On December 21, 2021, the Tax Court issued a Memorandum Opinion in the case of Huff v. Commissioner (T.C. Memo. 2021-140). The primary issue presented in Huff was whether the petitioners’ miniature donkey breeding operation was an activity engaged in for profit within the meaning of IRC § 183.
Held: Actually, yes.
Author’s Note on Huff v. Commissioner
Judge Patrick J. Urda (who delivered this opinion) was a Classics major at Notre Dame, where he graduated summa cum laude. As an inveterate Latin nerd, my respect for Judge Urda it is unquestionable. The Huff opinion only furthers my admiration for the good jurist.
Background to Huff v. Commissioner
The petitioners “are an extremely wealthy couple who wanted to supplement the income of their adult daughter.” To do so, the petitioners did not let her rest on her parents’ laurels or her trust fund. Instead, they took a completely logical step and began breeding miniature donkeys through Ecotone Farm, LLC (Ecotone), a wholly owned entity.
During 2013 and 2014 the breeding activity produced losses of $87,236 and $47,039, respectively, which “piqued the interest” of the IRS, who thereafter issued a notice of deficiency that disallowed deductions for these losses and determined deficiencies for their 2013 and 2014 tax years of $37,022 and $19,615, respectively, as well as accuracy-related penalties under IRC § 6662(a). Nonetheless, the Tax Court found that the Huffs engaged in the breeding activity with an “actual and honest objective of making a profit,” and the Tax Court concluded that the 2013 and 2014 loss deductions were allowable and that the petitioners are not liable for penalties.
Stated more succinctly, the miniature donkeys carried the day, adorable little beasts of burden, as they are…
The petitioner-husband was an incredibly successful investor and asset manager. He founded his own asset management firm, and it had substantial success. In 2003, at the behest of his daughter, the petitioner-husband “took a detour from the world of high finance and founded Doggy Styles, Inc., a dog grooming business.” His daughter, Jennifer, desired to open “her own canine salon” after having worked at a greyhound rescue, in a veterinarian’s office, and as a dog groomer.
The petitioner-husband helped Jennifer pick a location for the business by studying traffic and parking patterns, negotiated rent (with the petitioner-wife drafting the lease), and paid the costs to construct the necessary facilities. The petitioner-husband and his employees also advised Jennifer on marketing and bookkeeping. The business was ultimately a success.
In 1987, the petitioners purchased 31.35 acres in New Jersey, subject to a conservation easement that permitted most equestrian and agricultural uses. In the late 1990s the petitioners purchased 7-1/2 acres of adjacent property for Jennifer. During the years at issue, she lived on that property with her then husband, a herpetologist. (What that last bit has to do with the opinion is anyone’s guess, but Judge Urda thought it an important point; so I’ll allow it.)
“Sometime before 2010 [the petitioner-husband] began to investigate potential uses for his farmland, consulting with Arthur Papetti, “a friend and fellow business magnate whose line of business was eggs.”
“These conversations ultimately settled on miniature donkeys.”
Sweet baby Jesus, the only thing that would make this opinion better is if Judge Holmes authored it. He would have had a freakin’ field day like this little guy.
Mr. Papetti, who had extensive experience in the field (and who sadly passed away in 2019), enticed Mr. Huff with the promise of considerable returns for successfully breeding donkeys with desirable attributes, such as height (under 30 inches), color (black and white spotted or solid red), and proper conformation (very generally, an equine’s shape, structure, and proportionality). As part of these conversations Mr. Papetti detailed the importance of maintaining registries of the miniature donkeys as a means to analyze family history and increase the chances of breeding a valuable miniature donkey.
Suffice it to say, the petitioner-husband did his homework, including consulting with the Director of Equine Services at Cornell Veterinary Medicine, an Equine and Livestock Resource Educator at Cornell Cooperative Extension Orange County, a Forage Crops Specialist at Purdue University, a Veterinary Technician at Purdue University School of Veterinary Medicine, and an Extension Horse Specialist at Penn State University.
In mid-2010 the petitioners decided to move forward with breeding miniature donkeys. Between May and August 2010 Ecotone purchased five miniature donkeys. Over the next eight years, Ecotone bought 20 more miniature donkeys, while selling 20. The 20 donkeys that were sold included some of the donkeys that had been purchased as well as some donkeys born on the farm. By 2019 the breeding stock had been culled to five donkeys, all under 25 inches tall. All told Ecotone paid $92,985 for 25 donkeys between 2010 and 2018 while selling 20 donkeys during that same time period for $23,500.
Breeding proved tricky. Although Ecotone’s general plan was to breed donkeys as small as possible, some of the foals were delivered stillborn or with genetic deformities.
Some donkeys of smaller stature were “simply uninterested in the pleasures of the flesh,” which somewhat “complicated” the breeding process.
Activities Not Engaged in for Profit
Taxpayers generally can deduct all ordinary and necessary business expenses paid or incurred in carrying on a trade or business. In general a taxpayer may not deduct expenses associated with activities not engaged in for profit, such as activities carried on primarily as a sport or hobby or for recreation. The term “activity not engaged in for profit” is defined by IRC § 183(c) as any activity other than one with respect to which deductions are allowable for the taxable year under IRC § 162 or under paragraph IRC § 212(1) or (2).
An activity overcomes the limitation set forth in IRC § 183 if it “was entered into with the dominant hope and intent of realizing a profit.” The expectation of profit need not have been reasonable, but the taxpayers must have entered into the activity, or continued it, with profit as the objective.
Indeed, the question is not whether the Tax Court thinks that a particular mode of doing business is wise, but whether the taxpayer honestly believed that the method he employed would turn a profit for him.” Stated differently, the test is the taxpayer’s subjective intent, not whether a reasonable businessman would have done the same.
Breeding and raising equines may be an activity entered into for profit; however, more often, the Tax Court is faced with cases in which breeding horses does not reflect a legitimate profit-making purpose. The “stereotypical abusive scenario involving horse breeding is the wealthy businessman who runs a real business during the week and owns a ‘gentleman’s farm’ as a weekend retreat where he keeps horses for the recreation of himself and his family and friends.” In that case the taxpayer “dabbles” in breeding horses, with no expectation of ever making a profit, so that he can deduct the expenses of his horses “and thereby have Uncle Sam subsidize the weekend farm.”
Whether the requisite profit objective exists is determined by looking at all the surrounding facts and circumstances. “Evidence from years outside the years in issue can be relevant if it provides context to evaluate the taxpayer’s overall requisite profit motive.”
The Nine Factors
Treas. Reg. § 1.183-2(b) lists nine objective factors to be considered in this regard:
- the manner in which the taxpayer carries on the activity;
- the expertise of the taxpayer or his advisers;
- the time and effort expended by the taxpayer in carrying on the activity;
- the 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, from the activity;
- the financial status of the taxpayer; and
- elements of personal pleasure or recreation.
Neither a single factor, nor the existence of even a majority of the factors is controlling, but rather an evaluation of all the facts and circumstances is necessary.
Manner of Carrying on the Activity: Business Plan
According to Treas. Reg. § 1.183-2(b)(1), carrying on an activity in a businesslike manner and maintaining complete and accurate books and records may indicate a profit objective. “Taxpayers operate in a businesslike manner when, among other things, they have a business plan, advertise goods or services, keep complete records, and respond to losses by changing what they do.” This factor leaned toward the Huffs.
The Huffs believed that the herd would be self-perpetuating and provide a steady stream of income. The record before us shows purchases of miniature donkeys that might be bred on the Huffs’ farmland, which had been significantly modified for just that purpose. Although Ecotone did not reduce its business plan to writing, its consultation with experts, implementation of major changes to the farm (fencing, pasture, sanitation, and barns, among others), and purchases of breeding stock provide compelling evidence that such a plan existed.
Manner of Carrying on the Activity: Recordkeeping
Maintenance of complete and accurate books and records is another consideration in determining whether the activity is conducted in a businesslike manner. “At a minimum the taxpayer’s books and records must contain the basic information required to make educated business decisions.” Taxpayers, however, “need to do more than just keep records to indicate a profit motive; they also need to use those records in an attempt to improve financial results.” In this case Ecotone maintained separate books and records from the Huffs, in which it detailed donkey purchases, veterinarian visits, and costs such as equipment, supplies, maintenance, and services.
Manner of Carrying on the Activity: Responses to Problems
“A change of operating methods, adoptions of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.” Ecotone changed different aspects of its operation in response to exposure and stillborn deaths, including feeding changes, electrifying and closing up parts of the donkey sheds for additional warmth, rotation of pasture lands, and alterations to breeding schedules. Although the IRS critiqued these decisions, the Tax Court believed that they were consistent with an intent to improve profitability.
Manner of Carrying on the Activity: Conclusion
The Tax Court was persuaded that the Huffs ran Ecotone in a businesslike manner during the years at issue. Having made a significant investment, the Huffs were faced with the choice of folding up shop—and thus losing the value of their investment—or making changes to try to achieve profitability going forward. The Huffs acted in a businesslike manner in pursuing the latter path with Ecotone.
Expertise of the Huffs and Advisers
Preparation for an activity by extensive study or consultation with experts also may indicate a profit motive when the taxpayer carries on the activity as advised. Knowledge of the activity itself apart from its economics is not enough to clear the hurdle; a taxpayer must demonstrate expertise and attempts to improve results in a money-losing business.” Where a taxpayer deviates from expert advice, “a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.”
The Huffs had no prior experience in breeding, boarding, buying, or selling miniature donkeys when they first contemplated embarking on the miniature donkey breeding activity. Mr. Huff nevertheless commissioned deep research into nutrition, soil quality, waste management, water supply, and other aspects of running a miniature donkey breeding business. Most significantly, Mr. Huff enlisted the help of a miniature donkey “expert,” who was involved in miniature donkey breeding and advised him about the industry and market. Ultimately, the Tax Court concluded that multiple years of experience with miniature donkeys gave the Huffs sufficient experience to disagree with their expert’s approach and try a different path to profit.
Time and Effort Expended
Treas. Reg. § 1.183-2(b)(3) provides that devoting personal time and effort to carrying on an activity may indicate a profit motive, particularly if the activity does not have substantial personal or recreational aspects. A limited investment of time does not necessarily suggest otherwise, so long as the taxpayer employs competent and qualified people to carry on such activity.
Although the Huffs invested a limited amount of time in running Ecotone’s donkey operation, they had only a very limited amount of time to invest given their other business pursuits. The Tax Court did not believe that they would add to their already full agenda the time and effort involved in breeding miniature donkeys without an important reason, i.e., building a profit-generating business for Jennifer.
Faced with constraints on their time that limited their direct involvement, the Tax Court examined whether the Huffs employed competent and qualified people to carry on the activity. They did.
Expectation That Assets May Appreciate in Value
“The term profit encompasses appreciation in the value of assets, such as land, used in the activity.” The taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.” Ecotone’s pattern of selling miniature donkeys at a loss suggests that appreciation of the breeding stock was unlikely. Thus, this factor weighs in favor of the IRS.
Success in Other Activities
“The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.” A track record of success in other business ventures may indicate that the taxpayer has the entrepreneurial skills and determination to succeed in subsequent endeavors. Thus, a taxpayer’s success in other, unrelated activities also may indicate a profit objective.
Thus, this factor weighs in favor of the Huffs.
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.” The Tax Court has recognized that the startup phase of an equine breeding activity is generally 5 to 10 years. Moreover, losses sustained because of unforeseen or fortuitous circumstances beyond the taxpayer’s control do not preclude a profit motive.
The Tax Court agreed that the donkey breeding business was within its startup phase during the years at issue and that the exception set forth in Treas. Reg. § 1.183-2(b)(6) thus applies. Ecotone began the breeding activity in 2010 and was still trying, as Mr. Huff put it, to “crack the code” to assemble the right breeding core during 2013 and 2014.
Given that the years at issue were less than five years into the breeding operation, the Tax Court concluded that the losses sustained were not indicative of a lack of a profit motive.
Occasional Profits from the Activity
The amount of profits in relation to the amount of losses incurred may provide useful criteria in determining the taxpayer’s intent. As of the date of the trial in this case, Ecotone had not yet earned a profit from its miniature donkey breeding activity, so this factor favored the IRS.
Financial Status of the Huffs
“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.” The Tax Court held that properly construed, the regulation merely makes the commonsense point that the expectation of being able to arrange to have the tax collector share in the cost of a hobby may often induce an investment in such a hobby which would not otherwise occur.” Accordingly “the concurrent existence of other income poses the question, rather than answers it.”
In answering that question, the Tax Court has previously considered whether losses from an activity offset substantial other income, consistent with Congress’ concern about wealthy individuals attempting to generate paper losses for the purpose of sheltering unrelated income, it has also considered the activity’s recreational aspects.
What the Tax Court had not yet considered, according to my exhaustive research, was miniature donkeys.
Elements of Personal Pleasure or Recreation
The absence of personal pleasure or recreation relating to the activity in question may indicate the presence of a profit objective. At trial Mr. Huff credibly testified that he derived “zero personal pleasure” from the miniature donkeys. As he explained:
It’s a lot of work. I don’t cuddle them. I don’t pet them. There is no satisfaction of having these. These are not pets. This is like livestock.
Author’s Note: To keep with the equine theme, what a jackass. How can you not cuddle a miniature donkey? It defies nature.
In fact, Mr. Huff testified that miniature donkeys are “quite ugly” and look like a “gigantic hairball”.
Author’s Note: See id. (observing that Mr. Huff is a heartless ass).
Mr. Huff also pointed out that, unlike horses, miniature donkeys could not make up for the hard work with the joys of the saddle. Jennifer echoed this point, explaining that her “dad’s kind of a business guy not the cuddly animal type.” No kidding. Finding Mr. Huff’s cool personal feelings toward the miniature donkeys believable, the Tax Court concluded that this factor favors the Huffs.
The nonexclusive objective factors establish that Ecotone had an actual and honest profit objective during the years at issue. Its partnership loss deductions for these years, thus, were allowable.
- It bears noting that four of the donkeys are named in the opinion: Firebug, Flame, Peanut, and Sioux. ↑
- IRC § 162(a). ↑
- IRC § 183(a); Treas. Reg. § 1.183-2(a). ↑
- Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984), aff’g 78 T.C. 471 (1982); see, e.g., Helmick v. Commissioner, T.C. Memo. 2009-220 at *7. ↑
- See Hulter v. Commissioner, 91 T.C. 371, 393 (1988); Treas. Reg. § 1.183-2(a). ↑
- Cornfeld v. Commissioner, 797 F.2d 1049, 1053 (D.C. Cir. 1986), aff’g T.C. Memo. 1984-105. ↑
- Id. (citing Allen v. Commissioner, 72 T.C. 28, 33 (1979)). ↑
- See, e.g., Engdahl v. Commissioner, 72 T.C. 659, 665-66 (1979); Den Besten v. Commissioner, T.C. Memo. 2019-154, *18. ↑
- Helmick, T.C. Memo. 2009-220 at *7. ↑
- Id. ↑
- See Keanini v. Commissioner, 94 T.C. 41, 46 (1990); Treas. Reg. § 1.183-2(b). ↑
- Den Besten, T.C. Memo. 2019-154 at *18; see also Price v. Commissioner, T.C. Memo. 2014-253, *52, aff’d, 633 F. App’x 101 (3d Cir. 2016). ↑
- See Golanty v. Commissioner, 72 T.C. 411, 426-27 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981); see also Phillips v. Commissioner, T.C. Memo. 1997-128, *5. ↑
- Metz v. Commissioner, T.C. Memo. 2015-54, *26; see also Helmick, T.C. Memo. 2009-220 at *8; Treas. Reg. § 1.183-2(b)(1). ↑
- See, e.g., Miller v. Commissioner, T.C. Memo. 2008-224, *4; Phillips T.C. Memo. 1997-128 at *6. ↑
- Treas. Reg. § 1.183-2(b)(1). ↑
- Den Besten, T.C. Memo. 2019-154 at *22. ↑
- Metz, T.C. Memo. 2015-54 at *36; see also Golanty, 72 T.C. at 430 (explaining that “trappings of a business” are insufficient and that “the keeping of books and records may represent nothing more than a conscious attention to detail”). ↑
- The Tax Court notes, however, that there was no indication that the Huffs used these records to analyze Ecotone’s profitability or expenses, rather than merely memorializing amounts for tax reporting purposes. In fact, the record before the Tax Court showed little attention to the expenses being incurred in this operation, which is in considerable tension with an eye on profit. Thus, this factor was neutral. ↑
- Treas. Reg. § 1.183-2(b)(1). ↑
- See Treas. Reg. § 1.183-2(b)(2); see also Metz, T.C. Memo. 2015-54 at *39. ↑
- Metz, T.C. Memo. 2015-54 at 44. ↑
- Treas. Reg. § 1.183-2(b)(2). ↑
- See id.; see also Miller, T.C. Memo. 2008-224 at *7. ↑
- See Engdahl, 72 T.C. at 670 (“We think it unlikely that the taxpayers would embark on a hobby costing thousands of dollars and entailing much personal physical labor without a motive.”). ↑
- Treas. Reg. § 1.183-2(b)(4). ↑
- Id. ↑
- Treas. Reg. § 1.183-2(b)(5). ↑
- Annuzzi v. Commissioner, T.C. Memo. 2014-233, at *25-*26; see also Whatley v. Commissioner, T.C. Memo. 2021-11, *26; Den Besten, T.C. Memo. 2019-154 at *29-*30. ↑
- Rabinowitz v. Commissioner, T.C. Memo. 2005-188, *13; see also Metz, T.C. Memo. 2015-54 at *52; Blackwell v. Commissioner, T.C. Memo. 2011-188, *7; Miller, T.C. Memo. 2008-224 at *6 (observing a dissimilar business shed light on “business acumen and ability to develop and improve businesses”). ↑
- Treas. Reg. § 1.183-2(b)(6). ↑
- See Engdahl, 72 T.C. at 669; Rinehart v. Commissioner, T.C. Memo. 2002-9, 2002 WL 23954, at *8. ↑
- See Treas. Reg. § 1.183-2(b)(6). ↑
- Treas. Reg. § 1.183-2(b)(7). ↑
- Treas. Reg. § 1.183-2(b)(8). ↑
- Engdahl, 72 T.C. at 670. ↑
- Id.; see also Metz, T.C. Memo. 2015-54 at *58. ↑
- See Rabinowitz, T.C. Memo. 2005-188 at *14 ↑
- Taras v. Commissioner, T.C. Memo. 1997-553, *9, aff’d, 187 F.3d 627 (3d Cir. 1999). ↑
- Blackwell, T.C. Memo. 2011-188 at *8. ↑
- Treas. Reg. § 1.183-2(b)(9); see also Taras, T.C. Memo. 1997-553 at *9. ↑
- See, e.g., Engdahl, 72 T.C. at 670-71. ↑