On December 16, 2021, the Tax Court issued a Memorandum Opinion in the case of Skolnick v. Commissioner (T.C. Memo. 2021-139). The primary issue presented in Skolnick was whether the petitioner’s “horse activity,” undertaken through his LLC, was an activity not engaged in for profit within the meaning of IRC § 183 during 2010-2013.
Held: Petitioners were just horsing around, but they had reasonable cause to avoid the accuracy-related penalties.
On Horse Breeding and Miniature Donkeys
This case is a classic example of equine-related deductions being disallowed.
There is a LONG history of equine-related deduction cases, and very few ever turn out well for the taxpayers. One exception to this rule is the case of Huff v. Commissioner, T.C. Memo. 2021-140, the very next case on the Tax Court’s docket, in which Judge Urda found that the taxpayers credibly presented evidence that their miniature donkey breeding operation was engaged in with the requisite profit motive. Check out the Huff case, here.
Judge Lauber begins the opinion by noting that the trial in Skolnick lasted for FIVE days.
The petitioner, Mitchel, was a breeder of standardbred horses which are used in competitive harness racing. His first wife (Leslie) and his second wife (Brianna) were involved in the case because they filed joint returns with the petitioner between 2010 and 2013, but they otherwise did not have an ownership in Bluestone Farms (the horse breeding operation).
The petitioner was a successful IT consultant, whose father was a successful standardbred horse breeder. The two had a falling out, and the petitioner founded Bluestone Farms with a partner, Eric Freeman, in 1998.
Bluestone’s mission was to acquire land and establish a Standardbred breeding farm that would sell high-quality yearlings at respected public auctions. Yearlings not sold would be retained as broodmares, with the goal of increasing the quality of Bluestone’s broodmare band and of future yearlings. Bluestone also planned to earn income by selling breeding rights to any successful stallions it acquired. The petitioner “found the breeding aspect of the new venture especially appealing.”
And that’s all we have to say about that.
The petitioner and Eric bought a 60-acre farm, hired a full-time farm manager, improved and landscaped the farm, cleared the land, planted trees, built a barn, added horse paddocks, and installed automatic watering systems. In 2000, the petitioner returned to work at the IT consulting firm because he believed he could not handle Bluestone’s expenses otherwise.
The petitioner and Eric prepared a second business plan in 2000, as Bluestone had been unprofitable for the first 18 months of its operation. Although Bluestone was still losing money hand over hoof, it expanded its operations by purchasing a second property (Wert Farm) in September 2002. A third business plan was drafted in 2003. In 2007 Bluestone purchased its third parcel of land, another former dairy farm, adjacent to the second farm.
Judge Lauber notes that “[t]he conventional wisdom in the Standardbred industry is that owners need roughly two acres of land per horse. Bluestone’s purchase of the [second and third farms] would thus have enabled it to expand its broodmare band significantly. But that never happened.”
In 2008, after separating from his first wife, the petitioner moved his residence to Bluestone Farms. Brianna moved in with him in April 2009. They continued to live on the property, rent-free, during 2010-2013. There was never any formal agreement among Bluestone’s partners regarding the financial consequences of their doing so. The pair significantly renovated the farmhouse and property, which Bluestone paid for.
The petitioner’s responsibilities included reviewing monthly bills and financial reports, signing checks, balancing checkbooks, answering emails, talking to customers, meeting with the veterinarian, and monitoring the breeding process; however, the farm manager, Brenda, was in charge of the day-to-day operations of the farm. Bluestone had between 7 and 10 employees during 2010-2013, some full time and some part time. Mitchel nominally supervised these employees, but they set their own schedules and worked largely independently.
Brianna was “an equine artist,” whatever the hell that means. The Tax Court notes that although she played no formal role in Bluestone’s operations, as early as November 2011, she had a Bluestone business credit card, which she used. Regularly.
During 2010-2013 Bluestone had three main sources of potential income: horse sales (selling yearlings and any horses that were culled), income from racing the horses (in the form of purses or breeder’s awards), and stud fees (selling the rights to breed with a stallion).
The Claimed Ordinary Business Losses
For each year at issue, Bluestone incurred ordinary business losses that ranged from 150% to almost 300% of its income—half a million dollars in 2010, and nearly one million dollars in 2011, 2012, and 2013. The following years (not at issue in the case, but illustrative of the substantial losses) reported ordinary business losses of $977k, $710k, $481k, and $993k. For the 20-year period beginning in 1998 and ending in 2017, Bluestone reported total ordinary business losses of $14,590,320.
Allowability of Horse Activity Losses
IRC § 162(a) allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” If an activity is not engaged in for profit, no deduction is allowed except to the extent of gross income derived from the activity (reduced by deductions allowable without regard to whether the activity was engaged in for profit). Thus, losses are not allowable for an activity that a taxpayer carries on primarily for sport, as a hobby, or for recreation.
To be entitled to deductions under IRC § 162(a), the taxpayer must show that he engaged in the activity with an actual and honest objective of making a profit. The taxpayer’s expectation of profit does not have to be reasonable, but his intent to make a profit must be genuine. In making this determination the Tax Court accords greater weight to objective facts than to the taxpayer’s subjective assertions. The Tax Court determines whether the taxpayer has the requisite intent to earn a profit on the basis of all surrounding facts and circumstances.
IRC § 183(d) has a safe harbor for activities consisting in major part of breeding, training, showing, or racing horses. Such an activity will be presumed to be engaged in for profit if the activity produces gross income in excess of deductions for any two of the seven consecutive years ending with the tax year, unless the Commissioner establishes to the contrary. Suffice it to say, Bluestone produced no gross income in excess of deductions for any year from 1998 through 2013, the last tax year in issue. Thus, the presumption is inapplicable.
Treas. Reg. § 1.183-2(b) sets forth a nonexclusive list of nine factors relevant in ascertaining whether the taxpayer conducted an activity with the intent to earn a profit.
- the manner in which the taxpayer conducts the activity;
- the expertise of the taxpayer or his advisers;
- the time and effort spent 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;
- the financial status of the taxpayer; and
- elements of personal pleasure or recreation.
Manner in Which Activity Is Conducted
“The fact that the taxpayer carries on the activity in a businesslike manner may indicate that the activity is engaged in for profit.” A “businesslike manner” may be suggested by the maintenance of “complete and accurate books and records” and a plausible business plan. The Tax Court also considers whether the taxpayer conducts the activity “in a manner substantially similar to other activities of the same nature which are profitable,” and whether the taxpayer changes “operating methods, adopts new techniques or abandons unprofitable methods in a manner consistent with an intent to improve profitability.”
Bluestone’s records were voluminous. They included information about its overall finances and income/expense figures horse by horse. Bluestone advertised its business, maintained a website, and hired a CPA to prepare its tax returns. It had full-time employees and appears to have filed all necessary employment-related paperwork. It carried mortality insurance on its horses and liability and property damage insurance on its farmland. Bluestone and its partners had separate bank accounts. However, Bluestone’s records had important inaccuracies and gaps, particularly as they relate to money…such as who actually owned the company and in what proportion.
Having a business plan, written or unwritten, may suggest that an activity is conducted in a businesslike manner. Bluestone last prepared a written business plan in 2004; however, that plan was “woefully out of date” by 2010. The manner in which Bluestone conducted its activities shows that it was largely insensitive to costs.
Another nonbusinesslike feature was the persistent blending of personal and business elements. Mitchel resided at Bluestone Farms throughout the tax years at issue. He and Brianna lived there rent free, but there was never any formal agreement among Bluestone’s partners regarding the financial consequences of their doing so. Bluestone made no effort to ascertain the portion of these expenses attributable to Mitchel’s personal residence, and he did not reimburse Bluestone for any of these outlays.
Books and Records
For IRC § 183 purposes, the key question is not whether the taxpayer keeps records, but whether the taxpayer uses his records to improve profitability and implement techniques for controlling expenses and increasing income. As the Tax Court stated many years ago: “The purpose of maintaining books and records is more than to memorialize for tax purposes the existence of the subject transactions; it is to facilitate a means of periodically determining profitability and analyzing expenses such that proper cost saving measures might be implemented in a timely and efficient manner.” The petitioner presented no evidence that Bluestone used its records, after 2004, to develop plans to reduce expenses or otherwise bring the farm into profitability. This was, apparently, a hot-button issue for the Tax Court. Indeed, the Tax Court observed that “[m]ore telling in our view are the changes to operating procedures that petitioners did not make.
Expertise of the Taxpayers or Their Advisers
Consulting with industry experts and studying accepted business practices when preparing for an activity may suggest a profit motive. the record does not indicate what type of advice petitioners sought from their advisers. For IRC § 183 purposes, the most relevant advice concerns how to profit from the activity, not just how to conduct the activity well. Given the petitioner’s previous experience in the standardbred industry and the number and quality of the people they consulted, this factor favors petitioners. Nonetheless, “because serious hobbyists, no less than profit-motivated entrepreneurs, often seek expert advice about the subjects of their interest,” the Tax Court accorded this factor relatively little weight.
Taxpayer’s Time and Effort
A taxpayer’s devotion of considerable time and effort to an activity may indicate a profit motive, “particularly if the activity does not have substantial personal or recreational aspects.” Intention to derive a profit may also be supported by the taxpayer’s “withdrawal from another occupation to devote most of his energies to the activity.” Even where a taxpayer himself devotes limited time to an activity, a profit motive may be indicated if he “employs competent and qualified persons to carry on such activity.”
Although the petitioner did not ride horses recreationally, he “clearly derived personal enjoyment from the work [he] chose to do, as well as from the social opportunities and status in the Standardbred community that participation in Bluestone afforded [him].” Further, he avoided most of the unpleasant aspects of running the farm, like cleaning the stalls and maintaining the grounds.
Expectation of Appreciation in Value
A profit motive may be indicated if a taxpayer expects that assets used in the activity will appreciate in value. Petitioners maintain that they expected both Bluestone’s farmland and its horses to appreciate. Mitchel testified to his belief that both have in fact appreciated and that, if Bluestone were liquidated, the proceeds would be more than sufficient to offset all of Bluestone’s past losses.
Success of the Taxpayer in Carrying On Other Similar 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.” The petitioner’s previous career was in software. While starting any business shows an entrepreneurial inclination, there is no evidence that their success in these prior endeavors was any predictor of success in horse breeding. Nor is there any evidence that the petitioner was a “turnaround expert” skilled at reforming an unprofitable business into a profitable one.
History of Income or Losses
Long periods of losses following the initial startup phase can indicate the lack of a profit motive. This inference may not arise where losses are due to “customary business risks or reverses” or to “unforeseen or fortuitous circumstances which are beyond the control of the taxpayer.” Such fortuitous circumstances include “drought, disease, fire, theft, weather damages…or depressed market conditions.”
Bluestone’s losses were large and sustained. Petitioners lost more than $11.4 million between 1998 and 2013 without a single profitable year. We have previously held that the startup phase for a horse-breeding activity is 5 to 10 years. however, Bluestone’s losses did not stop after 5 or even 10 years. Indeed, during the tax years at issue, after 12 years of operation, Bluestone lost more than $3.5 million.
Amount of Occasional Profit
A taxpayer’s derivation of some profits from an otherwise money-losing venture may support the existence of a profit motive. Nonetheless, “[a]n occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit.” The petitioner did not derivate any profit from Bluestone from its founding in 1998 through the end of 2013, the last year in issue.
In the absence of actual profits, “an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit.” The Tax Court has previously found certain horse activities—especially racing activities—to be highly speculative ventures, even likening them to wildcat oil drilling ventures.
Taxpayer’s Financial Status
The fact that a taxpayer has substantial income or capital at his disposal from sources other than the activity in question may indicate that he does not engage in that activity for profit. This is especially true if “the losses from the activity generate substantial tax benefits” and “if there are personal or recreational elements involved.” The petitioner did not rely on Bluestone for financial support.
Elements of Personal Pleasure or Recreation
The fact that a taxpayer derives personal pleasure from an activity, or finds it recreational, may suggest that he engages in it for reasons other than making a profit. That does not mean that a business becomes a hobby just because the taxpayer enjoys it. As the Tax Court has said, “suffering has never been made a prerequisite to deductibility.”
That said, “where the possibility for profit is small…and the possibility for gratification is substantial, it is clear that the latter possibility constitutes the primary motivation for the activity.” The petitioner enjoyed buying, selling, breeding, and racing Standardbred horses. The evidence at trial convinced the Tax Court that the pleasure he derived from these activities, rather than any hope of making a profit, accounted for his persistence in subsidizing Bluestone’s continuous losses.
“Toting Up” the Factors (or Not)
As the Tax Court has noted in prior cases, determining profit motive under IRC § 183 is not a matter of toting up factors but requires evaluating all the facts in a qualitative sense. In the present case, the Tax Court concluded that four factors listed in the regulations have the greatest salience and importance given the circumstances of these cases–the manner in which the activity was conducted, the history of losses, the taxpayers’ financial status, and the elements of personal pleasure or recreation.
All four of these factors strongly favored the IRS. Only one factor favors petitioners—the expertise of the taxpayers and their advisers—and the Tax Court afforded this factor little weight on the facts here. Ultimately, the Tax Court concluded that the petitioner did not conduct Bluestone’s horse activity during 2010-2013 with a genuine intent to make a profit. IRC § 183, thus, disallows as deductions the losses that Bluestone passed through to the petitioner.
(T.C. Memo. 2021-139) Skolnick v. Commissioner
- Huff v. Commissioner, T.C. Memo. 2021-140. ↑
- IRC § 183(b). ↑
- Treas. Reg. § 1.183-2(a). ↑
- See Hulter v. Commissioner, 91 T.C. 371, 392 (1988). ↑
- Treas. Reg. § 1.183-2(a). ↑
- Keanini v. Commissioner, 94 T.C. 41, 46 (1990); Treas. Reg. § 1.183-2(a). ↑
- See Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981); Treas. Reg. § 1.183-2(b). ↑
- See Donoghue v. Commissioner, T.C. Memo. 2019-71. ↑
- Treas. Reg. § 1.183-2(b)(1). ↑
- Id. ↑
- Id. ↑
- Cf. McKeever v. Commissioner, T.C. Memo. 2000-288 (explaining that failure to keep track of expenses per horse can imply a lack of profit motive). ↑
- See Metz v. Commissioner, T.C. Memo. 2015-54. ↑
- See Morley v. Commissioner, T.C. Memo. 1998-312. ↑
- See Phillips v. Commissioner, T.C. Memo. 1997-128; Treas. Reg. § 1.183-2(b)(1). ↑
- See Bronson v. Commissioner, T.C. Memo. 2012-17 (finding taxpayer’s recordkeeping was not businesslike where the entity claimed deductions for personal expenses), aff’d, 591 F. App’x 625 (9th Cir. 2015). ↑
- See Whatley v. Commissioner, T.C. Memo. 2021-11, *20 (finding that farm was not operated in a businesslike manner where taxpayer deducted expenses of “doubtful legitimacy” including depreciation for a personal residence). ↑
- Burger v. Commissioner, T.C. Memo. 1985-523, aff’d, 809 F.2d 355 (7th Cir. 1987); see Golanty v. Commissioner, 72 T.C. 411, 430 (1979) (“[T]he keeping of books and records may represent nothing more than a conscious attention to detail…[unless the taxpayer] show[s] that she used them to improve the operation of the enterprise.”). ↑
- See Treas. Reg. § 1.183-2(b)(1). ↑
- See Treas. Reg. § 1.183-2(b)(2). ↑
- See Whatley, at *20-*21; Heinbockel v. Commissioner, T.C. Memo. 2013-125 (finding that taxpayer lacked a profit motive where he consulted aircraft experts but produced no evidence of discussions with aircraft experts or other advisers “about the potential profitability of the aircraft”). ↑
- Treas. Reg. § 1.183-2(b)(3). ↑
- Id. ↑
- Id. ↑
- Cf. Morley, T.C. Memo. 1998-312 (describing how the taxpayer’s horse activity forced him to spend less time with his family and caused him to get home “after dark, very tired, in a bad mood, and dirty with a ‘certain aroma’ from his work on the farm”). ↑
- Treas. Reg. § 1.183-2(b)(4). ↑
- Treas. Reg. § 1.183-2(b)(5). ↑
- See Whatley, at *26-*27 (finding this factor neutral where taxpayer who owned a cattle farm previously worked in the banking and logging industries). ↑
- See Easter v. Commissioner, T.C. Memo. 1992-188 (finding no evidence of taxpayer’s having previously turned around a money-losing business). We view this factor as neutral. ↑
- See Treas. Reg. § 1.182-2(b)(6). ↑
- Id. ↑
- Id. ↑
- See Engdahl v. Commissioner, 72 T.C. 659, 669 (1979). ↑
- See Treas. Reg. § 1.183-2(b)(7). ↑
- Id. ↑
- Id. ↑
- See Dawson v. Commissioner, T.C. Memo. 1996-417. ↑
- Treas. Reg. § 1.183-2(b)(8). ↑
- Id. ↑
- Treas. Reg. § 1.183-2(b)(9). ↑
- Jackson v. Commissioner, 59 T.C. 312, 317 (1972). ↑
- Dodge v. Commissioner, T.C. Memo. 1998-89, aff’d without published opinion, 188 F.3d 507 (6th Cir. 1999). ↑
- See Treas. Reg. § 1.183-2(c), Ex. 3 (noting that the activity of raising and racing horses “is of a sporting and recreational nature”). ↑