A few months ago, a CPA friend of mine asked me for advice. He had just picked up a new client, a very successful businessman who earned significant income from his 9-5 gig. In addition, the client also operated a horse breeding activity that generated large losses used by the taxpayer to partially offset his taxable income. The client’s horse breeding “business” had never generated a profit in its five-year history, and in light of the string of losses, the client had recently made the decision to abandon the activity.
The question posed was the following: how concerned should the CPA be that his client will find his horse breeding activity subject to IRS scrutiny?
My answer: very. As we’ve discussed in the past, Section 183 — the so-called “hobby loss rules — exist for the sole purpose of determining whether a taxpayer’s activity is a “trade or business” or a “hobby.” If the activity is a trade or business, losses of the activity may be deducted in full and can offset other sources of income, subject to certain limitations. If the activity is a hobby,however, a taxpayer can only deduct losses to the extent of the income. The regulations establish nine factors the courts will examine to aid in their determination:
1. The manner in which the taxpayer carries on the activity.
2. The expertise of the taxpayer or his advisers.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The expectation that the assets used in the activity may appreciate in value.
5. The success of the taxpayer in carrying on similar or dissimilar activities.
6. The taxpayers history of income or losses with respect to the activity.
7. The amount of occasional profits.
8. The financial status of the taxpayer.
9. Does the activity lack elements of personal pleasure or recreation?
The reason for my concern is that the Section 183 case history is literally filled with decisions holding that a horse breeding activity is a hobby, rather than a business. This is due in large part to the large recreational element of the “business,” and the fact that losses from the activities often offset otherwise taxable income of the taxpayer, as the typical horse breeder is an affluent taxpayer to begin with.
Yesterday, however, the Tax Court provided a glimmer of hope for horse breeders with its decision in Blackwell v. Commissioner, TC Memo 2011-188. In Blackwell, the taxpayer was able to overcome the horse breeding “taint” by carrying on the activity in a very professional manner, satisfying the majority of the Section 183 factors. In particular, the taxpayers:
Prepared to start up the horse breeding and training activity by taking educational courses relating to the care, management, breeding, and economics of horses, and by purchasing, caring for, training, and selling a number of horses.
Developed a rather comprehensive written business plan relating to the proposed horse activity.
Took 6 or 7 years learning about horse breeding and management before attempting to engage in a for-profit horse breeding activity.
Were not absentee, aloof, or recreational horse owners. They managed and worked diligently and daily on the horse activity, doing essentially all of the horse maintenance herself.
They consulted expert horsemen, hired expert horse trainers to assist in training the horses, advertised, showed the horses, and paid significant stud fees to have their mares bred with stallions which they regarded as having good bloodlines.
In their efforts to make improvements to the horse activity, taxpayers’ made adjustments in their business plan, moving from reining horses to cutting horses and selling their horses as yearlings.
Maintained reasonably good books and records of income and expenses relating to their horse activity.
After nine years, the taxpayers terminated their unprofitable horse activity in light of the losses realized.
Interstingly, the Tax Court held that Blackwell’s activity did not have significant elements of personal pleasure, even though the taxpayer had a lifelong interest in horses. The court added:
The facts of this case do not indicate that petitioners’ FHF horse activity was motivated or driven by personal pleasure alone. As we have found, petitioners had actual hopes for the sale of their horses at a profit, and petitioners’ horse activity is appropriately described as a “business”. Petitioners’ business plan did not work out and income did not exceed expenses, but we discern few recreational and sports aspects in petitioners’ FHF horse activity; rather, in petitioners’ motive, efforts, and investment in carrying on their FHF horse activity during the years in issue we discern and find a profit objective.
See prior discussions here: