file a Schedule C but listed Mr. Root’s principal business as a consulting business, reporting $300,000 of gross receipts and net profits of $10,000.
By May 2018, however, someone convinced the Roots that they could have reported an NOL on their 2014 return which would then allow them to carry that loss forward to 2017. So they amended their 2014 return and then filed a 2017 return claiming an NOL carryforward from 2014 of $3.7 million. On their 2018 return they claimed an NOL from 2014 of $3.3 million.
On audit of the 2017 and 2018 returns, the IRS said “no way” and disallowed the NOLs, also imposing the §6662(a) accuracy-related penalty for substantial understatement of tax.
Thus, the years at issue are 2017 and 2018. But the resolution depends on the validity of the 2014 NOL deduction. On their 2017 return the Roots claimed an NOL carryforward from 2014 of $3.7 million. On their 2018 return they claimed an NOL from 2014 of $3.3 million.
Well, I suppose a disallowance of $8 million in deductions is worth fighting, and so the Roots hired a law firm and petitioned Tax Court. That is when they discovered just how bad the advice they received had been. But it gives us a good lesson.
Lesson: Gotta Be “Operating” to Get NOL
Are you thinking hobby farm? Me too! And so was the IRS. I mean, the Roots never even applied for the relevant licensing from the county. And in the subsequent arbitration against their architect and builder, the settlement agreement referred to the lodge as a “high-end custom home.” But the Roots testified they intended the lodge to be for a business purpose, not personal. And Judge Toro says, in footnote 4, that “in view of our disposition, we need not resolve the parties’ factual dispute on this point.”
So this is not a hobby case. It’s about how and why the Roots did not qualify for a §172 carryforward because their losses did not come from an existing business. That disposition, dear readers, is a really lovely exegesis on what it means to be "operating" a business for 172 purposes, which is the same as “carrying on” a trade or business for 162 purpsoes. Here are my take-aways:
First, you don’t need actual income to be “carrying on” a business. We’ve seen this lesson before in Lesson From The Tax Court: No Product? No §162 Deduction!, TaxProf Blog (Feb. 1, 2021). The cases supporting that proposition all involve taxpayers who at least had contractual obligations to provide goods or services but just failed before any transactions were consummated. See Kellett v. Commissioner, T.C. Memo. 2022-62; Steven Austin Smith v. Commissioner, T.C. Summ. Op. 2019-12 (July 1, 2019). Judge Toro makes this point, citing to Cabintaxi Corp. v. Commissioner, 63 F.3d 614 (1995), which is a Judge Posner opinion, and so well worth your time.
But if you don’t have income you at least need contracts or other indications that you are ready and able to earn money. The Roots had nothing. They had no contracts to use the lodge commercially. Worse, Judge Toro finds that “throughout its existence, the lodge lacked the tools and infrastructure to accept customers.” Op. at 12. So there was, literally, nothing to show that the lodge was anything other than a useless structure.
Second, start-up activities are not carrying-on activities. The Roots tried to argue that their purchase of the acreage in the 1990’s or maybe the construction of the lodge in the 2000’s, or maybe their sporadic hosting of events on their acreage in the 2000’s should qualify as carrying-on activities. Nope. Judge Toro does a great job in rejecting all of those points. He basically says “yeah, those are all start-up costs and activities.” His actual language was this: “While the lodge was being designed and built, the purported business could not have performed the purpose for which it was organized.” Op. at 14.
Third, to be carrying on a business requires “continuity and regularity.” That is one of the biggest Factors in the Wobbly Table created by the Supreme Court in Grotzinger. Judge Toro find this factor weighs heavily against the Roots. Until 2008 they were running what was essentially a multinational company. Sure they may not have had time themselves to run a guest ranch lodging business, but they still could have proved involvement by, for example, showing that they had hired and supervised employees to perform business operations. They did not do that.
“And after the 2008 sale of Sabroso—when the Roots might have had more time to devote to the lodge—Mr. Root continued serving as the chief executive officer of Jim Root & Co. Moreover, by that time, the lodge’s defects had become apparent. Beyond their activities in pursuing construction remediation and ultimately recovery for their losses, the Roots have not shown that they were regularly and actively engaged in the running of the lodge.” Op. at 17.
Bottom line: Even accepting that the Roots truly intended to start a profit-making business of renting out lodging on a guest ranch, the facts and circumstances convinced Judge Toro that they simply had not started the business by 2014 and so §172 could not apply.
Comment 1: Penalties. The Roots appeared to have received really bad tax advice. It is somewhat curious, however, that their attorneys made zero effort to demonstrate their reasonable reliance on a qualified professional. That would enable them to avoid the §6662(a) 20% penalty which, when we are talking about an total $8 million adjustment, is not chump change. Judge Toro notes:
“The record does not demonstrate the qualifications of the advisers, the nature of the communications with them, or the quality or objectivity of the advice the Roots received. These facts are necessary to our analysis, and it was the Roots’ burden to provide them. This they did not do.” Op. at 20-21.
But perhaps their attorneys knew it would be futile to put … Norm Peterson (RIP) on the stand?
Comment 2: §165(c)(2). Again, thinking about the 2014 tax return, I wonder why the Roots did not attempt to claim a §165(c)(2) deduction. The idea would be that they entered into their various construction contracts with the intent of making a profit from the lodge. They could point to Dominie v. Commissioner, T.C. Memo. 1975-94, as support for the proposition that abandoning the activity before any business started does not prevent a loss deduction under §165(c)(2). Their attorneys made a belated attempt to argue that (see Op. at footnote 1), but I don’t see how it would help them with the 2017 and 2018 years. It would be a deduction to take on the 2014 return and by the time the IRS was auditing the 2017 and 2018 years, that was a closed year.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.
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