Horse Breeding Was a Hobby, Not a Business

Horses For ProfitCross References: Stuller, 7th Circuit Court of Appeals, January 26, 2016

The taxpayers lived in Illinois and owned several profitable restaurants. They also owned and bred horses on a farm in Tennessee. They hired an experienced horse trainer to train their horses and manage the farm. Under an agreement between the trainer and the taxpayers, the horse trainer received payments for training the horses, a 50% interest in horses born on the farm, prize money won by the horses at shows, the right to breed his own horses with the taxpayer’s horses for free, and the right to trade his horses with the taxpayer’s horses.

The horse breeding activity was organized as an S corporation that lost money in every year between 1994 and 2009, except for one year in which it earned a $1,500 profit. The taxpayers loaned some $1.5 million over the years to the S corporation to keep the horse breeding activity in business, with none of the money ever being paid back.

The IRS determined that the horse-breeding was not an activity engaged in for profit under IRC section 183, and therefore, the taxpayers could not use flow through S corporation losses to offset their income from other sources. The court used nine factors in Regulation section 1.183-2(b) to determine whether the activity was a hobby or a for-profit business. The non-exclusive list of relevant factors found in that regulation includes:

  1. The manner in which the taxpayer carries on the activity.
  2. The expertise of the taxpayer or his advisors.
  3. The time and effort expended by the taxpayer.
  4. The expectation that assets may appreciate in value.
  5. The taxpayer’s success in other similar or dissimilar activities.
  6. The taxpayer’s history of income or losses.
  7. The amount of occasional profits, if any.
  8. The financial status of the taxpayer.
  9. Elements of personal pleasure or recreation.

No one factor is determinative. Instead, all relevant facts and circumstances are to be taken into account. More weight is given to objective facts than a taxpayer’s statement of intent.

Expertise of advisors.

One factor the taxpayers argued should be in their favor was that they had hired an experienced horse trainer to run their farm. This horse trainer had over 50 years of experience in training and breeding horses. However, the court said the trainer’s expertise did not extend to the financial and business aspects of running a horse-breeding operation. The trainer himself testified that he did not breed horses to make money, and that it had been years since he sold a horse that he had bred, and that his income was largely derived from fees collected to train horses.

The court also noted that the taxpayer’s agreement with the trainer made it difficult for the taxpayers to make a meaningful profit on any horse that was bred. The trainer automatically received half the sale proceeds, in addition to the right to breed his own horses for free, and to trade his horses with the taxpayer’s horses, even though the taxpayers incurred all of the associated expenses with breeding and raising the horses. The trainer also received substantial payments for training the horses, which were additional expenses incurred by the taxpayers. Yet the taxpayers never considered re-negotiating the terms of their agreement with the trainer.

The taxpayer also tried to argue that they received advice from their accountant. The accountant, however, testified that while he provided advice related to the creation of the S corporation, prepared its tax returns, and generated annual reports of its assets and liabilities, he was not capable of providing advice specific to the horse-breeding industry.

Financial status of the taxpayer.

The taxpayers were financially successful with their restaurants. They also owned profitable rental properties and other investments. Money from these activities was used to finance the horse breeding activity over the years. The court said the best objective indicator that their horse-breeding was a hobby and not a business was their high tolerance for losses. Some $1.5 million was loaned to the S corporation, interest free, in order to keep the horse-breeding operation afloat.

Expectation that assets may appreciate.

The taxpayers also argued that there was evidence that the Tennessee farmland might appreciated in value. By 1999 the farm had a house and 332 acres with some 30 horses at the farm.

The court said this expectation of appreciation did not offset the combination of other objective facts showing that the S corporation was not run with the intent to profit. For one thing, the farm house and land, assets with the most potential for appreciation, was not owned by the S corporation but rather directly by the taxpayers.

Considering the poor record keeping, the lack of business practices directed at making a profit, its substantial annual losses, and the significant tax benefits to the taxpayers, there is no clear error in finding that the totality of facts and circumstances showed the S corporation was not run as an activity with the intent to profit. Therefore, the flow through losses were not allowed to offset the taxpayer’s other income.

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