Horse Breeders Win in Tax Court

Originally Published on forbes.com on August 13th,2011

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Section 183 of the Internal Revenue Code tells us that we cannot deduct losses unless we are trying to make a profit.  The rules surrounding this issue are sometimes referred to as “hobby loss” rules.  I follow cases in this area pretty closely. You might say it is a hobby of mine.  The IRS seems to be particularly hard on people who lose money breeding horses.  I don’t get it.  The animals are very large and seem to defecate quite a bit.  I’d rather be doing tax research.  Tax Court judges seem to share my sentiment.  Horse breeders often win in Tax Court.  They certainly have a better track record thanAmway IBO’s (Independent Business Owners).  The latest case is that of Mark Blackwell.

Mark Blackwell and his wife Patti claimed net losses of slightly over $550,000 from 2003 to 2009.  Patti worked 30 hours a week as a nurse, her salary gradually rising over the period from the mid thirties to the mid fifties.  Mark’s salary fluctuated between 300k and close to 1.2 million.  Those numbers scream hobby loss, but they managed to win in Tax Court.  It is a case worth studying as they pretty much managed to do everything right.

In approximately 1996 Patti enrolled in the Equine Industry Management bachelor’s degree program at the University of Minnesota. In that program Patti took courses relating to the health care, showing, judging, breeding, bloodlines, and training of horses; the management of a horse activity as a business; and the economic aspects of horse breeding and training. In that program Patti in 1998 received another bachelor’s degree magna cum laude.

Becoming expert in the activity be it horse breeding or drag racing is not enough to establish that you are attempting to make a profit.  That is where Mark came in :

In 1999, in further preparation for starting up their horse breeding and training activity, Mark, with Patti’s assistance, prepared a detailedbusiness plan relating to the purchase, breeding, training, showing, and sale of reining horses. The business plan included sections entitled “Executive Summary”, “Market Overview”, “Advertising and Promotion”, and “Proforma Income Statement”.

Hard work is a factor:

Each day Patti would feed the horses, groom them, exercise them, turn them out, and clean out the horse stalls. 

With her training in medicine and to avoid additional expenses, Patti did much of the health maintenance on the horses without hiring a veterinarian. Patti vaccinated and dewormed the horses. She did the “foal watch” and would assist in the delivery of the foals.

Keeping proper records is critical even for establishing deductions in a profitable business.  In a business with losses it is even more critical:

In connection with their FHF horse activity, petitioners maintained a bank account under the name of FHF, and petitioners used BarnPro, a recognized horse farm software program, to record and keep track of FHF income and expenses.

If records are kept purely with a view to substantiating deductions that will not suffice.  Taxpayers should show that they used information to make course corrections, as they tried to steer in a profitable direction:

In 2006 petitioners shifted their horse breeding and training activity from reining horses to cutting horses because by 2006 cutting horses were in greater demand in the horse industry. 

At one point petitioners began trying to sell some of their horses as long yearlings to avoid horse training expenses they would incur if they kept the horses longer.

The best evidence that you are trying to be profitable is, of course, to become profitable.  Failing that, giving up the activity after a reasonable trial is also good evidence:

Petitioners believed in 2004 they had a broodmare band which would allow them to sell their foals at the national level. They hoped the sale of Sonata’s foal would recoup much of FHF’s investment. At one point two of petitioners’ horses were shipped to Missouri for sale with the hope of selling each horse for $15,000. Because of a softening of the horse market, the horses were each sold for less than one- half of the price expected. One of petitioners’ foals (Boonalicious) was a filly by a leading cutting stallion. Boonalicious’ stud fee was $15,000. Petitioners were optimistic about their prospects with this filly. Petitioners hired an experienced horseman to fit and present Boonalicious at the National Reined Cow Horse Futurity in Reno, Nevada. They understood that the horseman was the best of the best. They were devastated when they received only $6,500 for the horse, less than 10 percent of what similar horses had sold for in prior years and what they thought she was worth. Petitioners consulted all the experts and did everything the experts told them to do, but finally in 2009 petitioners determined that their FHF horse business was not sustainable.

The Blackwells rated well on almost all of the nine factors.  This decision is well worth studying.

(1) The manner in which the taxpayer carries on the activity;

(2) the expertise of the taxpayer in carrying on the activity;

(3) the time and effort expended 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 loss with respect to the activity;

(7) the amount of occasional profits, if any, which are earned by the taxpayer;

(8) the financial status of the taxpayer;

(9) elements of personal pleasure or recreation

I have not done a systematic study of horse cases as I did for Amway cases.  My overall sense, though, is that taxpayers frequently win these cases.  Since the IRS gets to pick the best cases, from their viewpoint, to go all the way with, it seems like they might start directing their energies elsewhere, because the Court seems to think these people aren’t just horsing around.Mark E. Blackwell, et ux. v. Commissioner, TC Memo 2011-188