T.C. Memo. 2013-221
UNITED STATES TAX COURT
ZAVRA D. RODRIGUEZ, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
ANDREA M. RODRIGUEZ, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 5093-11, 5094-11. Filed September 18, 2013.
Anthony V. Diosdi, for petitioners.
Timothy A. Froehle, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: In separate notices of deficiency, respondent determined
deficiencies in petitioners’ Federal income tax and related accuracy-related
penalties for 2007 as follows:
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[*2] Accuracy-related penalty
Petitioner Deficiency sec. 6662
Andrea M. Rodriguez $24,701 $4,940
Zavra D. Rodriguez 22,228 4,445
Petitioners, while residing in California, petitioned this Court for a
redetermination of their deficiencies and penalties. The parties were able to
resolve a number of issues reflected in the stipulation of settled issues filed
October 23, 2012. We decide two remaining issues: (1) whether petitioners’
horse-breeding activity was “an activity not engaged in for profit” within the
meaning of section 1831 for 2007. We hold it was; and (2) whether petitioners are
liable for the accuracy-related penalties under section 6662(a). We hold they are
not.
FINDINGS OF FACT
The parties’ stipulation of facts with accompanying exhibits, their
supplemental stipulation of facts with accompanying exhibits to the extent
admitted during trial, and the stipulation of settled issues are incorporated herein
by this reference. We find the facts accordingly.
1
Unless otherwise indicated, section references are to the Internal Revenue
Code (Code) in effect for the year at issue, and Rule references are to the Tax
Court Rules of Practice and Procedure.
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[*3] I. Petitioners’ wage income history
Andrea has been employed by the State of California as a “state
investigator” since at least 1993. Between 1993 and 2000, Andrea and her then
husband, José Rodriguez, filed a joint Federal income tax return for each year and
reported a combined annual income, including wages, ranging from $78,000 to
$108,000. After their divorce, Andrea reported her annual income, including
wages, ranging from $48,000 to $71,000 for years 2001 through 2009; except that
in 2007, the year at issue, Andrea had $69,977 additional income from a
distribution from pensions and annuities.
Zavra, Andrea’s daughter, began filing Federal income tax returns in 2002.
Zavra reported annual wage income ranging from $22,000 to $35,000, except in
2007 when she also received a distribution from pensions and annuities of
$69,977 (the same amount Andrea received in the same year).
II. Petitioners’ horse-breeding activity
A. History of income and losses from the horse-breeding activity
1. Queensland’s losses
Andrea and her then husband José began their horse-breeding activity,
Queensland Horse Farm (Queensland), in 1993, which petitioners have conducted
at all relevant times at a 40-acre farming property in Farmington, California
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[*4] (Farmington property).2 From its inception through 2009, the horse-breeding
activity never turned a profit and in fact incurred more than $1.8 million of losses
reported on Schedule F, Profit or Loss From Farming. Between 20023 and 2008,
Andrea and Zavra each claimed half of the deductions for the annual losses
resulting from the activity. With the losses, petitioners were able to offset all of
their income during the period between 1993 and 2008 and incur zero tax liability
as shown in the following table:4
2
Andrea and José purchased the Farmington property in 1989. When they
purchased the Farmington property, the property also included a residence where
petitioners have lived since.
3
Zavra became Andrea’s partner in the horse-breeding activity in 2002. See
infra. The record does not show that Zavra filed a Federal income tax return
before 2002.
4
In 2009 Zavra left the partnership and did not claim any loss deduction
from the horse-breeding activity. As a result, Zavra had a tax liability of $11,829
on her $31,129 wage income from 2009.
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[*5] Andrea’s Zavra’s
Income & Income &
wages Taxable wages Taxable
(excluding Schedule F income (excluding Schedule F income
Schedule F income or (after Schedule F income or (after
Year1 income) (loss) deductions) income) (loss) deductions)
1993 $77,664 ($113,988) -0- --- --- ---
1994 83,495 (57,321) -0- --- --- ---
1995 --- --- --- --- --- ---
1996 --- --- --- --- --- ---
1997 --- --- --- --- --- ---
1998 --- --- --- --- --- ---
1999 105,468 (145,699) -0- --- --- ---
2000 107,947 (156,149) -0- --- --- ---
2001 57,487 (135,370) -0- --- --- ---
2002 58,505 (81,565) -0- 21,503 (81,565) -0-
2003 70,790 (59,924) -0- 26,162 (59,924) -0-
2004 67,798 (49,877) -0- 33,401 (49,877) -0-
2005 67,635 (58,118) -0- 33,131 (58,118) -0-
2006 50,158 (83,165) -0- 34,738 (83,165) -0-
2007 121,876 (105,424) -0- 104,607 (105,424) -0-
2008 53,198 (97,662) -0- 34,377 (97,662) -0-
2009 47,735 (128,452) -0- 31,129 -0- 11,829
Total 969,756 (1,272,714) -0- 319,048 (535,735) 11,829
1
Andrea and José’s Federal income tax returns for years 1995 through 1998 are not part of the
record.
2. Queensland’s income
Queensland’s income stream over the years was dismal and sporadic; it
totaled approximately $15,000 between 1993 and 2009. During the five-year
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[*6] period between 2004 and 2008, Queensland generated zero Schedule F
income. The following table shows Queensland’s history of farm income:
Schedule F income from
Year Queensland
1993 $750
1994 775
1995 ---
1996 ---
1997 ---
1998 ---
1999 -0-
2000 -0-
2001 2,250
2002 5,000
2003 6,000
2004 -0-
2005 -0-
2006 -0-
2007 -0-
2008 -0-
2009 346
Total 15,121
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[*7] B. Petitioners’ research and expertise relating to the horse-breeding
activity
1. Andrea
Andrea started riding horses at the age of three and received formal
instruction when she was in high school and college. As she traveled the world
and became familiar with different types of horses, Andrea became fascinated with
warmbloods, which are horse breeds primarily from countries where riding is an
older discipline than it is in the United States. Andrea particularly enjoyed riding
Swedish warmbloods described as medium-sized warmbloods that are known to be
sport horses and performance horses.
In 1990 Andrea took a class in dressage where she learned dressage
exercises and techniques. Dressage is an equestrian sport that emphasizes
controlled athletic movements of a horse and requires the horse to spend years to
become athletically fit enough to perform certain routines; it is very similar to
gymnastics or ballet for humans. There are certain breeds of horses that are more
successful in this discipline because of the desirable phenotype that is malleable to
controlled movements. The medium-sized Swedish warmblood is an ideal breed
for this type of riding.
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[*8] Before Queensland’s inception, Andrea already focused her research on
breeding Swedish warmbloods. She became a member of the Swedish Warmblood
Association (SWA), which periodically dispatched inspection teams from Sweden
to the United States to grade and evaluate horses presented at inspection events.
Even though she did not own any horses at the time, Andrea would attend the
inspections to learn about SWA’s criteria of grading horses. Andrea also wanted
to see the horses in performances and study the overall phenotype that SWA’s
breeding program tried to achieve. In 1989 Andrea also became a member of the
California Dressage Society, which sought to promote dressage in California
through performances, competitions, and clinics.
In addition, Andrea contacted almost all Swedish warmblood breeders in the
United States and Canada and a great number of them in Sweden for purposes of
seeking expert advice on breeding Swedish warmbloods. For example, Andrea
contacted Jan Phillipson, the president of ASVH, which is the Swedish warmblood
state association and registry, to seek marketing advice as well as advice on the
suitability of Swedish warmbloods for sport performances and competitions.
In the early 1990s petitioners also met with Helen Dilworth on multiple
occasions. Ms. Dilworth at the time had owned and operated Trilogy Farm, a
horse-breeding farm and business in Santa Cruz, for five years. During their
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[*9] meetings, petitioners would ask Ms. Dilworth general questions about her
approach to breeding Swedish warmbloods, evaluating foals, and marketing and
valuing horses. But Ms. Dilworth did not provide advice specific to petitioners’
own operation or business plan. While Ms. Dilworth believes that she breeds
good horses, she also acknowledges that “there are very few people in the world
right now that are making any money breeding horses.” There has been little
contact between petitioners and Ms. Dilworth in the past 10 years.
Besides contacting those familiar with breeding Swedish warmbloods,
Andrea also went to the Small Business Administration (SBA) in San Francisco
ostensibly to obtain business advice from their SCORE Program. SCORE consists
of a group of retired executives who offer mentoring services to small businesses.
In connection with obtaining business advice from SCORE, Andrea submitted a
business plan in 1993 (1993 business plan) that contained only general
information. See infra. The plan mainly discussed breeding of horses. After
Andrea submitted the business plan, she talked to an individual from SCORE
about the plan, but the person had no knowledge about horses, had never been part
of any horse business, and was not acquainted with anybody who had horses or a
horse business. The record is devoid of details regarding the content of any
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[*10] business advice Andrea might have received from the individual through
this consultation.
2. Zavra
Zavra began taking riding lessons when she was a child. She has always
enjoyed being around horses as they have always been a part of her life, so much
so that at one point she dreamed of becoming a horse veterinary physician. As
early as 1985 when Zavra was 12, she already began studying about horses.
Between 1991 and 1993 she attended University of California in Davis (UC
Davis) sporadically for two years and took classes in agricultural sciences and
animal husbandry. She also took classes in horse breeding, artificial insemination,
and general management and care. Zavra had an internship at UC Davis on horse
breeding as well as internships with local veterinarians. In addition, she took
classes in the Swedish language while at UC Davis with the idea that she could
later communicate with breeders in Sweden.
Around the same time, Zavra started to focus her research on breeding
Swedish warmbloods. She contacted associations in Sweden and reviewed
competition results. Zavra believed on the basis of her research that Swedish
warmbloods were more marketable and more suitable for sport performances and
competitions. In 1993 Zavra traveled to Sweden, met with breeders there to find
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[*11] the best horses, and brought back with her about five horses from Sweden.
In 1996 she arranged the purchase and shipping of horse semen from Sweden.
C. The manner in which petitioners carried on the horse-breeding
activity
1. Business plan
Andrea allegedly devised a business plan for her horse-breeding activity as
early as 1981 and submitted it to the SBA in San Francisco for feedback. The
1993 business plan submitted to the SBA was a revision of this original business
plan and, according to petitioners, was updated several times following the initial
submission to the SBA. The initial submission from 1993 is the only business
plan in evidence. The record does not show when the last time petitioners revised
or revisited their business plan was.
The 1993 business plan contains five paragraphs of general description of
the horse-breeding activity. It provides mainly information on breeding and
training Swedish warmbloods. It states that Queensland is geared toward “the
serious upper-level horse rider[s] * * * who are able to invest a great deal of time,
effort, and money into their sport.” It continues to state that “the initial investment
of purchasing a horse is the least costly aspect of Dressage and Jumping. The
daily care and upkeep for a horse is actually the greater expense.” It claims that
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[*12] Queensland would require a large upfront investment, including startup
costs, and any return on the investment would be delayed until the horses become
marketable. According to the 1993 business plan, the startup cost for Queensland
would be roughly $560,000.
The 1993 business plan essentially acknowledges that the purchasing of a
horse constitutes only a small part of the overall longterm investment in owning
and training a Swedish warmblood for sport, and the greater expense would be the
daily care and upkeep. It thus appears that the longer petitioners held on to a
horse, the more the potential profit from that horse would diminish in part because
of the substantial overhead expenses. But the business plan fails to identify any
considerations that may affect how petitioners could maximize profits from their
horses.
The 1993 business plan also fails to articulate specific business
requirements for the activity or provide the activity’s financials. For example, the
business plan does not have an operating costs projection, a multiyear profit and
loss (P&L) projection, a balance sheet, or a cashflow statement often found in
many business plans.
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[*13] 2. Advertising
By 2007 petitioners had placed no more than a handful of advertisements in
various trade magazines and publications to list some of their horses for sale.
They had also advertised the selling of semen of their stallions. However, there is
no evidence that these advertisements generated any actual sales or were
successful in reaching any potential buyers. There is nothing in the record
suggesting petitioners have examined the effectiveness of their advertising efforts.
3. Budgeting
At least before 1999, Andrea and José, and possibly Zavra as well, used an
accounting software to track expenses and a special horse-breeding software to
track their inventory. Andrea would keep track of daily expenditures on index
cards, and someone would then enter the information into the accounting software.
Petitioners maintained a separate checking account for Queensland but only
between 1993 and 1999.
Although petitioners kept track of Queensland’s expenses and inventory,
they never personally prepared any financial statements to scrutinize the activity’s
P&L, assets and liabilities, or cashflow despite the fact that the information
needed to run the financials was, according to Andrea, readily available through
the accounting software. Nonetheless, petitioners allegedly made rough financial
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[*14] projections annually to determine the amount of income necessary to recover
expenses incurred in the previous years and to generate a profit. Clearly, any
financial projections that petitioners might have made had very little impact on the
business decisions relating to Queensland since the activity continued to lose
money every year and, as we will discuss below, petitioners did very little to turn
the tide.
4. Insurance coverage
Petitioners did not have any insurance coverage for their horse-breeding
activity and did not receive any insurance proceeds for a casualty loss relating to
the activity as a result of a fire in 1999 (1999 fire). However, Andrea and her then
husband had an insurance policy underwritten by Farmers Insurance Group to
cover their personal property on the Farmington property and received insurance
proceeds of $165,485 covering personal property lost in the 1999 fire.
5. Financing the horse-breeding activity
To finance the horse-breeding activity, both Andrea and Zavra used their
wage income to pay the activity’s expenses. Andrea also used life insurance
proceeds of $242,000 that she received in 2006 and the $100,000 of proceeds of a
2005 home equity loan secured by the Farmington property to pay Queensland’s
expenses.
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[*15] Queensland did not have any outside investors, and the record does not
show petitioners had secured a commercial loan from a third-party lender to
finance the horse-breeding activity.
D. Assets used in the horse-breeding activity
1. The horses
Petitioners’ horse-breeding activity initially encompassed only the selling of
the horses that they bred. In 2007 Queensland had 29 horses. Since inception,
petitioners have sold 7 horses as follows:
Horse Year sold Price
Sabella 1997 $6,500
Gwenna 2001 2,250
Garrisson 2002 5,000
Cassanova 2003 2,500
L’Irco 2003 1,500
Ikebano 2003 1,500
Lamira 2010 5,000
Lamira was an example of a diploma mare--that is, she was inspected and
found to be a horse of high quality--and was sold for $5,000 in 2010, among the
highest selling prices in Queensland’s history. But the journey she traveled to her
eventual sale was a costly one. Andrea bought Lamira for approximately $15,000
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[*16] in 1993 when she was nine months old. For about eight years Andrea had to
spend at least $800 a month to board and train Lamira, or about $75,000 in the
aggregate. At one point during the mid 1990s, Lamira was appraised for $25,000.
Later, petitioners received an offer to purchase Lamira for $110,000, which
petitioners rejected. Petitioners eventually sold Lamira at the age of 17 for $5,000.
In 1998 Andrea began to include the selling of her stallions’ semen as part
of the horse-breeding activity. At the time, she had contracted to sell in 1999
roughly $25,000 worth of semen that would have produced 10 breedings. Because
the 1999 fire destroyed the semen and prevented Andrea from performing the
contracts, Andrea did not complete any of the contracted sales and did not actually
receive any income in 1999 from selling horse semen. Petitioners did not contract
for any sales of horse semen in any other year.
2. The Farmington property
Since 1989 when Andrea and her then husband purchased the Farmington
Property, they had allegedly made certain improvements. Presently, Andrea,
Zavra, and Zavra’s three-year-old child live at the residence on the Farmington
property.5
5
For 2007, petitioners claimed utility and insurance expenses relating to
their personal residence as part of the horse-breeding activity’s expenses on their
(continued...)
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[*17] There is nothing in the record showing the fair market value of the
Farmington property and the improvements on the property.
E. Time and efforts spent in the horse-breeding activity
In 2007 Andrea worked 40 hours a week as a litigation investigator for
Department of Transportation for the State of California. Andrea claims that she
also worked 84 to 112 hours every week in petitioners’ horse-breeding activity
during all relevant times. Andrea also claims that in some years she had other
part-time employments and worked 10 to 25 additional hours a week. According
to Andrea, there were days when she worked two or three days through without
sleep as well as days when she slept in the barn with the horses when the mares
were about to give birth. She includes the number of hours spent sleeping with
her horses as hours worked for the horse-breeding activity.
Even though petitioners hired manual labor from time to time, Andrea put in
a lot of her own physical labor in the horse-breeding activity. For example, she
physically built the barns herself--putting up outdoor shelters, digging holes for
fence posts, setting the posts with cement, putting up plywood, and corrugating
roofs. She also installed the watering systems to three of the barns and built
5
(...continued)
Schedule F.
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[*18] arenas for horse training. Andrea performed many repairs using her
knowledge in welding work such as building a gate.
A typical day for Andrea at Queensland would start between 4 a.m. and 5
a.m. when she would go out to the farm and check on the horses and the other
animals to make sure they were where they were supposed to be. She would also
feed the animals and closely examine them to make sure that they were eating and
not lame and had no big cuts or scrapes. In addition, she sometimes would need to
“worm” the animals, which is a process of killing intestinal parasites. Andrea has
always been very meticulous and insisted on performing these tasks herself to
ensure her animals receive the best care or at least the standard of care that would
be satisfactory to her.
In 2007 Zavra worked at least 40 hours a week for the horse-breeding
activity. She was also employed part time as a “vendor rep” for Excell Marketing
LC, working 2 to 16 hours per week.
F. Petitioners’ other activities engaged in for profit
During all relevant times, petitioners did not conduct any similar or
dissimilar activities engaged in for profit.
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[*19] G. Intervening events
1. Selenium deficiency in the surrounding area
Around 1998 Andrea discovered that hay from her local area, which she
used to feed her horses, was deficient in selenium. A lack of selenium in a horse’s
diet would have a negative effect on the horse’s muscles and could cause medical
problems that can be life threatening. To rectify the problem, Andrea began to
import hay containing adequate amounts of selenium from other parts of the
country. Importing hay from other areas proved to be very costly--instead of $3 a
bale for local hay, imported hay could cost petitioners as much as $17 a bale, or
600% more.
2. The 1999 fire
The 1999 fire caused damage to petitioners’ residence on the Farmington
property as well as property that was part of the horse-breeding activity. The fire
consumed many acres of the farm and other Queensland assets, such as inventory,
blankets, show bridles, halters, show halters, and books and records of the activity.
After the fire destroyed the barn, the barn was rebuilt and placed back in service
around 2007.
The fire took down Queensland’s utility lines for months, leaving it without
electricity and running water while they were down. One horse died from the
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[*20] incident, and many others became stressed. It also destroyed the tanks that
stored the horse semen petitioners had allegedly planned to sell. According to
petitioners, the fire adversely affected petitioners’ ability to breed horses because
it destroyed much of the necessary equipment. The farm’s reconstruction was not
completed until 2008.
3. Missed inspection in 2001
Petitioners had organized an inspection to be conducted by the Swedish
Warmblood Association of North America (SWANA) at the fairgrounds in Santa
Rosa, California. Petitioners rented the fairgrounds and planned to have some of
their horses inspected by the SWANA team. They anticipated future breeders and
prospective Swedish warmblood buyers, who had previously contacted them to
express interest in purchasing their horses, to attend the event. The inspection was
scheduled to take place on September 12, 2001.
As a result of the terrorist attacks on the World Trade Center the day before
the scheduled inspection, the SWANA inspectors were unable to travel to Santa
Rosa and the inspection was canceled. Consequently, the SWANA team did not
inspect the 15 to 19 horses that petitioners planned to bring to the inspection,
and petitioners did not meet with the prospective buyers and breeders at the
canceled event. Even though another inspection was set to take place the next day
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[*21] on September 13, 2001, at Ms. Dilworth’s Trilogy Farm in Santa Cruz,6
petitioners took only one or two young stallions to that inspection (Santa Cruz
inspection). Andrea explained at trial that logistical issues prevented the transport
of the remaining horses to Santa Cruz.
Andrea could not recall whether she took her horses to another inspection in
2002; nor is there anything in the record showing they took any of their horses to
an inspection in subsequent years. According to Andrea, horses must be inspected
at a certain age to receive a certain type of recognition, and thus missing the
inspection 2001 has had an adverse impact on the values of her horses. However,
petitioners have failed to state or quantify with specificity the extent to which the
missed inspection has had an adverse impact on the values of their horses.
H. Partnership between Andrea and Zavra
In 2002 Zavra joined Andrea as a partner to conduct the horse-breeding
activity. However, petitioners did not memorialize their alleged oral agreement to
form a partnership. The arrangement between petitioners appears to be that Zavra
would contribute her services as well as her wage income to pay certain expenses
of the horse-breeding activity in exchange for a 50% interest in the partnership.
Petitioners do not recall the amount of Queensland’s expenses Zavra has paid on
6
Farmington is about equidistant between Santa Cruz and Santa Rosa.
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[*22] behalf of the partnership or the value of any property or services Zavra
might have contributed to the partnership. Andrea’s then husband also contributed
about $2,000 every month--presumably while they were married--to the horse-
breeding activity but did not receive any partnership interest in return and thus had
never been a partner in the horse-breeding activity.
Petitioners filed Forms 1065, U.S. Return of Partnership Income, for 2002,
2003, 2005, and 2006.7 For 2002 and 2003 petitioners answered “No” to the
question “Is this partnership subject to the consolidated audit procedures of
sections 6221 through 6223?” For 2005 and 2006 petitioners answered “No” to
the question “Did the partnership file Form 8893, Election of Partnership Level
Tax Treatment, or an election statement under section 6231(a)(1)(B)(ii) for
partnership-level tax treatment, that is in effect for this tax year?”
OPINION
I. Jurisdiction
Generally, disputes over partnership items are subject to the unified audit
and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982
7
In the record are Forms 1065 attached to Andrea’s 2003 and 2005 Federal
income tax returns (but not Zavra’s returns for these years) and Forms 1065 to
Zavra’s 2002 and 2006 returns (but not Andrea’s returns for these years). Despite
the incomplete record, we are satisfied that both petitioners filed or at least
intended to file an identical Form 1065 for each of these four years.
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[*23] (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648. See generally
secs. 6221, 6225(a). To decide whether a partnership engages in an activity for
profit under section 183, we determine profit motive at the partnership level. See
Hill v. Commissioner, 204 F.3d 1214, 1218 (9th Cir. 2000) (citing Polakof v.
Commissioner, 820 F.2d 321, 323 (9th Cir. 1987), aff’g T.C. Memo. 1985-197,
and Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993), aff’g T.C. Memo
1991-212). Correspondingly, the disputed losses from Queensland are partnership
items of petitioners’ partnership in the horse-breeding activity during the year at
issue.8 Thus, absent an applicable exception, we do not have jurisdiction over the
disputed losses in these individual deficiency proceedings.
Section 6231(a)(1)(B) provides the so-called small partnership exception.
The term “partnership” under TEFRA does not include any partnership with 10 or
8
“[T]he term ‘partnership’ includes a syndicate, group, pool, joint venture,
or other unincorporated organization through or by means of which any business,
financial operation, or venture is carried on, and which is not * * * a corporation
or a trust or estate.” Sec. 761(a). A partnership exists when “the parties in good
faith and acting with a business purpose intend[] to join together in the present
conduct of the enterprise.” Commissioner v. Culbertson, 337 U.S. 733, 742
(1949). The parties do not dispute that petitioners intended to join together to
conduct the horse-breeding activity through a partnership described in sect.
761(a). One question presented here is whether that activity was engaged in for
profit in the year at issue. While we may occasionally refer to Queensland as a
partnership throughout this opinion, we do not intend to suggest that Queensland
was a profit-making, bona fide partnership for Federal income tax purposes.
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[*24] fewer partners who are individuals unless the partnership makes an election
to have the TEFRA procedures apply. Sec. 6231(a)(1)(B)(ii).
Petitioners claim that they orally entered into a partnership agreement in
2002 to carry on the horse-breeding activity and that they were the only partners in
the year at issue. Thus, their partnership is not a partnership under section
6231(a)(1)(B). Petitioners’ Forms 1065 for their partnership for 2002, 2003, 2005,
and 2006 show that they declined to make the election to have TEFRA apply.
While there is no evidence of a Form 1065 filed for 2007, there is likewise no
evidence showing petitioners filed a Form 8893, Election of Partnership Level Tax
Treatment, and made an election under section 6231(a)(1)(B)(ii) in 2007 or any of
the previous years to have the TEFRA procedures apply to them for 2007. We are
thus satisfied that an election under section 6231(a)(1)(B)(ii) was not in effect for
2007.
Because petitioners’ purported partnership is a “small partnership” that has
not elected to have TEFRA apply for 2007, we have jurisdiction to review in these
individual deficiency cases items otherwise subject to partnership-level
proceedings, including the disputed losses from the horse-breeding activity. New
Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161, 173 n.3 (2009) (citing
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[*25] Wadsworth v. Commissioner, T.C. Memo. 2007-46), aff’d, 408 Fed. Appx.
908 (6th Cir. 2010).
II. Perception of Andrea and Zavra as witnesses
In all cases, we observe the candor, sincerity, and demeanor of each witness
in order to evaluate her testimony and to assign weight to that testimony for the
primary purpose of finding disputed facts. We determine the credibility of each
witness, weigh each piece of evidence, draw appropriate inferences, and choose
between conflicting inferences in finding the facts of a case. The mere fact that
one party presents unopposed testimony does not necessarily mean that the elicited
testimony will result in a finding of fact in that party’s favor. We will not accept a
witness’ testimony on its face if we find that our impression of the witness coupled
with our review of the credible facts at hand conveys to us an understanding
contrary to the spoken word. See Neonatology Assocs., P.A. v. Commissioner,
115 T.C. 43, 84-87 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); HIE Holdings, Inc.
v. Commissioner, T.C. Memo. 2009-130, 97 T.C.M. (CCH) 1672, 1733 (2009),
aff’d, ___ Fed. Appx. ___, 2013 WL 1365354 (9th Cir. Apr. 5, 2013).
We find Andrea’s testimony to be generally unhelpful and unreliable. Her
testimony, especially during cross-examination, was ambiguous, equivocal, and
sometimes evasive. For example, Andrea was never able to provide during her
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[*26] testimony a timeframe when the Farmington property became partly
operational or fully operational after the 1999 fire. Her testimony was also
contradicted several times by her responses to the interrogatories that respondent
had previously propounded to her and other prior statements. For example,
Andrea testified at trial that after the 1999 fire, she began to use an accounting
software different from the one she used before the fire (i.e., Macintosh Quicken
as opposed to Microsoft Quicken); however, her responses to respondent’s
interrogatories stated that she abandoned her previous accounting methods and
devices altogether after July 1999, ostensibly to explain why she did not have an
accounting system for the year at issue. As another example, Andrea testified that
she took two young stallions to the Santa Cruz inspection, but her own notes next
to a copy of a refund check from SWANA for inspection fees in connection with
the Santa Cruz inspection state that she took only one stallion for inspection.
While we believe Zavra to be generally credible, we find her testimony
similarly unhelpful and unreliable. She claims that she entered into a partnership
with Andrea to carry on the horse-breeding activity for profit, but at the same time
she testified she did not know about the finances of the activity and not even the
$135,000 loss incurred in the year prior to her joining the partnership. It appears
her knowledge of Queensland’s operations and finances is extremely limited.
-27-
[*27] In sum, we give petitioners’ testimony little weight in our profit motive
determination.
III. “An activity not engaged in for profit”
Section 183 generally limits the deductions for an “activity not engaged in
for profit” to the amount of gross income received from the activity. Sec. 183(a)
and (b). Section 183(c) 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.” In
the Court of Appeals for the Ninth Circuit, the court to which an appeal of this
case most likely lies, an activity is engaged in for profit if the taxpayer's
“predominant, primary or principal objective” in engaging in the activity was to
profit. Wolf v. Commissioner, 4 F.3d at 713. In this context, the term “profit”
means economic profit, independent of tax savings. Id.
Petitioners bear the burden of proving that they entered into and during the
year in issue remained in the horse-breeding activity with a predominant, primary,
or principal objective of earning a profit. See Rule 142(a)(1); Welch v. Helvering,
290 U.S. 111, 115 (1993); Giles v. Commissioner, T.C. Memo. 2005-28, 89
T.C.M. (CCH) 770, 775 (2005). We determine profit intent on the basis of all
surrounding facts and circumstances. Golanty v. Commissioner, 72 T.C. 411, 426
-28-
[*28] (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir.1981); sec.
1.183-2(b), Income Tax Regs. While our inquiry into a taxpayer’s objective in
engaging in an activity focuses on the taxpayer’s subjective intent, we as the finder
of fact need not rely solely on the taxpayer's statement of intent but may resort to
objective facts to decide the true intent. See Indep. Elec. Supply, Inc. v.
Commissioner, 781 F.2d 724, 726 (9th Cir.1986), aff’g Lahr v. Commissioner,
T.C. Memo. 1984-472; sec. 1.183-2(a), Income Tax Regs.
The regulations set forth a nonexclusive list of nine factors in ascertaining a
taxpayer’s objective in engaging in an activity: (1) the manner in which the
taxpayer carries on 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 or recreation. None of these factors is controlling in
and of itself, and a decision as to a taxpayer’s intent is not governed by a
numerical preponderance of the factors. Sec. 1.183-2(b), Income Tax Regs.; see
-29-
[*29] also Golanty v. Commissioner, 72 T.C. at 426; Allen v. Commissioner, 72
T.C. 28, 34 (1979). We will examine these factors in turn.
A. The manner in which petitioners carried on the activity
The fact that a taxpayer carries on an activity in a businesslike manner may
indicate that the activity is engaged in for profit. Sec. 1.183-2(b)(1), Income Tax
Regs. Subfactors to consider in deciding whether a taxpayer has conducted an
activity in a businesslike manner include: (1) whether the taxpayer maintained
complete and accurate books and records for the activity; (2) whether the taxpayer
conducted the activity in a manner substantially similar to those of other
comparable activities that were profitable; and (3) whether the taxpayer changed
operating procedures, adopted new techniques, or abandoned unprofitable
methods in a manner consistent with an intent to improve profitability. Giles v.
Commissioner, 89 T.C.M. (CCH) at 776 (citing Engdahl v. Commissioner, 72 T.C.
659 (1979)); sec. 1.183-2(b)(1), Income Tax Regs.
Petitioners argue that they conducted Queensland in a businesslike manner
primarily on the basis of three claims: first, they developed a business plan that
they have modified over the years to reflect changing business environment;
second, they maintained complete and accurate records; third, they advertised the
sales of their horses. Petitioners’ claims are not supported by the record.
-30-
[*30] 1. Business plan
Andrea allegedly devised a business plan as early as 1981 and submitted it
to the SBA for feedback. She again submitted a business plan in 1993,
presumably updated from the 1981 plan, to the SBA to get further business advice.
But the 1993 business plan contains largely her descriptions of breeding and
training horses and says very little about how to turn the activity profitable.
Moreover, when the business plan does touch on profit-minded matters, such as
financials and startup costs, it includes only very high-level discussion that would
leave any businessperson very few clues as to how to make a profit from
Queensland.
Indeed, the 1993 business plan itself raises other red flags. It states that
Queensland is geared toward “the serious upper-level horse rider[s] * * * who are
able to invest a great deal of time, effort, and money into their sport”, suggesting
that the market for selling Swedish warmbloods is a niche market with very few
buyers. On the other hand, the business plan also states that the ongoing
operational costs are high. On the basis of the history of Lamira, for example, we
know a Swedish warmblood’s value tends to decrease over time after it reaches its
prime. In other words, petitioners’ business is selling a product that is subject to
depletion and with significant overhead, and its target market is small and
-31-
[*31] potentially highly competitive. We would expect a person who is seriously
profit-minded to discuss in her business plan how she intends to control costs and
overhead, to promote her products through consistent and aggressive marketing
efforts to broaden the purchaser base, and to maximize the retail value of her
horses by determining when it is the optimal time to sell. But petitioners’ 1993
business plan fails to address any of these important business issues. Thus, we
give the 1993 business plan very little weight.
We also find no credible evidence to support petitioners’ claim that they
regularly updated their business plan to reflect changing market conditions.
Despite the discovery of selenium deficiency in the local hay in 1998, the 1999
fire, the terrorist attacks in 2001, and the economic downturn that followed, in
addition to a history of substantial losses, there is no evidence showing petitioners
have done anything to adapt to the market challenges or adopt new techniques and
operating methods to turn the losing activity into a profitable venture. See sec.
1.183-2(b)(1), Income Tax Regs. Action--or inaction in this case--speaks louder
than words. See Phillips v. Commissioner, T.C. Memo. 1997-128, 73 T.C. M.
(CCH) 2296, 2300 (1997) (finding business plan can be evidenced by action).
Petitioners’ inaction here convinces us that they did not change their business
-32-
[*32] plan, if there ever was one, in a manner consistent with a business venture
engaged in for profit.
2. Maintaining complete and accurate books and records
The failure to keep financial records, such as journals, ledgers, income and
expense reports, income statements, P&L statements, and financial projections
indicates a lack of businesslike operations. Giles v. Commissioner, 89 T.C.M.
(CCH) at 776 (citing Surridge v. Commissioner, T.C. Memo. 1998-304).
Although a taxpayer need not maintain a sophisticated cost accounting system for
any purported business activity, she must at least keep and produce records that
would enable her to make informed business decisions and otherwise allow her to
cut expenses, increase profits, or evaluate the activity’s overall performance. Id. at
777 (citing cases). Finally, the failure to maintain a separate bank account or to
prepare a budget also indicates a lack of businesslike operations. Id. at 776.
At the outset, we express our doubt over Andrea’s testimony that she kept
financial records for the horse-breeding activity using Macintosh Quicken after the
1999 fire (including the year in issue). Her prior inconsistent statements given in
response to respondent’s interrogatories impeached that testimony. Further,
petitioners failed to corroborate their testimony that they kept complete and
-33-
[*33] accurate business records with documentary evidence. Thus, we decline to
find as a fact that they continued to keep such books and records after the 1999
fire.
Even if we assume for the sake of the argument that petitioners used some
sort of accounting system to keep track of Queensland’s expenses and inventory,
Andrea’s own testimony reveals that they have never used the available data to
produce or to prepare any P&L statements, earnings reports, budgets, break-even
analyses, or any similarly detailed financial statements that would help them to cut
expenses, increase profits, and evaluate the overall performance of their horse-
breeding activity. See Golanty v. Commissioner, 72 T.C. at 430. At most, the
types of records petitioners maintained would help them substantiate Queensland’s
expenses,9 but that is insufficient to show they kept them in a business fashion to
foster profit. See McKeever v. Commissioner, T.C. Memo. 2000-288, 80 T.C.M.
(CCH) 358, 367 (2000). And the fact that Queensland incurred losses year after
year allows us to draw a factual inference that in evaluating Queensland’s
declining financial performance, petitioners did not actually rely on any rough
financial projection that they might have made as to the activity. Finally,
9
In fact, petitioners’ records can substantiate only $106,700 of the $210,847
expenses reported on their 2007 Schedule F.
-34-
[*34] petitioners stopped maintaining a separate bank account for the activity after
1999, making it harder to separate and track business expenses and personal
expenses.10 In sum, petitioners failed to present credible evidence that they used
any record to implement cost-saving measures or to improve profitability.
3. Advertising
Petitioners rely on a handful of advertisements placed idly in trade
magazines and publications to argue that they “embarked on an intensive
advertising program” to market their products. As we noted earlier, the nature of
petitioners’ target market would require them to market their products
competitively and aggressively to reach a broad buyer base. We find it difficult to
believe that only a handful of advertisements placed in trade magazines and
publications can achieve that result. Indeed, the small volume of sales petitioners
generated over the years allows an inference that their advertising efforts were
futile. Thus, their failure to expand their marketing efforts over the years to reach
a larger customer base is not consistent with the behavior of a profit-oriented
taxpayer. See McKeever v. Commissioner, 80 T.C.M. at 368 (citing Dodge v.
10
There is at least one other instance of commingling accounts. For 2007
petitioners reported utility and insurance expenses relating to their personal
residence as part of the horse-breeding activity’s expenses on their Schedule F.
-35-
[*35] Commissioner, T.C. Memo. 1998-89, aff’d without published opinion, 188
F.3d 507 (6th Cir. 1999)).
Moreover, petitioners fail to provide any evidence to show their
participation in certain marketing events actually generated any actual leads or
sales. It is unclear whether petitioners have ever examined the effectiveness of
their advertising efforts and whether they have explored other marketing avenues.
In sum, we give little weight to petitioners’ claim that they engaged in
advertising in a businesslike manner.
4. Insurance coverage
Petitioners did not have adequate insurance coverage to insure
Queensland’s assets against casualty loss. As a result, petitioners were not able to
recover the value of Queensland’s assets after they were destroyed in the 1999
fire. Not having adequate insurance coverage is inconsistent with carrying on an
activity in a businesslike manner.
5. Changing methods to improve profitability
A change of operating methods, adoption of new techniques, or
abandonment of unprofitable methods may also indicate a profit objective. Sec.
1.183-2(b)(1), Income Tax Regs.
-36-
[*36] Petitioners claim that they began to sell their stallions’ semen as a way to
generate additional profit. In 1998 they contracted to sell about $25,000 worth of
semen that could produce 10 breedings. Assuming petitioners could sustain the
same level of semen sales every year after 1999, the sales would generate only
very moderate income but would do little to affect the activity’s bottom line.
Queensland was incurring expenses of $100,000 or more every year. The amount
of income that any semen sales could potentially generate would be insufficient to
defray Queensland’s annual expenses, not to mention to recuperate losses from the
previous years.
In fact, petitioners were never able to generate any income from the sales of
semen. Petitioners blame the failure in making semen sales on the 1999 fire,
which they claim destroyed the semen that they could have sold. But petitioners
fail to explain why they could not sell semen in other years after the fire.
Indeed, petitioners blame a series of unfortunate events for their losses: the
discovery of selenium deficiency in local hay in 1998, the 1999 fire, the terrorist
attacks in 2001, and the recession. We do not doubt that these events had a
serious impact on petitioners’ activity, so much so that they might have crumpled a
business. But facing these multiple hurdles and setbacks of the magnitude
petitioners are pleading, a profit-minded person likely would have cut her losses
-37-
[*37] and abandoned the venture altogether, unless there was some reasonable
expectation that she could overcome these hurdles by adopting new strategies or
techniques to improve profitability. Absent such reasonable expectation, a profit-
oriented person likely would not continue to pour money into a losing venture.
Petitioners want us to believe the above unfortunate events affected their
ability to make Queensland profitable. Be that as it may, petitioners fail to tell us
what they have done to adapt to and to adjust their methods to meet these
challenges. Indeed, the record shows they have done very little. Recovery could
take time, especially given the economic environment, but there had been six to
nine years between the intervening events and the tax year at issue, and all signs
were pointing to a grimmer outlook. Notwithstanding that, petitioners continued
to contribute substantial amounts of their own cash into the activity without any
change in their way of running Queensland. Petitioners’ failure to improve
profitability and unwillingness to abandon the venture under the circumstances
only lead us to conclude as a factual matter that they were personally attached to
the venture and their “predominant, primary or principal objective” was not to
profit.
-38-
[*38] 6. Conclusion
There is no credible evidence showing that petitioners carried on their
horse-breeding activity in a businesslike manner. This factor favors respondent.
B. The expertise of petitioners or their advisers
A taxpayer’s expertise, research, and study of the accepted business,
economic, and scientific practices of an activity, as well as his or her consultation
with experts, may be indicative of a profit objective. Sec. 1.183-2(b)(2), Income
Tax Regs. In a case concerning a horse-breeding activity, our focus is to examine
a taxpayer’s knowledge of the business or economic aspects of horse breeding as
opposed to her knowledge on the subject of horse breeding from the perspective of
a horse breeder. See Giles v. Commissioner, 89 T.C.M. (CCH) at 778.
Petitioners assert that they sought business advice from the SBA in San
Francisco first in 1981 and again in 1993 around the time when they started the
activity. They also point out that they sought business and marketing advice from
Ms. Dilworth in the early 1990s. Finally, they claim that they asked for business
advice from other breeders here and in Sweden about breeding and training
Swedish warmbloods.
At the outset, we note that, besides petitioners’ self-serving and vague
testimony about having received some unspecified expert advice, the record is
-39-
[*39] devoid of credible evidence suggesting that petitioners prepared for the
economic aspects of the activity by study or consultation with experts or that they
were informed of what the ultimate costs might be, how they could achieve any
level of cost efficiency, the amount of revenue they could reasonably expect, or
any potential risks that might negatively affect their breeding activity. See id.
Further, the credible evidence in the record does not show petitioners have
sought relevant business advice. With respect to the advice they sought from the
SBA, there is no credible evidence to show that petitioners talked to anyone from
the SBA who was knowledgeable of horse breeding or the economic aspects of a
horse-breeding business. In fact, Andrea acknowledged at trial that the individual
who allegedly advised her had no knowledge about horse breeding or its business
aspects. Further, Andrea went to the SBA between the early 1980s and the early
1990s. But petitioners cannot explain how any business advice that they obtained
then would continue to be relevant to their horse-breeding activity after 1998,
which marked the beginning of a series of “unfortunate” events and disasters (i.e.,
the 1999 fire, the recession, etc.) that allegedly had an unforeseen impact on their
activity. In the same vein, any advice petitioners might have obtained from other
breeders in the United States and abroad two decades ago would be unhelpful.
-40-
[*40] Petitioners’ claim that they relied on Ms. Dilworth’s advice is similarly
unpersuasive. When petitioners approached Ms. Dilworth in the early 1990s, Ms.
Dilworth had been in the horse-breeding business for no more than five years. In
the light of our decision in Engdahl in which we found the startup phase of a
horse-breeding activity to be 5 to 10 years, see Engdahl v. Commissioner, 72 T.C.
at 669, we have reservations over Ms. Dilworth’s qualification as an expert in the
business and economic aspects of breeding Swedish warmbloods at that time.
Moreover, despite the frequent initial visits and telephone calls, petitioners had not
spoken to Ms. Dilworth much in the past 10 years. Any relevant advice Ms.
Dilworth might have given in the 1990s, just like the advice from the SBA, would
no longer be relevant given the new problems facing petitioners during the years
since 1998.
The lack of business contact between Ms. Dilworth and petitioners in the
last 10 years is significant. One would expect that a profit-minded taxpayer would
have sought out Ms. Dilworth--or the SBA--for updated advice based on new
information about the new challenges petitioners were then facing.11 Petitioners’
11
Indeed, Ms. Dilworth testified that “there are very few people in the world
right now that are making any money breeding horses.”
-41-
[*41] failure to at least attempt to obtain updated and relevant business advice
after the intervening events is inconsistent with an intent to profit.
This factor favors respondent.
C. The time and effort spent by petitioners in carrying on the activity
The fact that a taxpayer devotes much of her personal time and effort to an
activity may indicate a profit objective, especially where the activity does not
involve substantial personal or recreational aspects. Giles v. Commissioner, 89
T.C.M. (CCH) at 779 (citing McKeever v. Commissioner, T.C. Memo. 2000-288
and Daley v. Commissioner, T.C. Memo. 1996-259). A taxpayer’s withdrawal
from another occupation to devote his or her time and effort to an activity also
may indicate a profit objective. Id. (citing Burleson v. Commissioner, T.C. Memo.
1983-570); sec. 1.183-2(b)(3), Income Tax Regs.
Petitioners allege that they performed almost all of the work with little help
from hired labor. Andrea claims she spent 84 to 112 hours week in the horse-
breeding activity in addition to working 40 to 65 hours a week in her full-time and
part-time jobs. Zavra asserts she worked 40 hours a week in the horse-breeding
activity and 2 to 16 hours a week in her part-time job.
We find petitioners’ assertions to be incredible. First, petitioners presented
no documentary evidence or testimony from third parties to support their claims or
-42-
[*42] the proposition that 100% of the time they spent was for business. Andrea
acknowledged at trial that some of the 84 to 112 hours included time she slept in
the barn with her horses. Thus we discount her testimony that 100% of her time
was spent for business. There is likewise a lack of credible evidence to show that
Zavra’s 40 hours spent every week was all business, especially in the light of the
fact that Queensland has been a family activity in which she spent many hours
with her family.
We also note that Andrea’s testimony was incredible on its face. By her
count, between her other employments and time spent on the activity, she worked
124 hours to 177 hours a week when there are only 168 hours in a week. The only
way she could possibly work this many hours is by neither sleeping nor eating for
days. Without any other evidence to corroborate this fantastical claim, we decline
to accept it.
Moreover, Andrea never decreased the number of hours worked in her full-
time job; sometimes she even worked extra hours in her part-time employments.
Thus, we draw an inference from this fact and believe that Andrea had to keep her
paid employments in order to subsidize her losing horse-breeding activity. In
other words, if Andrea really expected that the activity was on its way to turn a
profit, one would expect that she would have slowly phased out of her full-time
-43-
[*43] and part-time jobs and focused her energy primarily on Queensland.
Because she did not, we suspect that she intended to continue to rely on her other
employment to make a living and subsidize the horse-breeding activity.
This factor favors respondent.
D. The expectation that assets used in the activity may appreciate in
value
A taxpayer’s expectation that assets such as land and other tangible property
used in an activity may appreciate to create an overall profit may indicate that the
taxpayer has a profit objective as to that activity. Sec. 1.183-2(b)(4), Income Tax
Regs. An overall profit is present if net earnings and appreciation are enough to
recoup losses sustained in prior years. Giles v. Commissioner, 89 T.C.M. (CCH)
at 779 (citing Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), aff’d, 379
F.2d 252 (2d Cir. 1967)).
Petitioners claim that they reasonably expected that their inventory and the
Farmington property would appreciate to generate an overall profit. The credible
evidence in the record does not support such a claim.
As to the Farmington property purchased in 1989, petitioners have failed to
produce any credible evidence to suggest that it has appreciated sufficiently to
offset over $1.8 million of losses Queensland suffered between 1993 and 2009.
-44-
[*44] Nor is there any credible evidence showing the specific fair market value of
the Farmington property.
As to the horses, by Andrea’s admission, she projected that she could sell all
of her horses for $225,000 to make a $15,000 profit for 2007.12 In other words, at
the time she made the projection for 2007, she no longer expected that she could
recuperate Queensland’s prior losses of more than $1 million. Yet she continued
to invest more than $200,000 in the activity in 2007. This is inconsistent with a
profit intent.
Setting aside petitioners’ inability to recoup all prior losses, Andrea’s
expectation that she could make a $15,000 profit for 2007 was itself unrealistic.
To create that profit margin, petitioners would have to sell all of her 29 horses at
about $7,750 per horse. The most petitioners have ever received from selling a
horse was $6,500 in 1997--which was before the fire, the terrorist attacks, and the
recession--and the most horses petitioners have ever sold in any given year was
three in 2003. The projection, obviously based on an assumption that would have
been used by only the most incorrigible optimist, is overwhelming evidence of the
12
Andrea’s testimony shows that petitioners at one point hoped to sell their
horses for $50,000 to $60,000 each. However, it is clear from Andrea’s testimony
that she no longer had that expectation by the time she made her income projection
for 2007.
-45-
[*45] absence of a profit motive. See Swigert v. Commissioner, T.C. Memo.
1982-500, 44 T.C.M. (CCH) 992, 996 (1982); Wittstruck v. Commissioner, T.C.
Memo. 1980-62, 39 T.C.M. (CCH) 1168, 1170 (1980) (“Continued retention of
the * * * [disputed activity] after any reasonable hope of profit has clearly been
ruled out makes it very difficult for us to find a good faith expectation of profit.”),
aff’d, 645 F.2d 618 (8th Cir. 1981).
This factor favors respondent.
E. Petitioners’ success in carrying on other similar or dissimilar
activities
Although an activity is unprofitable, the fact that a taxpayer has previously
converted comparable activities from unprofitable to profitable enterprises may
show a profit objective. Sec. 1.183-2(b)(5), Income Tax Regs.
The record shows that petitioners have not engaged in other activities
similar or dissimilar to the horse-breeding activity by which we may evaluate their
success in those other activities. Thus, this factor is neutral. See Rundlett v.
Commissioner, T.C. Memo. 2011-229, 102 T.C.M. (CCH) 307, 310 (2011);
Whitecavage v. Commissioner, T.C. Memo. 2008-203, 96 T.C.M. (CCH) 119, 122
(2008).
-46-
[*46] F. The history of income or losses with respect to the activity
The fact that a taxpayer incurs a series of losses beyond an activity’s startup
years may indicate the absence of a profit objective as to that activity unless the
losses are attributable to unforeseen or fortuitous circumstances beyond the
taxpayer's control. Sec. 1.183-2(b)(6), Income Tax Regs. We have previously
held that the startup phase of a horse-breeding activity may be 5 to 10 years. See
Engdahl v. Commissioner, 72 T.C. at 669.
Petitioners argue that their losses following the startup years were
attributable to unforeseen and fortuitous circumstances beyond their control. We
disagree.
1. Selenium deficiency
In 1998 petitioners discovered hay local to Queensland did not have
adequate selenium, resulting in selenium deficiency in their horses’ diet that could
cause serious medical problems to their horses. As a result, petitioners had to
import hay from other areas at significant costs. While the discovery might have
been unforeseen in 1998, the problem was ongoing and by 2007 it was no longer
an unforeseen or fortuitous event. One would thus expect a profit-oriented person
to explore other more cost-effective alternatives; or if breeding and raising horses
at the same location continued to be cost prohibitive, one would expect it to be a
-47-
[*47] factor to consider in deciding whether to relocate the activity or to abandon
it altogether. Petitioners’ failure to show us that they have considered these
business issues makes it difficult for us to believe that their decision to stay at the
same location was motivated by profit.
2. 1999 fire
Petitioners contend that the 1999 fire also adversely affected their horse-
breeding activity because it destroyed some inventory (mostly semen) and the
equipment for breeding horses. Andrea testified that the farm’s reconstruction was
not completed until 2008; however, it is not clear when Queensland returned to
being operational.
On the basis of petitioners’ own testimony, it appears the 1999 fire affected
only their ability to breed horses and sell semen. Petitioners presented no credible
evidence that can substantiate a claim that the fire prevented them from continuing
to train and sell their horses in stock. If, for the sake of argument, the fire
completely shut down Queensland so that petitioners were no longer able to train
and sell their horses until they completed the reconstruction in 2008, we question
why any profit-minded person would continue to hold on to the inventory during
the 10-year period instead of relocating or liquidating the inventory. If the fire did
not affect petitioners’ ability to train and sell their horses, Queensland’s history of
-48-
[*48] generating dismal income from selling horses leaves us unpersuaded that the
1999 fire had anything to do with the activity’s bottom line.
Finally, we attribute losses resulting from the fire to petitioners’ failure in
the first instance to get adequate insurance coverage on the activity’s property;
getting sufficient insurance coverage was something within their control and what
they could have done. If petitioners had bought adequate insurance coverage as a
business-minded person would have, they could have recovered any casualty loss
and rebuilt the farm more quickly.
In sum, we decline to find that the activity’s losses can be attributed to the
1999 fire when petitioners could have prevented and mitigated some if not most of
the losses.
3. Missed inspection in 2001
Petitioners also assert that the missed horse inspection in Santa Rosa in
2001 negatively affected the marketability of their horses and thus their values.
We find petitioners’ argument incredible on its face.
The lack of evidence showing petitioners have taken any of their horses to
an inspection since 2001 leads us to find that they did not do so. If inspections
were important, as petitioners claim, to marketing a horse and increasing its value,
we question why petitioners failed to take any of the horses that missed the 2001
-49-
[*49] inspection to another inspection in subsequent years to obtain value-
enhancing diplomas for these horses.
Andrea testified that horses must be inspected at a certain age. This
testimony suggests that many of the horses that missed the 2001 inspection would
not be eligible for another inspection in a subsequent year. If so, there would be
little hope that these horses would appreciate if their value depended on
inspection. Thus, petitioners’ decision to continue to hold on to these horses with
no reasonable expectation for appreciation is inconsistent with a profit intent,
especially in the light of the fact that keeping these horses requires substantial
costs. Either way, there is no credible evidence to support petitioners’ claim that
the activity’s losses can be attributed to the missed inspection in 2001.
4. Depressed market conditions during the recession
Finally, petitioners attribute their losses to the recession in the 2000s and
the resulting depressed market conditions. They argue that their case is “strikingly
similar” to Engdahl. We disagree.
In the Engdahl case, we agreed with the taxpayers that their losses from the
horse-breeding activity could be explained by a series of unfortunate events
beyond their control. Engdahl v. Commissioner, 72 T.C. at 669. Some of these
events included a change in market conditions and the rising costs associated with
-50-
[*50] maintaining and training horses. But in Engdahl, unlike in the present case,
we found there was a profit intent because the taxpayers there made changes to
their operation; and when they realized their activity would not become profitable,
they attempted to sell it. Id. Here, as we stated earlier, petitioners did not present
credible evidence that they made any changes to their operation or adopted any
new techniques or business methods to weather the recession; nor have they tried
to dispose of the activity when it should have become apparent that the activity
would not be profitable. Even after 2007, the year when the activity’s earnings did
not meet petitioners’ expectation according to Andrea’s own testimony, petitioners
continued to incur additional expenses of about $200,000 in 2008 and about
$130,000 in 2009. This is yet more overwhelming evidence that shows a lack of
profit intent.
5. Conclusion
For reasons stated, this factor favors respondent.
G. The amount of occasional profits
The amount of profits earned in relation to the amount of losses incurred,
the amount of the investment, and the value of the assets in use may indicate a
profit objective. See sec. 1.183-2(b)(7), Income Tax Regs. Absent actual profits,
the opportunity to earn substantial profits in a highly speculative venture may be
-51-
[*51] enough to indicate profit intent. See id.; see also Giles v. Commissioner, 89
T.C.M. (CCH) at 780-781 (citing Dawson v. Commissioner, T.C. Memo. 1996-
417).
Petitioners argue that they embarked on a business to introduce a popular
but underrepresented breed of performance horse to the United States and it
presented an opportunity for significant profit. We are not persuaded.
Petitioners, again, presented no credible evidence, other than their self-
serving and vague testimony, that they could sell their horses at top prices to offset
15 years of losses. Petitioners’ speculation was not grounded in anything other
than an empty aspiration that is insufficient to overcome the complete absence of
profits in Queensland’s history. In these 15 years, none of petitioners’ horses,
except Lamira, was of the quality to generate top prices. When someone offered
to buy Lamira for $110,000, petitioners rejected the offer. Petitioners have not
brought any of their horses to another inspection since 2001 and have not
attempted to expand their customer base by engaging in more aggressive
advertising or marketing. Petitioners’ conduct during these years simply does not
support their contention that “significant profit” sufficient to offset their
substantial accumulated losses was attainable.
In sum, this factor favors respondent.
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[*52] H. Petitioners’ financial status
A taxpayer’s lack of substantial income or capital from sources other than
an activity may indicate that the activity is engaged in for profit. See sec. 1.183-
2(b)(8), Income Tax Regs. The fact that a taxpayer does have substantial income
from sources other than an activity, on the other hand, may indicate that the
activity is not engaged in for profit. The latter is especially true where losses from
the activity generate substantial tax benefits or where there are personal or
recreational elements involved. Sec. 1.183-2(b)(9), Income Tax Regs.
Petitioners maintain that they are not wealthy individuals and that they used
their wage income and other savings to finance their horse-breeding activity.
Petitioners argue that this factor thus lies in their favor. We disagree.
We have previously held that section 183 does not apply only to wealthy
taxpayers who engage in unprofitable activities to create “paper” losses to offset
against unrelated income. Ranciato v. Commissioner, T.C. Memo. 1996-67, 71
T.C.M. (CCH) 2116, 2119 (1996). Under this factor, we compare the income
generated by an activity with the taxpayer’s taxable income from sources other
than the activity and query whether the taxpayer’s ability to earn income elsewhere
allows her to finance an otherwise unprofitable activity from which she derives
some personal or tax benefits. See id.
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[*53] Between 1993 and 2008, petitioners together had a combined wage income
of $1.2 million.13 On the other hand, Queensland’s income during the same period
was less than $15,000 but it incurred more than $1.6 million in expenses. To
finance these expenses, petitioners used their wage income as well as life
insurance proceeds, proceeds from a 2005 home equity loan, and personal
savings.14 The income and funds from these other sources thus enabled petitioners
to engage in their horse-breeding activity that, as we discuss below, has strong
personal elements.
Moreover, the losses from Queensland significantly reduced petitioners’ tax
liability between 1993 and 2008--that is to say petitioners paid zero Federal
income tax on a combined income of $1.2 million from these 15 years. Thus, the
tax liability petitioners would have incurred but for Queensland’s losses has gone
to subsidize an activity that lacks a profit motive. This is a substantial tax benefit.
This factor favors respondent.
13
Zavra did not file a Federal income tax return before 2002 and thus had no
reported wage income. As to Zavra, this figure includes only her wage income
beginning in 2002.
14
It is also telling that petitioners never attempted to finance Queensland
with a commercial loan; or if they tried to apply for one, they did not get one.
While it is not a requirement, financing an activity with a business loan from a
disinterested party at arm’s length is indicative of the for-profit nature of the
activity.
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[*54] I. Elements of personal pleasure or recreation
The presence of personal pleasure or recreation from an activity may
indicate the absence of a profit objective. Sec. 1.183-2(b)(9), Income Tax Regs.
The mere fact that a taxpayer derives personal pleasure from an activity, however,
does not necessarily mean that she lacks a profit objective with respect to the
activity. A profit objective may be present in the latter case if the activity is truly
engaged in for profit as evidenced by other factors. Giles v. Commissioner, 89
T.C.M. (CCH) at 781 (citing Jackson v. Commissioner, 59 T.C. 312, 317 (1972)).
Petitioners argue that the record does not have any evidence that petitioners
ever rode horses for pleasure. They also point out that Andrea does not enjoy
horseback riding on account of an old injury.
In these cases, we believe petitioners derive pleasure from their horse-
breeding activity because they are attached to their horses. Both Andrea and
Zavra grew up around horses. Even though Andrea may no longer ride horses, we
believe that she enjoys being around them. Zavra has always enjoyed being
around horses and at one point aspired to be a horse veterinarian. This attachment
may explain why petitioners would not let go of their horses and continue to incur
substantial expenses to care for them.
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[*55] We also believe Andrea derives an additional pleasure from having her
family live in the same household that Queensland has made possible. Further,
Andrea, through Queensland, has been able to provide a secure and permanent
environment for her daughter to engage in an activity for which Zavra has a
special passion. As we have stated before: “The gratification derived from an
occupation worth doing, possibly beneficial to others, and probably requiring long
hours of arduous labor, must still not be confused with an intention to return a
profit.” White v. Commissioner, 23 T.C. 90, 94 (1954), aff’d, 227 F.2d 779 (6th
Cir. 1955).
This factor favors respondent.
J. Conclusion
We conclude on the basis of our discussion above that petitioners did not
carry on their horse-breeding activity in 2007 with a predominant, primary, or
principal profit objective.
IV. Accuracy-related penalty
Respondent determined that petitioners are liable for accuracy-related
penalties for 2007 because petitioners substantially understated their income tax
or, alternatively, because they were negligent or disregarded rules or regulations.
See sec. 6662(a) and (b)(1) and (2). There is a substantial understatement of
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[*56] income tax if the amount of the understatement for the taxable year exceeds
the greater of 10% of the tax required to be shown on a return for a taxable year or
$5,000. Sec. 6662(d)(1)(A). Alternatively, we will sustain respondent’s
determination to impose accuracy-related penalties if we determine petitioners
failed to make a reasonable attempt to comply with provisions of the internal
revenue laws or disregarded rules or regulations by acting carelessly, recklessly, or
with intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(1) and (2), Income Tax
Regs. Only one accuracy-related penalty may be imposed for a given portion of an
underpayment even though that portion implicates more than one form of
misconduct described in section 6662(b). Sec. 1.6662-2(c), Income Tax Regs.
Because respondent has carried his burden under section 7491(c) to show that
petitioners’ losses claimed for 2007 resulted in substantial understatements of their
income tax, we need not decide whether petitioners would also be liable for the
penalties by reason of negligence or reckless disregard of rules or regulations.
Once respondent has proved his prima facie case for imposing penalties
under section 6662(a), petitioners bear the burden of proving that the penalties are
unwarranted by establishing an affirmative defense such as reasonable cause or
substantial authority. See secs. 6664(c)(1), 6662(d)(2)(B).
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[*57] Although we have determined that petitioners’ horse-breeding activity was
not engaged in for profit, under the circumstances of this case, we find that
petitioners “made a reasonable and good faith error in applying the law to the facts
of this case.” See Connolly v. Commissioner, T.C. Memo. 1994-218, 67 T.C.M.
(CCH) 2973, 2974 (1994), aff’d, 58 F.3d 637 (5th Cir.1995). Petitioners have
indeed made some good-faith efforts to comply with the law, but those efforts
nonetheless fell short. Accordingly, on the specific facts of this case, the totality
of the circumstances, and evidence presented at petitioners’ trial, we find
petitioners not liable for the section 6662(a) accuracy-related penalties for the year
at issue.
V. Conclusion
Any arguments not discussed in this opinion are irrelevant, moot, or lacking
in merit.
To reflect the foregoing,
Decisions will be entered under
Rule 155.