In Garbini v. Commissioner [T.C. Summary Opinion 2004-2007], the tax court said that the taxpayers did not keep the type of records which could be used to increase the profitability of the ranch.
They never prepared a business plan, or budgets or market projections which would outline strategies for ensuring a profit.
The court said that their recordkeeping practice of creating monthly lists from canceled checks simply was inadequate and not indicative of a prudent and reasonable person in business.
Records should be as comprehensive as possible, and help show how you made efforts to reduce expenses in order to operate the ranch in a profitable manner.
It is also important to have periodic appraisals of your ranch property to help substantiate any appreciation in value. The appraisal should take into account improvements you have made to the ranch which help enhance value.
Cattle ranching is a time-consuming activity that requires significant day-to-day participation by the owner.
Many ranchers are itinerant, that is, they only occasionally visit the ranch to oversee activities. They hire ranch managers who provide management services.
How regularly you are physically present at the ranch has much less relevance nowadays on one’s actual day-to-day management of the ranch, because management duties can be conducted from any location.
The problem with this is that if you delegate management control to another individual, this will be evidence you are engaged in a passive activity, particularly if you cannot prove you have participated in the venture for 500 hours or more per year.
The IRS often rules any losses in such cases are “passive” in nature, and therefore cannot be used to offset other income of the taxpayer.
To show you have retained management control, an important item of evidence is a written contract with the ranch manager.
Not having a written contract is not only unbusinesslike, but can create problems with regards to the passive loss rule.
In a contract with the manager, it should be made clear that you, the taxpayer, retain ultimate management authority pertaining to all aspects of the venture.
That includes what cattle to buy, what to sell, hiring and firing decisions for contract labor and every manner of day-to-day decision making.
It should indicate that you retain the power to hire and fire workers and the power to direct their activities.
The contract should make clear that success of the venture depends in large part upon the decisions made entirely by you in consultations with advisers, including the ranch manager.
It should also indicate that your participation is required to be on a regular, continuous and substantial basis. The contract should make clear that any decisions by the ranch manager must be authorized by the taxpayer.
To supplement the contract, it is helpful to maintain a time log showing the amount of time you devote to the ranch activities.
The time expended should consist of such things as speaking to other ranchers, determining which type of cattle to breed, the pricing and what would have the most value for the situation.
Your time also should include attendance at auctions, preparation prior to the auctions and consultations with industry experts for the purpose of buying and selling cattle.
It should also indicate the amount of time spent researching the cattle industry by studying industry journals, reference materials and Internet resources.
Any consultations with advisers should also be included, referencing the names of the consultants, what advice was obtained and what decision or action was taken in response. 
John Alan Cohan is a lawyer who has served the livestock, horse and farming industries since 1981. He can be reached at: (310) 278-0203, or at his website: www.johnalancohan.com
