by Kimberly Stevens, alliantgroup Associate
What’s the best way to lead a horse to water? In the tax world, it’s by expecting a profit. On April 29, 2014, Tax Court Judge Elizabeth Paris issued an opinion regarding whether a horse-racer-turned-trainer may deduct certain horse-related expenses under section 183(b). The decision hinged on whether the petitioner could demonstrate he had the requisite profit objective to satisfy the requirements of section 183(b). Ultimately, the Court considered nine non-dispositive factors and reached an opinion favorable to taxpayers.
Background of Section 183
The Internal Revenue Code defines an activity not engaged in for profit as “any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212.” The Code begins with a presumption that, “if the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity (determined without regard to whether or not such activity is engaged in for profit), then, unless the Secretary establishes to the contrary, such activity shall be presumed for purposes of this chapter for such taxable year to be an activity engaged in for profit.” However, the Code makes an exception for horse-related activities, stating “in the case of an activity which consists in major part of the breeding, training, showing, or racing or horses, the preceding sentence shall be applied by substituting ‘2’ for ‘3’ and ‘7’ for ‘5’.”
These provisions are often referred to as the “hobby loss rules,” and provide a useful test to determine the intent of a taxpayer to conduct activities for profit. Ultimately, however, the final determination of a taxpayer’s intent to conduct a business activity for profit is accomplished by evaluating nine different factors as a whole. Moreover, the facts and circumstances must indicate the taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit. The relevant factors are:
- Manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or his advisors;
- The time and effort expended by the taxpayer in carrying on the activity;
- Expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- Elements of personal pleasure or recreation.
Furthermore, the existence of the requisite profit objective is a question of fact that must be decided on the basis of all of the facts and circumstances. In resolving this factual question, greater weight is given to objective facts than to a taxpayer’s statement of intent.
The Facts and Holding of Roberts v. Commissioner
Merrill Roberts began his career as a restaurant owner after purchasing an abandoned restaurant in 1969. Subsequently, he owned a gentlemen’s club, a pizza parlor, and eventually opened six other establishments in the Indianapolis area. Around 1997, petitioner bought a 45-acre parcel of land containing a horse stable used by the former owner. Because this acquisition made petitioner an official owner of a horse boarding stable, he was invited to a dinner hosted by the Indiana Thoroughbred Owners and Breeders Association. Later, Petitioner asked his trainer to “show him the ropes” of horse training, and eventually purchased his first two horses for $1,000 each in 1999. By 2001, he increased the amount of horses at his stable from two to ten, and even purchased a breeding stallion.
In 2004, Petitioner consulted a specialized professional called a blood stock agent for horse purchasing and breeding advice so he could substantially expand the bloodlines of the horses in his breeding program. By 2005, he wanted to build his own horse training facility on the Morris Street property, but the stable was in disrepair. Approximately one year later, Petitioner purchased a 180-acre parcel of land near Mooresville, Indiana for $1 million, and within the next six months he invested between $500,000 and $600,000 in building improvements for a first class horse training facility. The facility, completed and placed in service in 2007, includes a large training track, portable horse stalls, unique rehabilitation equipment, several specialized training areas, and small apartments for employees. Eventually, Petitioner focused his attention of choosing the races in which in horses would compete. His efforts were so successful that one of his horses was nominated to run in the Triple Crown Races. Petitioner claimed losses for horse-related activities on his tax returns for years 2005 through 2008. In March of 2011, the IRS issued a notice of deficiency to petitioner in the amounts of $169,785, $617,119, $297,150, and $297,640 for the same years, and this lawsuit ensued.
In her opinion, Judge Paris applied the above-mentioned nine factors to petitioner to determine whether his efforts constituted an honest object of making a profit. First, Judge Paris considered the manner in which Petitioner carried on the activity of horse training. Notable facts to the analysis were Petitioner’s significant changes in operation, adoption of new techniques, and abandonment of unprofitable methods when Petitioner moved from the Morris Street property to the Mooresville property. Particularly noteworthy was Petitioner’s hiring of an assistant horse trainer, which Judge Paris considered a significant change in Petitioner’s business model. The IRS contended Petitioner’s disorganization and reliance on an accountant were not “businessnesslike.” Ultimately, this factor favored Petitioner in tax years 2007 and 2008, but was neutral for tax years 2005 and 2006.
Next, the Court briefly considered the expertise of the taxpayer and his advisors. It was particularly significant that Petitioner incorporated advice from industry experts, and immersed himself into all aspects of the horse racing business. Specifically, Petitioner learned to administer medication and rehabilitate injured horses. Moreover, Petitioner participated in trade associations, was solicited for expertise advice, made contributions to the horse racing lobbying efforts. It was determined that Petitioner was “on the ground floor of improving economic conditions for horse racing in Indiana.” Thus, Petitioner satisfied this factor for all four tax years.
The subsequent factor analyzed was the amount of time and effort devoted to the activity. In Barbour v. Commissioner, the Court found that full-time participation in an activity tended to show that a taxpayer was engaged in a for-profit activity. Further, Barbour suggests that participation in unpleasurable work associated with an activity tends to show a profit objective. Here, Petitioner worked on horse-related activities some portion of every day by at least 2002 and full time by at least 2005. Additionally, Petitioner often endured cold winter temperatures to work with his horses. Furthermore, Petitioner performed other unpleasant and burdensome activities such as administering shots and rebuilding fences. In sum, petitioner devoted a significant amount of his personal time and effort to carrying on the activities where the activities did not have substantial personal or recreational aspects, and this tends to show a profit objective. The court found that, by tax year 2005, Petitioner devoted time and effort appropriate to demonstrate a profit objective for all the tax years in issue.
The fourth consideration is the expectation that the assets used in the activity will appreciate in value. Here, Petitioner’s horse-related activities include two different types of appreciable assets: first, the horses that petitioner bred and trained; second, the real property and capital improvements associated with his training facility. The IRS agreed that the horses were appreciable assets, but took issue with the real property. The court relied on the rule that, when a taxpayer’s primary intent is not to profit from the land, then the appreciation of the land is considered in a section 183 profit analysis. When Petitioner first purchased the Morris Street property, his primary intent was to gain from the real estate appreciation. Thus, the court next looked to his intent in purchasing the Mooresville property. There, petitioner specifically purchased and held the Mooresville property to breed and train horses. It was determined his primary intent was to build a premier horse training facility, and he purchased property to suit his needs. Petitioner started searching for a new location because problems arose from building a barn on the Morris Street property. Accordingly, when petitioner transferred the headquarters of his horse-related activities to Mooresville in 2007, this was the first tax year that real estate appreciation expectation weighs in favor of finding for petitioner’s profit objective under section 183. The factor was neutral for tax years 2005 and 2006.
Judge Paris immediately awarded the next factor to Petitioner when analyzing the issue of success in carrying on other activities. The Court considered that Petitioner built a successful nightclub business with little background, expanded his bar into a network of six different establishments, began a car dealership and an insulation company, and became a successful real estate speculator. In examining the next factor, the amount of occasional profits, the Court also expeditiously awarded it in favor of Petitioner. The Court opined, “Horse racing can be very speculative, and the expectation of profit may be very small. Racing a horse has been compared to investing in a wildcat oil well, where there may be substantial expenditures with little chance of profit.”
The eighth consideration is the financial status of Petitioner. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit. The court noted that Petitioner was not an excessively wealthy individual – his house was mortgaged, and he continued to work long hours at a physically demanding endeavor after resigning from several successful ventures. Further, petitioner participated less in the personal and recreational aspects of the horse-related activities starting in tax year 2007. Again, the court awarded every year under review to Petitioner.
Finally, the ninth factor is whether the activity involves personal pleasure or recreation. The presence of personal motives in the carrying on of an activity may indicate that the activity is not engaged in for profit, especially where recreational or personal elements are involved. At this point, the Court examined the difference between attending the racetrack and operating a training facility. Judge Paris opined, “While there is certainly work involved while at racetracks, there is also a higher level of recreation and social activity available at a racetrack. In contrast, the training facility is a largely private operation void of social or recreational activities.” During 2005 and 2006, Petitioner divided his time equally in the social and business aspects of horse racing. In 2007, when Petitioner hired the assistant trainer and built the training facility on the Mooresville property, his focus shifted toward business activities. Moreover, the Court opined that “a taxpayer may start an activity without a profit objective and later develop the desire and objective to earn a profit from the undertaking.” Accordingly, it was found that tax year 2007 was the year in which this was accomplished.
Ultimately, petitioner established the requisite profit objective for tax years 2007 and 2008, but not for tax year 2005 or 2006. The definitive year was 2007, when Judge Paris noted Petitioner “significantly changed his operation, opened a new facility on real estate specifically purchased for horse-related activities, and transitioned out of the recreational aspect of horse racing.” Accordingly, this analysis is highly fact-intensive, as learned from this case and others we have seen at alliantgroup, LP. In any hobby situation, the IRS and Tax Court will apply these nine factors to the circumstances to make its determination. As in this case, situations change over time and what were hobby losses became fully deductible as the Petitioner got more serious. Judge Paris also discussed substantiation at length (there was an unfortunate incident of records being burned in a fireplace). As always, it is important to maintain proper documentation to support the facts – the last thing you want is an IRS nightmare.