IRC Section 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. IRC Section 183(b). Therefore, 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 Section 162(a), the taxpayer must show that he engaged in the activity with an actual and honest objective of making a profit. Although the taxpayer’s expectation of profit does not have to be reasonable, the intent to make a profit must be genuine.
The Section 183 regulations set forth a nonexclusive list of nine factors the IRS and courts use in determining whether a taxpayer conducted an activity with the intent to earn a profit. No factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome. The factors to be considered are: (1) the manner in which the taxpayer conducts the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort spent by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure.
In Skolnick, Mitchell Skolnick and Eric Freeman co-founded Bluestone Farms a partnership, whose stated mission was to acquire land, establish a horse breeding farm and sell the yearlings at public auction. After considering the nine factors, the IRS, and ultimately the Tax Court, disallowed the taxpayers’ losses from Bluestone Farms for the years 2010-2013. Although Section 183(d) has a safe harbor for breeding, training, showing, or racing horses when the activity produces gross income in excess of deductions for any two of the seven consecutive years, Bluestone failed to produce any gross income for any year from 1998 to 2013. In fact, Bluestone incurred expenses that ranged from 150% to 300% of its income annually. In addition, the taxpayers failed to maintain accurate or complete business records and according to the court there was a “persistent blending” of personal and business elements. The taxpayers lived on the Bluestone property without paying rent, used business credit cards to pay personal expenses and allowed personal horses to stay on the business property at no charge. The court also noted that the taxpayers did not spend any significant time running the business and “avoided most of the unpleasant aspects of running the farm, like cleaning the stalls and maintaining the grounds”. The only good news was the court determined the taxpayers were not liable for an accuracy-related penalty because their CPA had prepared returns for two other horse farms and had advised the taxpayers that the losses were properly deducted.
In Huff, the husband and wife were a hedge fund manager and an attorney, respectively, with a net worth in the range of $750 million. However, the taxpayers were concerned about their adult daughter Jennifer’s modest earnings and founded Ecotone Farm LLC, which ran an operation breeding miniature donkeys. According to the opinion, “Mr. Huff believed that he could turn the miniature donkey operation over to his daughter once the breeding program had been properly established, allowing her to benefit from his sweat equity. He was particularly enamored with this idea given Jennifer’s passion for animals and the proximity between their farms.” The IRS disallowed the taxpayers’ losses they claimed in 2013 and 2014 from Ecotone because the couple didn’t engage in the breeding activity for the primary purpose of making a profit. Although the breeding operation had not been profitable, the court reviewed the nine factor test under the Section 183 regulations and concluded that the taxpayers formed the breeding operation with the dominant hope and intent of making a profit. The court cited the taxpayers extensive research and consultations they conducted, hiring of experts, and the determination to turn over an established, successful business to their daughter. The court also referenced Mr. Huff’s testimony that he derived “zero personal pleasure” from being around miniature donkeys, found the animals to be “quite ugly”, and did not like to pet or cuddle them.
These two cases are good examples of how the IRS attacks and the Tax Court reviews business ventures that annually report losses and how taxpayers can lose and win a hobby loss case. They are also more evidence that Donkeys Are The Ones With Real Horse Sense.
For questions regarding this blog post or any other civil or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or firstname.lastname@example.org.