Tax Court Allows Multimillion Multiyear Arabian Horse Losses

This post was originally published on Forbes Apr 10, 2015

I love it when Tax Court judges write about sex.

  In the case of Howard and Christie Metz Judge Holmes refers to the story of President Coolidge and his wife being given separate tours of a farm.  Mrs. Coolidge observing a rooster on the job asked how often he might be expected to do his roosterly duty and the guide indicated dozens of time in a day. She asked the guide to point that out to Mr. Coolidge.  The President inquired as to whether it was the same hen each time. And wanted someone to let Mrs. Coolidge know that the answer was negative.  The story is the origin of a principle known as the "Coolidge effect".  Judge Holmes was noting that apparently the Coolidge effect is not operative in horses.

Before the late 1970s (and like registered thoroughbreds to this day), Arabian stallions and Arabian mares engaged in traditional breeding. But not all live covers produced foals, and it was a rare stallion who could mount more than two mares per day. Cf., e.g., roosters

We then get a footnote about the Coolidge effect.  You should always read the footnotes.  Good stuff down there.

A Really Big Horse Loss Case

Howard and Chistie Metz statrted Silver Maple Farm in 1989.  From 2004 to 2009, they lost millions of dollars.  The IRS was thinking maybe they were not really trying to make money breeding Arabian horses.  Although the IRS has hobby loss cases in many areas, the horse business seems to predominate.  It may be because everything that I know about the horse business comes from reading tax cases, but the fun in it really escapes me.  They are large animals that seem to defecate a lot and the tales of woe make the business seem like one GD thing after another.

The judge notes the ubiquity of horse cases

Horse-farm cases come in herds and not in single stallions, and are among the most frequently litigated under section 183. Each case turns on its facts, see, e.g., Pederson v. Commissioner, T.C. Memo. 2013-54, (comparing a small sample of five horse-breeding cases with different outcomes), which can vary widely. They range from the wealthy businessman who runs a real business but keeps a gentleman's farm as a weekend retreat whose expenses he tries to subsidize through deductions to sophisticated, well-run operations that just haven't been able to consistently make a profit.

The fate of stallions whose job seemed rather enviable back in the day when their partners in horse breeding had to be living within a couple of hundred miles is one of the topics discussed at length in decision.

 Top stallions took an increasing share of the breeding market—and, with the approval of frozen semen for use in artificial-insemination programs, could continue to compete in that market even posthumously. But for stallions who did not win the genetic lottery, there was left mostly gelding, giveaways, and gourmet dog food. The only slightly less predictable result—which also affected SMF as we describe below—was an increase in genetic problems as the Arabian gene pool shrank.

You get this level of detail because the Metzes have to convince the Tax Court that despite continuous operating losses totaling over $14 million over 11 years, they really were trying to make money, There were the industry problems:

 As we've already described, the Arabian horse market has had a lot of problems during the last two decades; by all accounts the last 20 years have been a bit of a nightmare for those in the industry. The expulsion of the Arabian Horse Registry of America from the World Arabian Horse Organization prevented American Arabian horse farms from marketing their horses to the world. 

Even after the AHRA was let back into the herd in 2008 things did not drastically improve; the bottom fell out of the economy that fall, and the Great Recession depressed the demand for luxury goods worldwide.

One GD Thing After Another

And then there were the problems that were specific to Silver Maple Farm.

 The veterinary services of their equine medical clinic turned out to be unexpectedly substandard (which resulted in fewer foals than reasonably expected); two of SMF's mares foundered (essentially losing a hoof) and were thereafter only able to breed through a more intensive and expensive technique that required embryo transfers; a statistically significantly higher proportion than normal of colts to fillies were born, which held back SMF's future breeding plans; and a stallion that the Metzes thought was excellent breeding stock turned out to be subfertile.

That last stallion is your classic "You had one job" story.

And It's A Win For The Taxpayer

The case ends up being a really good review of the nine factors and somewhat to my surprise, given the numbers, was a win for the Metzes.  Breeding Arabian horses is crazy crapshoot of a business, but it can be a business.  As you can note from the snippets I gave you Judge Holmes fills the decision with horse puns.  It is a really good read.  One of the issues where he takes on the IRS is the notion that the Metzes have to make a case that they have a prospect for making back all the money they have lost

We continue to agree with our interpretation of Bessenyey in Helmick and hold that the Metzes “meet their burden as to any year for which they show that they expected eventually to recoup losses sustained in the 'intervening years' *** between the current year and the hope-for profitable future.” Id. This is to say that if a taxpayer can expect to generate an overall profit from the current year onward, then it can't be said that he lacks a profit objective simply because he will never generate an overall profit over the lifetime of the activity.

Interest Tracing

There were two other issues in the case.  One concerned the interests tracing rules.  The Metzes were living off a stock portfolio that was 50% leveraged and had deducted all the interest as investment interest.  The Tax Court ruled that all the interest was probably deductible one way or the other and pushed it back to be sorted out between the IRS and the couple.  I think they may have been cut a break there.  Actually trying to do interest tracing in full accordance with the regulations is a nightmare.  I suspect few taxpayers with complex situations end up being fully compliant in that area.

Tax Pro Screw Up Does Not Void Accuracy Penalty

There other problem was an accuracy penalty. As they tried to better their horse operations by moving they had a big gain on the sale of real estate, which they did not report.  The reason for the non-reporting was a bad hand off between accountants as the couple shifted west.

The source of this omission is a miscommunication about the ranch's sale when they moved SMF to California. Up through the date of trial the Metzes retained the Henjes, Conner & Williams (HCW) accounting firm, and had retained them for more than 20 years. The Metzes also had an in-house accountant in Florida. But when they moved their operation to California they turned over their Florida accounting records to a Naples, Florida firm because their in-house accountant wasn't moving with them. 

The retention of the Naples accountants led to a botched relay of information—that firm sent the proceeds and transaction details from the Florida  sale to JP Morgan but didn't copy HCW. JP Morgan then applied the proceeds to pay down a chunk of the acquisition indebtedness that SMF had incurred to buy the two parcels of California land.

HCW had standard practices to prepare its clients' tax returns and had followed them faithfully for the Metzes for many years. We believed the Metzes' tax accountant when he testified that his practice was to look at SMF's balance sheet each year and, if there was a change, to ask whether there had been a disposition. In the year of the Metzes' relocation, however, there was land in the balance sheet at the beginning and end of the year. The HCW accountant therefore didn't think to ask about a disposition, and the records of the disposition hadn't made their way to him because they'd been misrouted by the Florida accountants.

If you told that story to some CPAs who had been in the business a long time, you would get two different reactions.  One would be a kind of "There but for the grace of God, go I" and another would be "Well that would never happen with a transaction that my firm was involved with.  We have procedures and policies to avoid that type of thing".  The latter group is divided into two classes - people who are deluding themselves and liars. The humility of the "grace of God" crowd actually makes it less likely that they'll screw up that way because they will have a couple of paranoid partners who worry about stuff like that happening.

At any rate, the Metzes "reliance on professional" defense did not work, since they should have noticed that a gain or $2 million or so had slipped through the cracks and they were hit with the accuracy penalty.  Have to wonder whether that will end up coming out of somebody's malpractice coverage.

For My Sesquicentennial Real Time Readers 

Forbes contributors have been told that we should be swimming in our own lane, so you will note that I have not posted anything about Appomattox, which is where I am right now (Well actually I'm in Lynchburg as I write this.)  The surrender commemoration ceremonies yesterday were very moving, but you will have to go to one of my alternate blogs - We Are the Future Generations to read about them.  I thought that, since this was a horse case, I could at least include a picture of some of the horses that I saw that were involved in reenactments of the battles of Appomattox Station, where Custer's men captured the Army of Northern Virginia's rations, and Appomattox Courthouse, which convinced General Lee that he would have to go see General Grant.