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Thursday, March 28, 2013
section 183 hobby loss case
William R. Dodds v. Commissioner, TC
Memo 2013-76 , Code Sec(s) 183.
DODDS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Information: [pg. 682] Code Sec(s): 183 Docket: Dkt. No. 23609-11. Date Issued:
by Kerrigan, J. Tax Year(s): Years 2007, 2008. Disposition: Decision for
t. A taxpayer
may not fully deduct expenses regarding an activity under section 162 or 212 if
the activity is [pg. 686] not engaged in for profit. Sec. 183(a), (c);see also
Keanini v. Commissioner, 94 T.C. 41, 45 (1990).
183(a), if an activity is not [*10] engaged in for profit, no deduction
attributable to that activity is allowed except to the extent provided by
part, section 183(b) allows deductions that would have been allowable had the
activity been engaged in for profit but only to the extent of gross income
derived from the activity (reduced by deductions attributable to the activity
that are allowable without regard to whether the activity was engaged in for
defines an activity not engaged in for profit as “any activity other than one
with respect to which deductions are allowable for the taxable year under
section 162 or under paragraph (1) or (2) of section 212.” For expenses to be
fully deductible under section 162 or 212, taxpayers must show that they
engaged in the activity with the primary objective of making a profit. See
Westbrook v. Commissioner, 68 F.3d 868, 875 [76 AFTR 2d 95-7397] (5th Cir.
1995), aff'g per curiam T.C. Memo. 1993-634 [1993 RIA TC Memo ¶93,634]; see
also Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207].
183(d), an activity that consists in major part of the breeding, training,
showing, or racing of horses is presumed to be engaged in for profit if the
activity produces gross income in excess of the deductions for any two of seven
consecutive years, unless the Commissioner establishes to the contrary. See
also Wadlow v. Commissioner, 112 T.C. 247, 250 (1999). Petitioner's horse
breeding [*11] activity failed to produce income in excess of its deductions at
any time during its operation.
the presumption does not apply in this case. The expectation of a profit need
not be reasonable, but the taxpayer must conduct the activity with the actual
and honest objective of making a profit. Keating v. Commissioner, 544 F.3d 900,
904 [102 AFTR 2d 2008-6638] (8th Cir. 2008), aff'g T.C. Memo. 2007-309 [TC Memo
greater weight to objective facts than to the taxpayer's statement of intent.
Sec. 1.183-2(a), Income Tax Regs.; see also Keating v. Commissioner, 544 F.3d
years after the years in issue is relevant to the extent it creates inferences
regarding the taxpayer's requisite profit objective in earlier years. E.g.,
Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207]; Bronson v.
Commissioner, T.C. Memo. 2012-17 [TC Memo 2012-17].
taxpayer bears the burden of proving that the requisite profit objective exists.
Westbrook v. Commissioner, 68 F.3d at 876; see also Rule 142(a); Foster v.
Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207]. In order to shift the
burden, the taxpayer, among other things, must introduce credible evidence with
respect to that issue. Sec. 7491(a)(1); see also Higbee v. Commissioner, 116
T.C. 438, 441 (2001).
evidence is evidence the court would find sufficient upon which to base a
decision on the issue in favor of the taxpayer if no contrary evidence were
submitted. Rendall v. Commissioner, T.C. Memo. 2006-174 [TC Memo 2006-174],
aff'd, [*12] 535 F.3d 1221 [102 AFTR 2d 2008-5589] (10th Cir. 2008); see Higbee
v. Commissioner, 116 T.C. at 442-443.
below, petitioner failed to provide evidence for many of the issues. If we were
to consider solely the evidence petitioner presented, we would find that
petitioner did not engage in the horse breeding activity for profit as a matter
of fact. Therefore, petitioner failed to provide credible evidence within the
meaning of section 7491(a)(1), and the burden of proof remains with petitioner.
1.183-2(b), Income Tax Regs., provides a nonexhaustive list of the following
nine factors used to determine whether an activity is engaged in for profit:
(1) whether the taxpayer carries on the
activity in a businesslike manner;
expertise of the taxpayer and his or her advisors;
(3) the time
and effort expended by the taxpayer in carrying on the activity;
the taxpayer expects that the assets used in the activity might appreciate in
the taxpayer has had success carrying on other similar activities;
taxpayer's history of income or losses with respect to the activity;
(7) the amount
of occasional profits, if any, which are earned;
taxpayer's financial sta[pg. 687] tus; and
of personal pleasure or recreation. All facts and circumstances are to be taken
into account, and no single factor is determinative. Sec. 1.183-2(b), Income
Tax Regs.;see also Keating v. Commissioner, 544 F.3d at 904. [*13] 1.
Which Petitioner Carried On the Activity The fact that the taxpayer carries on
an activity in a businesslike manner and maintains complete and accurate books
and records may indicate a profit motive. Sec. 1.183-2(b)(1), Income Tax Regs.
Characteristics of a businesslike operation include the preparation of a
business plan and, in the case of horse breeding and sales, a consistent and
concentrated advertising program. Bronson v. Commissioner, T.C. Memo. 2012-17
[TC Memo 2012-17] (citing Golanty v. Commissioner, 72 T.C. 411, 431 (1979),
aff'd without published opinion , 647 F.2d 170 (9th Cir. 1981), Keating v.
Commissioner, T.C. Memo. 2007-309 [TC Memo 2007-309], and Dodge v.
Commissioner, T.C. Memo. 1998-89 [1998 RIA TC Memo ¶98,089], aff'd without
published opinion 188 F.3d 507 [84 AFTR 2d 99-6001] (6th Cir. 1999)). The ,
regulations further provide that a profit motive is indicated when a taxpayer
changes operating methods or adopts new techniques with an intent to improve
profitability. Sec. 1.183-2(b)(1), Income Tax Regs. Petitioner advertised his
horses on the Aeire Meadow Morgans Web site, in national and local magazines,
and with his business cards at horse shows and other venues. In those cases
where we have found that an animal breeder operated in a businesslike manner,
generally the breeder not only participated in shows but engaged in other forms
of substantial advertising. See, e.g., Engdahl v. Commissioner, 72 T.C. 659,
667 (1979); Keating v. Commissioner, T.C. Memo. [*14] 2007-309. The taxpayer's
advertising efforts, however, may not be insubstantial compared to the cost of
the activity. See Bronson v. Commissioner, T.C. Memo. 2012-17 [TC Memo
2012-17]. Because petitioner failed to provide any evidence regarding the cost
of his advertising efforts, we are unable to determine that his advertising
efforts were substantial compared to the cost of his horse breeding activity.
Petitioner failed to provide a business plan that included more than just
generalized goals. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo
2012-207]. Petitioner testified: “My initial plan wasn't written, but my plan
was to breed grade horses”. When he abandoned that plan, petitioner testified
that he was aiming to breed world caliber foals that could become successful
show horses. Petitioner's plan is inadequate for us to conclude that he had an
established business plan. See Keating v. Commissioner, T.C. Memo. 2007-309 [TC
Memo 2007-309] (finding that the taxpayer's plan “to raise good quality horses,
well-trained horses, horses that will give *** [the taxpayer] a good
reputation, horses that will do well in the market” was inadequate for us to
conclude that the taxpayer had an established business plan). Petitioner
likewise failed to maintain a budget or to make any financial projections,
economic forecast, or other analyses demonstrating financial management or
planning. See Keating v. Commissioner, 544 F.3d at 904; Foster v. Commissioner,
T.C. Memo. 2012-207 [TC Memo 2012-207]. Petitioner used profit and loss [*15]
statements prepared with QuickBooks, but there is scant evidence that
petitioner used them for the important purposes of cutting expenses, increasing
profits, and evaluating the overall performance of the operation. See Golanty
v. Commissioner, 72 T.C. at 430; Foster v. Commissioner, T.C. Memo. 2012-207
[TC Memo 2012-207]. Petitioner retained all receipts and insured his buildings
and some of the horses. Petitioner, however, commingled the financial affairs
of his horse breeding activity with his personal finances. Although QuickBooks
allowed petitioner to separate his personal finances from his breeding
activity, he paid all the expenses of the horse activity from his personal
account. This commingling of personal and activity funds is not indicative of
businesslike practices. See Montagne v. Commissioner, T.C. [pg. 688] Memo.
2004-252 [TC Memo 2004-252], aff'd, 166 Fed. Appx. 265 [97 AFTR 2d 2006-992]
(8th Cir. 2006). Perhaps the most important indication of whether an activity
is being performed in a businesslike manner is whether the taxpayer implements
methods for controlling losses, including efforts to reduce expenses and
generate income. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo
2012-207]; Dodge v. Commissioner, T.C. Memo. 1998-89 [1998 RIA TC Memo
¶98,089]. Petitioner provided no evidence showing that he tried to reduce his
expenses, abandoned specific activities that had proven unprofitable, or
implemented any cost-cutting measures. Rather, petitioner maintained a steady
[*16] pace of losses which skyrocketed to six figures in 2004, and petitioner
continued to hemorrhage money from 2004 to 2011, including the years at issue.
Petitioner's failure to produce any significant income was a key factor in his failure
to earn a profit. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo
2012-207]; Dodge v. Commissioner, T.C. Memo. 1998-89 [1998 RIA TC Memo
¶98,089]. Petitioner contends that he made changes in his operations over the
years in an effort to increase his income. Those changes involved switching
from the Pearsons' stallion in 2000 and then switching to national, world
champion, or grand national stallions in 2004. Petitioner did not produce any
evidence demonstrating that he made a careful and thorough investigation of the
potential profitability of these changes before making them.See Foster v.
Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207] (citing Taube v.
Commissioner, 88 T.C. 464, 481 (1987)). On balance, we are not persuaded that
petitioner carried on his horse activity in a businesslike manner. This factor
weighs against a profit objective. 2.
Petitioner and His Advisors The taxpayer's expertise, research, and extensive
study of an activity, as well as his or her consultation with experts, may be
indicative of a profit motive.See sec. 1.183- 2(b)(2), Income Tax Regs. As a
successful accountant, petitioner did not need to seek further business and tax
advice when he started his breeding [*17] activity. Petitioner had knowledge about
raising horses and other large farm animals from growing up on a farm, but his
knowledge was not extensive; there is no indication that he garnered any horse
breeding experience at that time. During the course of his horse breeding
activity, petitioner consulted with persons who were knowledgeable about horse
breeding, including professional breeders, a professional trainer, and a
professional horseman, and petitioner followed the advice they gave him. See
id.; see also Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207].
Petitioner spent time studying the Morgan bloodlines, but the record does not
indicate that petitioner spent an extensive amount of time studying the
bloodlines. Petitioner, however, hired a trainer who lacked experience with
Morgan horses. On balance, this factor weighs slightly in favor of a profit
Effort Petitioner Expended in Carrying On the Activity The taxpayer's devotion
of much of his or her personal time and effort to carrying on an activity may
indicate a profit motive, particularly if the activity does not involve
substantial personal or recreational aspects. Sec. 1.183-2(b)(3), Income Tax
Regs. Although petitioner continued to maintain his accounting practice, he
spent over 1,500 hours each year working on his horse breeding activity, often
performing hard manual and menial tasks such as feeding and [*18] walking the
horses and mucking stalls. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC
Memo 2012-207] (the taxpayers demonstrated the requisite profit objective when
they spent 20 hours a week doing hard manual and menial tasks in their horse
activity). This factor weighs in favor of a profit objective. 4.
That the Horses May Appreciate in Value An expectation that assets used in the
activity will appreciate in value may indicate a profit motive even if the
taxpayer derives no profit from current operations. Sec. 1.183-2(b)(4), Income
Tax Regs. Petitioner credibly testified that he expected his horses would
appreciate because of his successful breeding program and that he [pg. 689]
believed he could eventually produce a “golden cross” Morgan horse capable of
garnering stud fees exceeding $10,000 and a sale price exceeding $100,000.
Petitioner also provided some evidence that his 18-acre property increased in
value over time, from an estimated $207,000 in 2002 to an estimated $361,900 in
objective, however, may be inferred from such expected appreciation of the
activity's assets only where the appreciation exceeds operating expenses and
would be sufficient to recoup the accumulated losses of prior years. Foster v.
Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207]; see Golanty v.
Commissioner, 72 T.C. at 427-428. The appreciation of petitioner's horse
breeding assets does not [*19] begin to approach the amount of losses
petitioner has reported since the beginning of his horse activity.
also failed to provide any evidence linking his 18-acre property's increase in
value to his horse breeding activity. Without more information, we cannot
conclude that the property increased in value because of petitioner's horse
breeding activity. On balance, this factor is neutral. 5.
Success in Similar Activities Section 1.183-2(b)(5), Income Tax Regs., provides,
in pertinent part: “The fact that the taxpayer has engaged in similar
activities in the past and converted them from unprofitable to profitable
enterprises may indicate that he is engaged in the present activity for
profit”. Although petitioner successfully ran his accounting practice, his work
as an accountant is not sufficiently similar to operating a horse breeding
activity to indicate that he could do so successfully. See Berry v.
Commissioner, T.C. Memo. 2000-109 [TC Memo 2000-109]. This factor weighs
against a profit objective. 6.
History of Income or Losses A history of continued losses with respect to an
activity may indicate a lack of a profit motive. See sec. 1.183-2(b)(6), Income
Tax Regs. While a series of losses during the initial or startup stage of an
activity may not necessarily indicate [*20] a lack of a profit motive, a record
of large losses over many years is persuasive evidence that the taxpayer did
not have such a motive. Golanty v. Commissioner, 72 T.C. at 426; Foster v.
Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207].
cumulative losses should not be of such a magnitude that an overall profit on
the entire operation, including recoupment of past losses, could not possibly
be achieved. Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), aff'd, 379
F.2d 252 [19 AFTR 2d 1566] (2d Cir. 1967); Foster v. Commissioner, T.C. Memo.
2012-207 [TC Memo 2012-207]. If losses are sustained because of unforeseen or
fortuitous circumstances beyond the control of the taxpayer, such losses would
not be an indication of the lack of a profit motive. See sec. 1.183-2(b)(6),
Income Tax Regs. Petitioner realized no profits whatsoever in 17 years of
engaging in his horse breeding activity. He contends that his losses are not an
indication that he lacked a profit objective because the losses were caused by
factors beyond his control.
cites unexpected deaths, miscarriages, stillborn foals, and the negative effect
of the recession on horse sales. We acknowledge that horse breeding is a
speculative activity, but these events hardly account for an unbroken string of
17 years of losses. Furthermore, petitioner did not show that his horse
breeding activity would have been profitable if events beyond his control had
not [*21] occurred. See Burger v. Commissioner, 809 F.2d 355, 360 [59 AFTR 2d
87-431] n.8 (7th Cir. 1987), aff'g T.C. Memo. 1985-523 [¶85,523 PH Memo TC];
Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207].
also contends that because he switched from trying to breed grade horses to
world caliber horses in 2004, his horse breeding activity was in its initial or
startup stage in tax years 2007 and 2008. Petitioner, however, continuously
maintained a horse breeding activity from 1995 through 2011 with the same
knowledge, equipment, and space. The only change petitioner made was from
trying to produce one caliber of horse to trying to produce another caliber of
horse. We are unconvinced by [pg. 690] this argument, and we decline to “reset
the clock” in 2004 simply because petitioner altered the goal of his horse
breeding activity. Petitioner further contends that he could potentially earn a
substantial profit with one outstanding horse.
possibility of a speculative profit in a taxpayer's horse activity, however, is
insufficient to outweigh the absence of profits for a sustained period of
years. See Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207]; see
also Chandler v. Commissioner, T.C. Memo. 2010-92 [TC Memo 2010-92], aff'd, 481
Fed. Appx. 400 [110 AFTR 2d 2012-6059] (9th Cir. 2012); McKeever v.
Commissioner, T.C. Memo. 2000-288 [TC Memo 2000-288]. This factor weighs
heavily against a profit objective. [*22] 7. Amount of Petitioner's Occasional
Profits The amount of profits in relation to the amount of losses incurred may
provide useful criteria in determining the taxpayer's intent. Sec.
1.183-2(b)(7), Income Tax Regs. Petitioner never earned a profit from his horse
breeding activity. This factor weighs against a profit objective. 8. Petitioner's
Financial Status Substantial income from sources other than the activity may
indicate that the activity is not engaged in for profit. Sec. 1.183-2(b)(8),
Income Tax Regs. A taxpayer with substantial income unrelated to the activity
can more readily afford a hobby. Foster v. Commissioner, T.C. Memo. 2012-207
[TC Memo 2012-207]. This is particularly true if the losses from the activity
might generate substantial tax benefits. Golanty v. Commissioner, 72 T.C. at
429; Foster v. Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207].
substantial income from his accounting firm allowed him to continue his horse
breeding activity despite 17 years of substantial losses. See Foster v.
Commissioner, T.C. Memo. 2012-207 [TC Memo 2012-207]. Petitioner's horse
breeding activity also generated generous tax savings in the form of net losses
that offset petitioner's substantial accounting income. This factor weighs
against a profit objective. [*23] 9. Elements of Personal Pleasure or
Recreation The presence of personal motives and recreational elements in
carrying on an activity may indicate that the activity is not engaged in for
profit. Sec. 1.183- 2(b)(9), Income Tax Regs. Petitioner argues that neither he
nor his family members rode his horses and that his horse breeding activity
required him to engage in hard manual labor. We question, however, whether he
would have continued his money-losing horse breeding activity for 17 years
unless he received some satisfaction from the work. See Foster v. Commissioner,
T.C. Memo. 2012-207 [TC Memo 2012-207] (the taxpayers' horse activity involved
hard work, but the taxpayers would not have continued the losing horse activity
for many years had they not received satisfaction from the work). It is more
likely that such satisfaction, rather than a profit objective, accounts for
petitioner's persistence. On balance, this factor is neutral. Conclusion After
weighing all the facts and circumstances in the light of the relevant factors,
we conclude that petitioner did not engage in his horse breeding activity for
the years at issue with the requisite profit objective. Petitioner's many years
of losses without a meaningful plan for recouping them are most persuasive. See
we sustain respondent's determination regarding petitioner's horse breeding
Penalties Under Section 6662(a) Respondent determined that petitioner is liable
for accuracy-related penalties pursuant to section 6662(a) for tax years 2007
and 2008. Section 6662(a) adds to a tax 20% of any underpayment attributable
to, among other things, (1) negligence or disregard of rules or regulations
within the meaning of section 6662(b)(1); or (2) any substantial understatement
of income tax within the meaning of section 6662(b)(2). A substantial
understatement of income tax is defined as an understatement that exceeds the
greater of $5,000 or 10% of the [pg. 691] income tax required to be shown on
the return for the taxable year. Sec. 6662(d)(1)(A). The Commissioner bears the
burden of production with respect to this penalty. Sec. 7491(c). This burden is
satisfied if the Commissioner comes forward with sufficient evidence indicating
that it is appropriate to impose the relevant penalty. Higbee v. Commissioner,
116 T.C. at 446. Respondent determined that petitioner should have reported
$58,092 on his 2007 Federal income tax return and $70,846 on his 2008 Federal
income tax return. Respondent also determined that petitioner understated his
income tax by $39,685 for tax year [*25] 2007 and by $47,757 for tax year 2008,
which are both greater than $5,000 and greater than 10% of the income tax
required to be shown on the returns for the taxable years.
respondent has carried his burden to show that petitioner substantially understated
his income tax for tax years 2007 and 2008. If a taxpayer had reasonable cause
for and acted in good faith regarding part of the underpayment, no penalty is
imposed on that part. See sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs.
factor for demonstrating reasonable cause and good faith is the extent of the
taxpayer's effort to determine the proper tax liability. Sec. 1.6664-4(b)(1),
Income Tax Regs. Petitioner, a successful accountant, did not provide any
evidence regarding what, if any, effort he made to determine his proper tax
liability at the time of filing his 2007 or 2008 tax return. Each year
petitioner sustained significant losses from his horse breeding activity, and
any gross income he received from that activity was substantially lower than
his losses. Yet, he did not seek advice about whether to continue to treat his
horse activity as engaged in for profit. Petitioner is well educated and
familiar with Federal income tax laws and regulations. His experience,
knowledge, and education weigh against him. See Brown v. Commissioner, T.C.
Memo. 2011-83 [TC Memo 2011-83], aff'd, 693 F.3d 765 [110 AFTR 2d 2012-5881]
(7th Cir. 2012).
failed to show that he had reasonable cause for and acted in good faith
regarding the underpayment. [*26] We hold that petitioner is liable for the
substantial understatement penalty under section 6662(a) and (b)(2). We need
not address the applicability of the penalty on the grounds of negligence or
disregard of rules or regulations within the meaning of section 6662(b)(1) for
tax years 2007 and 2008. See sec. 1.6662-2(c), Income Tax Regs. Contentions we
have not addressed are irrelevant, moot, or meritless. To reflect the
foregoing, Decision will be entered for respondent.