“Don’t go into the horse breeding business” That is good advice. You might modify it to something like “ Go into horse breeding to follow your bliss, but don’t expect to make money at it . The way to make a small fortune in the horse breeding business is to start with a large fortune” Still good advice. Here is another piece of advice. “If you do go into the horse breeding business, even though you are trying to make money at it, don’t claim the tax losses, because you will get audited and lose and have to pay penalties” That is bad advice.
Take Those Losses
If in defiance of common sense, you go into the horse breeding business with profit as an honest objective and nonetheless experience losses, you should claim the losses. Other tax practitioners will point to numerous cases where horse breeders have their losses denied. They probably have not read as many horse cases as I have, but I have to say their evidence stands up. Back of the envelope, a litigated Section 183 horse cases is three times as likely to be an IRS win as opposed to a taxpayer win.
But litigated cases are a bad sample. Most cases settle. Unfortunately, any information on that is anecdotal, unlike the decided cases which are there for all to see. The word on the street is that cases settle for 50% (or sometimes over 80% in favor of the taxpayer) in appeals. And it is back to claiming the losses after that. But the really interesting thing is that in many of the litigated cases where taxpayers lose, they are actually winners if you take a broader view.
Another Losing Horse Case
This all brings up the Tax Court decision in the case of James and Elaine Donoghue (6/11/2019). I caught a tweet about this being another example of the supposed futility of claiming horse breeding losses . I think the tweeter is wrong but first, let’s discuss the loss.
A Virtual Farm
I have often remarked that everything that I know about horse businesses comes from reading Section 183 cases. Of late I have tried to supplement that a little bit. I found a forum that was discussing whether there was any way at all of making money breeding. One of the observations was that it absolutely could not be done if you were paying to board your horses. So it seems that the odds were against Marestelle Farm, which is how the Donoghues dubbed their operation.
Marestelle Farm was a “virtual farm”. Petitioners never actually owned a farm or a facility where they kept and trained their horses but instead paid other farms to do so. Although petitioners lived in Massachusetts during all of the years of their horse activity, the farms they used were in multiple States, including Massachusetts, South Carolina, Kentucky, Florida, and New York.
One Factor To Rule Them All
The Donoghues were facing a tab just over $30,000 including penalties for the years 2010, 2011 and 2012. The Tax Court went through the whole nine-factor drill (Manner activity is carried on, Expertise, Time and effort, Appreciation, Success in other endeavors, History of income or loss, Occasional profits, Financial status of taxpayers, Elements of personal pleasure).
My own slightly cynical view is that only the first factor (Manner activity is carried on) matters and that the judges fudge the other factors. In this case, it was eight in favor of the IRS. The fifth factor, success in other activities, was considered neutral because they hadn’t really done anything else entrepreneurial.
And The Five
The discussion of the”manner in which the activity is conducted”(Factor One in the regulation – Factor One and Only in my view) is interesting. Going straight from the regulation, there are three sub-factors. Sometimes you see four. In this case there are five. I found that there was precedent for the five and oddly one of those decisions was an exception to the rule I have found that winning on Factor 1 means that you win overall.
Maintained accurate books and records, prepared a business plan, conducted the activity in a manner similar to other activities that were profitable and in the case of horse breeding and sales ran a consistent and concentrated advertising program. The business plan and the concentrated advertising program are extensions of the regulation.
The Tax Court picked an odd nit:
For many years petitioners reported their income and expenses related to Marestelle Farm as if it was a sole proprietorship owned by Mr. Donoghue alone, despite the fact that since its inception in 1985 it was actually a partnership
I can’t get that excited about that when they are filing a joint return. It is not unusual for inattention to detail on returns to be held against taxpayers in assessing the manner in which business was carried on. I should note that in some instances married couples are allowed to forgo partnership returns on their joint business.
The most unbusinesslike thing, in the view of the Court, that the Donoghues did was not much.
According to petitioners, in order to improve Marestelle Farm’s profitability they changed its operations and procedures by no longer racing or breeding their horses and instead offering them up for sale and also by cutting expenses by leasing, rough boarding, and putting into training arrangements some of their horses. However, it is incredible to think that ceasing racing and breeding, no matter the amount of expenses cut, could lead to profitability.
It is mentioned early on that the Donoghues had shut down in 2014, so this might have been more of a wind-down phase. It is also worth noting that they were not using an attorney (reasonable given the stakes). If they had had counsel, their narrative might have been structured better.
The Magic Number
There is one other point of this case that is worth noting. The discussion of the eighth factor – financial status – gives a clue to who has to worry about hobby loss.
It is undisputed that petitioners received a total of over $100,000 in wage and Social Security income in each of the years at issue ($102,376 in 2010, $106,102 in 2011, and $111,374 in 2012). After applying their Schedule E deductions attributable to Marestelle Farm ($52,554 in 2010, $69,719 in 2011, and $61,028 in 2012) petitioners reported total tax due of $538 in 2010 and zero in 2011 and 2012. Section 183 does not apply just to wealthy individuals as even taxpayers with modest tax liabilities can have a motive to shelter those liabilities. (Emphasis added)
When TIGTA looked into whether IRS was pushing hard enough on hobby loss, the standard they used was loss of $20,000 or more, revenue of less than $20,000 for four years and W-2 over $100,000.
$100,000 per year still sounds wealthy to a lot of people – to a Tax Court judge making $169,300 who knows the attorneys he sees often make a lot more maybe not. I could not resist checking the inflation calculator and learned that it is the equivalent of $15,000 a year when I was a teenager in the late sixties. That was when “making your age” was a sign that you were making it.
The TIGTA report was in 2016. This case was docketed in early 2015 meaning it was coming off a deficiency notice from late 2014. Susan Crile who won an important hobby loss victory had a salary that ranged from $86,000 to $106,000 in the years under audit (2004-2008). With her financial status was rated a neutral factor. Really, I do think the judges fudge some of the factors to get to the decision they want.
We are not supposed to be giving audit lottery advice, but I think that if your client who has had persistent losses from their side activity – be it horses or multi-level marketing or whatever – has a W-2 that finally breaks into six figures, you should pay a little extra attention to the Section 183 issue.
How Are The Donoghues Winners?
Claiming horse losses for 2010-2012 cost over $5,000 in accuracy penalties. And then there was the stress and aggravation of the audit and the trip to Tax Court. So would it have been better if they had never deducted losses? I don’t think so.
From 1985 to 2012 Marestelle Farm incurred expenses totaling $1,008,303 but realized income totaling only $33,691, resulting in accumulated losses of $974,612.
The penalties on roughly $200,000 in disallowed losses do not make a dent in the savings from the $700,000 or so of losses that were allowed.
This type of thinking would not be valid for activity that was fraudulent in nature, but that is not what is going on. The losses you are claiming are clearly disclosed.
So if you have the intent to profit and you have losses, don’t let the fear of audit stop you. You might want to keep a few dollars aside just in case though.
Lew Taishoff covered the case just for me.
I am blogging James P. Donoghue and Elaine S. Donoghue, 2019 T. C. Memo. 71, filed 6/11/19, not for any novel legal propositions, nor for any off-beat factual circumstances, therein set forth, but rather for the delectation of my colleague Peter Reilly, CPA.
There was one procedural issue that I had to ask him about. There was a ruling in the docket indicating that the IRS head of examination did not have to testify. He responded.
This is a deficiency case, trial de novo, past isn’t even prologue. Whatever happened at examination is irrelevant; petitioners get to put in all their evidence, whatever examination allowed or disallowed.
A typical Taishoff Shakespeare reference there.