Davis v. Commissioner

T.C. Memo. 2000-101

UNITED STATES TAX COURT

HARVEY J. DAVIS AND PATRICIA A. DAVIS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7691-98. Filed March 27, 2000.

James F. McLeod, for petitioners.

C. Glenn McLoughlin and Brian A. Smith, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined deficiencies in

petitioners’ Federal income tax and a penalty under section 6662

as follows:
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Penalty
Year Deficiency Sec. 6662
1994 $9,614 $1,914
1995 11,855 2,356
1996 9,956 1,978

The issues for decision are:

1. Whether petitioners operated their Arabian show horse

activity for profit in 1994, 1995, and 1996. We hold that they

did.

2. Whether petitioners are liable for accuracy-related

penalties under section 6662(a) for substantial understatement of

tax for 1994, 1995, and 1996. We hold that they are not.

References to petitioner in the singular are to Harvey J.

Davis. Section references are to the Internal Revenue Code in

effect during the years in issue. Rule references are to the Tax

Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

A. Petitioners

Petitioners resided in Springfield, Missouri, when they

filed their petition.

1. Petitioner

Petitioner is an architect. From 1958 to 1965, he was a

partner with Johnson & Davis Architects.

In 1965, petitioner and a partner bought the patent rights

to a chemically reactive cement product. Petitioner and his
 - 3 -

partner formed M&D Enterprises, Inc. (M&D), to develop and market

the product. Petitioner was president of M&D from 1965 until it

was dissolved in December 1995.

Before he acquired the patent rights, petitioner

investigated the cement product by himself and with the

assistance of an engineer and chemist. He also investigated the

prior owner's books and how the prior owner conducted business.

Based on these investigations, petitioner believed that the

product was valuable and that the prior owners had mismanaged the

business. Petitioner established a plant to manufacture the

product and a sales force to market the product. The operation

became profitable after 6 years.

In 1975, petitioner founded and became president of

International Materials Corp. (IMC). IMC was formed to license

the cement product in countries other than the United States.

IMC licensed the cement patent to foreign manufacturers. In the

early 1980's, M&D's patent expired, and the company closed its

U.S. plant and ceased international licensing. After the patent

expired, M&D could no longer collect royalties.

Since 1980, petitioner has appeared as an expert witness in

construction litigation cases.

In 1994, petitioner acquired a truck stop and restaurant in

Cabool, Missouri, now known as Midwest Truck Stop, for $500,000.

Petitioner reviewed Midwest Truck Stop’s financial records before
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buying it. He believed that it was making money and had a great

location. Petitioner has operated it as a Schedule C business

since 1994. Petitioner bought Midwest Truck Stop because he was

looking for a good business for his son, Gaylan, to operate.

They also had considered buying convenience stores, but the

stores were not making much money. Gaylan has managed Midwest

Truck Stop since 1994. Midwest Truck Stop has been profitable,

and the value of its stock has increased since petitioner bought

it in 1994.

In 1997, petitioner bought the Greenfield Trading Post, a

gas station and convenience store. Petitioner has operated

Greenfield Trading Post as a Schedule C business since 1997.

Petitioner maintains detailed accounting records for Midwest

Truck Stop and the Greenfield Trading Post. Greenfield Trading

Post has daily computerized financial reports which petitioner

reviews twice a week. Midwest Truck Stop has a manual ledger

system with quarterly and annual reports. Midwest Truck Stop

also tracks large inventory items (such as fuel) daily.

2. Mrs. Davis

Mrs. Davis began her career as a computer operator at

Southern Colorado State University, where she worked from 1964 to

1970. She has worked for Dillons Stores, a retail grocery chain,

since 1978. She worked as a cashier from 1978 to 1979, as a head

cashier from 1979 to 1987, and as an office manager since 1987.
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3. Petitioners’ Residence

On September 9, 1971, petitioners bought a house with 1,638

square feet and 5 acres of land (referred to here as the

property) on West Farm Road 82, Springfield, Missouri, for

$23,500. They have lived there since 1971. Petitioners kept

cattle on their property from 1971 to 1974. Petitioners made the

following improvements to their residence from 1974 to 1987:

Improvement Date Cost

Enclose and convert garage
into family room with fireplace 11/74 $2,300

Remodel kitchen 6/79 4,000

Install central A/C 7/85 2,100

Enclose and convert carport
into garage 5/87 3,200

The real estate market in Springfield, Missouri, was fairly

stable from 1990 to 1994. In 1994, prices increased by about 10

percent. Prices have increased about 1-3 percent annually since

then.

Petitioners maintained $70,200 of property and casualty

insurance coverage on their residence in 1996. They raised the

property and casualty coverage on the residence to $74,500 in

December 1998.
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B. Petitioners’ Arabian Horse Activity

1. Petitioners’ Early Involvement With Horses

Petitioner owned a half Arabian gelding in his youth. He

trained the horse and entered it in calf roping exhibitions from

1942 to 1954.

In 1971, petitioners attended an Arabian horse show in

Albuquerque, New Mexico. Petitioner had never seen a purebred

Arabian horse and was very impressed. Petitioners ascertained

the price of some of the horses at the show. They also visited

several Arabian horse farms and looked at the facilities. They

wanted to own and raise Arabian horses someday.

Also in 1971, petitioners bought for pleasure a purebred

Arabian gelding named Alasana. Mrs. Davis and petitioners’

children learned to ride Alasana, and the children showed him in

4-H shows. Alasana died in 1985.

In 1990, Mrs. Davis visited Mountain View Arabians, an

Arabian horse farm in Colorado, that was owned by a woman in her

seventies. The owner had raised Arabian horses all her life and

was still showing horses. In 1990, petitioners visited the

McDannald Arabian farm, owned by Paul McDannald (McDannald).

McDannald trains, shows, and breeds horses, and teaches others

how to show horses. McDannald is a well-known horse trainer.

In 1990, petitioners visited two Arabian horse farms they

had visited in 1971. They preferred the McDannald Arabian farm
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because it had big new barns, more horses, more stallions, and 30

or more horses being trained for clients.

2. Petitioners’ Plans and Preparation

When they started their horse activity, petitioners chose

McDannald to advise them on the training, breeding, and showing

of their horses. McDannald advised petitioners sometime after

they started their horse activity that they did not need to buy

more land for it. He told them they should buy hay to feed their

horses rather than land on which to grow it.

In 1990, petitioners did not visit or know anyone with an

Arabian horse farm which was comparable to their own horse

activity. The McDannald Arabian horse farm was much larger and

not comparable to petitioners’ horse activity because McDannald

trained horses but petitioners did not. Petitioners did not

review the financial records of any Arabian horse operators

before starting their own Arabian show horse activity in 1990.

Petitioners began to operate their horse activity in 1990.

In 1990, petitioner drafted a business plan for 1991 to 1997 for

petitioners’ horse activity. Petitioners’ business plan for the

years in issue was to buy inexpensive horses and to try to

increase their value by training and showing them.

The plan analyzed costs to raise and train a horse.

Petitioner estimated that it would cost $6,545 plus labor to

breed and raise an Arabian colt for 3 years. However, petitioner
 - 8 -

was able to reduce some of his costs; for example, he estimated

that stud fees would be $1,500 and that it would cost $3 per day

to feed each horse. The stud fee for breeding petitioners’

horses to McDannald’s horse, Rumadii, was only $500. Petitioner

bought hay from his neighbor and paid to have it cut and baled,

reducing the daily cost of feed per horse to 51 cents.

The business plan included horse pedigree listings and

descriptions of some Arabian horses. It also included

petitioners’ plans for breeding and showing the horses and

building facilities for them. Petitioner concluded that they had

to raise extraordinary horses to be profitable. Petitioner

studied the bloodlines and history of Arabian horses back 100

years. He traced the ancestors of one of petitioners’ mares,

Vendalita, as far back as possible. He believed that he could

learn how to breed better horses by studying Arabian horse

genealogy. He believed that it would take him 10-13 years before

the activity would be profitable, in part because it can take up

to 5 years for an Arabian horse to reach maturity.

Petitioners have been members of the Southwest Missouri

Arabian Association, the International Arabian Horse Association

of Missouri, the American Horse Show Association, the Southwest

Missouri Horse Show Association, and the Arabian Registry since

1991. Petitioners are registered as breeders with the Arabian

Registry.
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3. Initial Stock

In 1990, petitioners acquired two Arabian geldings, Pryncz

for $200 and Prince Hilal for $500. Petitioners took Pryncz and

Prince Hilal to McDannald to be broken and trained. Petitioner

believed that the geldings would become more valuable if

McDannald broke and trained them. Neither of the geldings was

ever shown. Pryncz has a physical defect in his throat that

prevents him from being a successful show horse. This defect was

discovered during training.

Also in 1990, petitioners acquired from McDannald two

Arabian mares, Brigitta La Brisa and Vendalita, each for $2,000.

Petitioners agreed to give McDannald the right to a foal from

Vendalita as part of her purchase price. Petitioner believed the

value of the right to Vendalita’s first born foal was $3,000-

$4,000.

Petitioners intended to use Brigitta La Brisa as a broodmare

and to breed her to Rumadii in 1992. Rumadii had already

successfully sired Brigitta La Brisa’s filly, Vendalita.

Brigitta La Brisa had produced a filly, Vendalita, in 1985,

and a colt, Mundo, in 1987. Petitioners did not ask McDannald

whether Brigitta La Brisa had potential breeding problems before

they bought her, nor did McDannald mention any breeding problems

with the mare. However, Brigitta La Brisa had substantial

breeding problems after petitioners acquired her. In 1993, 1995,
 - 10 -

and 1996, unsuccessful attempts to breed Brigitta La Brisa were

made. Her breeding problem resulted from the fact that she had

not been bred for several years when petitioners acquired her.

Brigitta La Brisa produced a filly, Spanish Ballerina, in 1998.

Petitioners kept Spanish Ballerina, but she has no show record.

Petitioners have never shown Brigitta La Brisa.

Petitioners acquired Vendalita for her show potential and

her potential use as a broodmare. Vendalita had not been broken,

shown, or bred when petitioners acquired her. Petitioners have

shown Vendalita with some success. Vendalita has produced two

colts, Serrino in 1996, and Brilliant in 1997. Petitioners gave

Serrino to McDannald as part of Vendalita’s purchase price.

Petitioners kept Brilliant, but he has no show record.

In 1993, McDannald advised petitioners to buy an Arabian

gelding named Splendante. Petitioners bought Splendante for

$3,000 and showed him with some success.

In 1995, petitioners acquired an Arabian mare named That's

Amore. They agreed to give her prior owners the right to a foal

from Brigitta La Brisa and the right to a foal from That's Amore.

Petitioner estimated that those foal rights were worth $3,000 to

$4,000 each.

Petitioners have shown That's Amore. Before petitioners

acquired her, That's Amore produced two colts, Ligon in 1988 and
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Splendante in 1990, and a filly, De Lovelt, in 1991. That's

Amore has produced no other offspring.

In 1997, petitioners acquired an Arabian stallion, HB

Canadian Dsign, for $4,000. Petitioners have shown HB Canadian

Dsign.

Six of petitioners’ nine horses--Brigitta La Brisa,

Vendalita, That's Amore, Splendante, Brilliant, and Spanish

Ballerina--were sired by one of two stallions that McDannald

imported from Spain and that he used in his breeding program.

4. Improvements to Petitioners’ Residence for Use in the
Horse Activity

In 1990, petitioners’ residence was appraised at $65,000.

From 1990 to 1994, petitioners made improvements to their

residential property to accommodate their Arabian horse activity.

They built a barn to store hay and equipment; a five-stall stable

with a tack room, workshop, and storage area for hay and a horse

trailer; a 50- by 100-foot arena; and a corral. During that

time, they also acquired equipment such as a horse trailer and a

used pickup truck. The improvements cost about $23,000.

Petitioner planned and built most of the farm improvements

himself. He built the barn for the horses by himself in 1990.

He built the stable for the horses in 1990. He did not do the

concrete work or build the structure or roof of the stable, but

he installed the flooring and the siding and built the stalls and

tack room.
 - 12 -

Petitioner built the arena in 1990 by himself for the horses

to exercise. Petitioners do all of the maintenance and repairs

on the fence and the buildings.

In December 1998, petitioners’ property, including the farm

improvements, was worth $155,000. The farm improvements had a

fair market value, as of December 23, 1998, of $47,000.

5. Operations

Petitioners spent much of their free time training, showing,

and caring for their horses. In 1995, petitioner spent more than

1,600 hours and Mrs. Davis spent more than 700 hours on the horse

activity. Petitioner had no other full-time employment during

the years in issue.

Petitioner spent a large amount of time each week from 1991

through the years in issue caring for and training petitioners’

horses at the McDannald Arabian facility. Petitioners provided

all of the care for their horses except when the horses were at

McDannald’s farm.

Petitioners were actively involved in preparing their horses

for the show ring during the years in issue. Petitioners filmed

each of their horses at horse shows so they could critique their

performance.

In 1994, petitioners named their horse activity “Midwest

Spanish Arabians”. In 1995, petitioner began to use letterhead

with the Midwest Spanish Arabians logo for their horse activity.
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During the years in issue, petitioners advertised their

horses primarily by showing them at horse shows. They also had

baseball caps made bearing the Midwest Spanish Arabians logo.

Petitioners sold some and gave away some of these caps. They

advertised horses for sale by word of mouth and once in the

newspaper.

Petitioner did not insure his horses.

In July 1990, petitioners obtained from Empire Bank a

$15,000 home equity line of credit, secured by a mortgage on

their residence. They used the line of credit to finance some of

the improvements to the property that they planned to use in

their Arabian horse breeding activity.

Petitioners did not have a separate bank account for their

Arabian horse activity. Petitioners paid the expenses for their

horse activity from their personal account.

Petitioners have kept records of the income and expenses of

their Arabian horse activity since 1990. Petitioner kept

receipts for expenses and he made notes on the expense checks.

At the end of each year, petitioner prepared a summary of

expenses and gave it to his accountant to prepare petitioners’

income tax return.

Petitioner kept a ledger beginning in 1990 of petitioners’

expenses from 1990 to 1993. Beginning in 1994, Mrs. Davis used a

computer to keep a record of income and expenses. However, the
 - 14 -

computer data was lost sometime thereafter and petitioners

resumed keeping their receipts and handwritten summaries.

6. Petitioners’ Personal Enjoyment of Horses

Petitioners ride their horses only to train or show them.

Petitioners’ children and grandchildren do not ride petitioners’

horses.

Petitioner finds his Arabian horse activity to be rewarding.

He enjoys showing the horses, competing at the shows, and the

camaraderie of other horse people at the shows. Petitioner does

not enjoy the amount of driving that is required to participate

in horse shows or to train petitioners’ horses at McDannalds.

7. Petitioners' Gross Income, Appreciation, and
Horse-Related Losses

Petitioners reported the following amount of taxable income

on their tax returns from 1990 to 1996:

Taxable income Horse
(other than expenses
horse Horse including Horse Taxable
Year activity) income depreciation Depreciation losses income
1990 $263,832 -0- ($10,938) ($3,600) ($10,938) $252,894
1991 49,749 $120 (20,544) (6,369) (20,424) 29,325
1992 46,824 205 (19,652) (4,729) (23,935) 22,889
1993 44,498 190 (23,346) (3,912) (23,172) 21,326
1994 57,596 295 (26,018) (4,493) (25,723) 31,873
1995 60,215 519 (33,478) (3,490) (32,959) 27,256
1996 55,969 434 (29,164) (2,572) (28,730) 27,239

Petitioners reported on financial statements dated August

11, 1992, and June 11, 1993, that their horses were worth

$34,000. They reported on a financial statement dated July 21,

1995, that their livestock was worth $80,500.
 - 15 -

Petitioners’ expert, Diane O’Connor (O’Connor), appraised

petitioners’ Arabian horses in April 1998. At that time,

petitioners had the following amounts of unrealized appreciation

in the horses they owned or that were born to horses they owned

during the years in issue:

Cash Foal Total 1998 1998
Horse basis right cost Value Appreciation
Pryncz $200 none $200 $5,000 $4,800
Prince
Hilal 500 none 500 4,500 4,000
Brigitta
La Brisa 2,000 $3,000 5,000 20,000 15,000
Vendalita 2,000 3,000 5,000 25,000 20,000
Splendante 3,000 none 3,000 28,000 25,000
That’s
Amore none 6,000 6,000 30,000 24,000
Brilliant none none 0 5,000 5,000
Spanish
Ballerina none none 0 10,000 10,000
Total 107,800

OPINION

A. Whether Petitioners Operated Their Arabian Show Horse
Breeding Activity for Profit

The issue for decision is whether petitioners operated their

Arabian show horse breeding activity for profit in 1994, 1995,

and 1996.

A taxpayer conducts an activity for profit if he or she does

so with an actual and honest profit objective. See Osteen v.

Commissioner, 62 F.3d 356, 358 (11th Cir. 1995), affg. in part

and revg. on other issues T.C. Memo. 1993-519; Surloff v.

Commissioner, 81 T.C. 210, 233 (1983); Dreicer v. Commissioner,

78 T.C. 642, 645 (1982), affd. without opinion 702 F.2d 1205
 - 16 -

(D.C. Cir. 1983). In deciding whether petitioners operated their

show horse activity for profit, we apply the following nine

nonexclusive factors: (1) The manner in which the taxpayer

carried on the activity; (2) the expertise of the taxpayer or his

or her advisers; (3) the time and effort expended by the taxpayer

in carrying on the activity; (4) the expectation that the assets

used in the activity may appreciate in value; (5) the success of

the taxpayer in carrying on other similar or dissimilar

activities; (6) the taxpayer's history of income or loss with

respect to the activity; (7) the amount of occasional profits, if

any, which are earned; (8) the financial status of the taxpayer;

and (9) whether elements of personal pleasure or recreation are

involved. See sec. 1.183-2(b), Income Tax Regs. No single

factor controls. See Osteen v. Commissioner, supra; Brannen v.

Commissioner, 722 F.2d 695, 704 (11th Cir. 1984), affg. 78 T.C.

471 (1982); sec. 1.183-2(b), Income Tax Regs. Petitioners have

the burden of proof. See Golanty v. Commissioner, 72 T.C. 411,

426 (1979), affd. without published opinion 647 F.2d 170 (9th

Cir. 1981).

Petitioners called two expert witnesses. O’Connor appraised

petitioners’ horses. James Truitt (Truitt) appraised

petitioners’ property, including their residence and farm

improvements. As discussed below, petitioners have proven that

the appreciation in their horses and farm improvements was
 - 17 -

substantial in relation to their losses in the fifth through

seventh year of operating their horse activity.

B. Applying the Factors

1. Manner in Which the Taxpayer Conducts the Activity

Maintaining complete and accurate books and records,

conducting the activity in a manner substantially similar to

comparable businesses which are profitable, and making changes in

operations to adopt new techniques or abandon unprofitable

methods suggest that a taxpayer conducted an activity for profit.

See Engdahl v. Commissioner, 72 T.C. 659, 666-667 (1979); sec.

1.183-2(b)(1), Income Tax Regs.

Respondent contends that petitioners’ business plan was

inadequate because it contained little information about the

economics of the horse activity, and its financial projections

showed that petitioners would lose money from the activity.

Respondent contends that petitioners did not adequately

investigate other Arabian horse farms before they began their

horse activity because they did not examine the books and records

of other breeders and they visited much larger horse farms that

were involved in all aspects of the Arabian horse business.

Respondent contends that petitioners did not run the horse

activity in a businesslike manner because petitioners used the

same bank accounts for their horse activity and their personal

expenses. Respondent further contends that petitioner did not
 - 18 -

investigate the acquisition of or operate the horse activity in

the same way he ran his other profitable businesses.

We disagree that petitioners did not conduct their horse

activity in a businesslike manner. Petitioner had a specific

concept clearly in mind and pursued it consistently. He had a

business plan in 1990 for petitioners’ horse activity, and he

generally followed that plan. Petitioners’ plan appropriately

considered the costs of operating the activity. Although

petitioners’ business plan did not include a detailed written

budget, petitioners’ plan is evidenced by their actions. See

Phillips v. Commissioner, T.C. Memo. 1997-128 (taxpayers engaged

in Arabian horse breeding activity for profit; their actions

constituted a business plan despite the fact that they had no

financial plan or written budget). Petitioners consulted with

and relied on a well-known expert, built a barn, stable, and

arena, registered with the Arabian Registry as breeders, and

filmed their horses’ performances at horse shows to critique the

performance.

Petitioners kept complete financial books and records of

their horse activity. Petitioners also kept detailed records on

the horses and their training to monitor their successes and

failures. We think the differences in books and records between

the horse activity and their other businesses are understandable
 - 19 -

because the years in issue were the early stages of the horse

activity, which was very different from their other businesses.

Petitioners kept their expenses as low as possible.

Petitioner built most of the barn, stable, and exercise arena

himself. He significantly reduced some of his costs, such as

stud fees and the daily cost of feed per horse. Also,

petitioners sometimes negotiated reducing the purchase prices of

horses by offering a foal for a reduction in the cash price.

Respondent points out that the "show files" that petitioners

kept for each horse were not contemporaneously prepared but were

assembled in 1997. We infer nothing from this because the

preparation of the show files was based on information that

petitioners had contemporaneously.

This factor favors petitioners.

2. The Expertise of the Taxpayers or Their Advisers

Efforts to gain experience, a willingness to follow expert

advice, and preparation for an activity by extensive study of its

practices may indicate that a taxpayer has a profit motive. See

sec. 1.183-2(b)(2), Income Tax Regs.

Respondent contends that petitioners lacked expertise in

running a successful horse business, and that, although

petitioner studied the history of the Arabian horse and its

bloodlines, he spent little time investigating the business

aspects of an Arabian horse activity. Respondent contends that
 - 20 -

petitioners did not consistently rely on the advice of their

expert, McDannald. Respondent contends that, although

petitioners relied on McDannald to advise them about training,

breeding, and showing their horses, their principal adviser and

decision maker for buying and selling Arabian horses was Mrs.

Davis.

We disagree. At trial, petitioner testified that Mrs. Davis

made decisions as to acquisitions of property. We construe this

to mean that she made decisions to buy real property, not horses.

Petitioners sought and relied on the advice of McDannald, a

nationally known trainer of Arabian horses, about which horses to

buy. For example, McDannald advised petitioners to buy

Splendante in 1993. McDannald, however, did not advise

petitioners how to make a profit.

This factor is neutral.

3. Taxpayer's Time and Effort

The fact that a taxpayer devotes much time and effort to

conducting an activity may indicate that he or she has a profit

objective. See sec. 1.183-2(b)(3), Income Tax Regs. Petitioners

spent a substantial amount of time and effort on their Arabian

horse activity. Respondent concedes that this factor favors

petitioners.
 - 21 -

4. Expectation That Property Used in the Activity Would
Appreciate in Value

A taxpayer may intend to make an overall profit when

appreciation in the value of assets used in the activity is

realized. See Bessenyey v. Commissioner, 45 T.C. 261, 274

(1965), affd. 379 F.2d 252 (2d Cir. 1967); sec. 1.183-2(b)(4),

Income Tax Regs. There is an overall profit if net earnings and

appreciation are enough to recoup losses sustained in prior

years. See Bessenyey v. Commissioner, supra.

Respondent contends that petitioners had no realistic

expectation of recouping their losses from the horse activity

through appreciation of their assets. We disagree. Petitioners

provided expert appraisal testimony from O’Connor and Truitt.

Respondent called no witnesses and left petitioners’ appraisals

substantially unrebutted. We conclude that petitioners have

proven that the appreciation in their horses and farm

improvements was substantial in relation to their losses and that

they reasonably expected appreciation to exceed their losses.

a. Horse Appreciation

Respondent contends that petitioners did not expect their

horses to increase substantially in value because petitioners did

not discuss horse appreciation in their business plan.

Respondent points out that petitioners’ business plan contained

no projections of appreciation in the value of their farm

improvements or horses.
 - 22 -

We disagree. Petitioners’ financial statements for 1992,

1993, and 1995 show that petitioners believed their horses were

valuable and were increasing significantly in value. Petitioner

credibly testified that he expected petitioners’ horses and farm

improvements to appreciate in value and that he expected to

recover his losses by selling the appreciated assets. Thus, we

give little weight to the fact that petitioners’ business plan

contained no projections of appreciation in the value of

petitioners’ business assets.

Petitioners’ expectations were substantially corroborated by

appraisals they obtained from O’Connor. Respondent did not

challenge O’Connor’s appraisals for most of the horses except to

point out that she used a 1998 valuation date.

Respondent contends that O’Connor did not consider the

effect Brigitta La Brisa’s inability to breed from 1990 to 1997

had on her value in 1996. We disagree. O’Connor did consider

the fact that Brigitta La Brisa had difficulty breeding because

she appraised her with foal ($30,000) and without foal ($20,000).

Using the $20,000 amount in estimating the appreciation in value

of petitioners’ horses, petitioners still had a substantial

amount of appreciation from their horses.

Respondent contends that petitioners should not have

included Brilliant and Spanish Ballerina in their estimate of

appreciation because they were born after 1996. We disagree.
 - 23 -

Petitioners owned broodmares Brigitta La Brisa and Vendalita and

expected them to produce foals. Thus, they reasonably expected

that owning Brigitta La Brisa and Vendalita would lead to their

owning foals.

Respondent also contends that petitioners should not include

the value of HB Canadian Dsign, a horse they bought in 1997, in

their estimate of appreciation from their horses in the years in

issue. Respondent further contends that petitioners failed to

include the foal rights from Brigitta La Brisa, Vendalita, and

That’s Amore in their acquisition costs for those horses and that

the value of the foal rights reduces petitioners’ anticipated

appreciation. We agree with respondent on both of these points,

and we have corrected for it in our analysis.

Petitioners’ horses had appreciated by $107,800 as of their

1998 appraisal. This generally corroborates petitioners’

expectation before and during the years in issue that the value

of petitioners’ horses would increase substantially.

b. Appreciation in Petitioners’ Residence and Farm
Improvements

Petitioners contend that we should consider appreciation in

their farm property in applying this factor.

Truitt estimated that petitioners’ farm improvements (i.e.,

the barn, stable, and arena) as of December 21, 1998, were worth

$47,000. Petitioners’ cost of the improvements was about

$23,000. Thus, Truitt’s testimony supports a finding that
 - 24 -

petitioners’ farm improvements had appreciated $24,000 by 1998.

We assume the vast majority of this appreciation occurred as the

improvements were made because they were self-constructed.

Petitioner expected that, for each dollar he spent on the

farm improvements, it would increase the value of petitioners’

property by $2. Also, as stated above, petitioners’ horses and

farm improvements appreciated significantly in value during the

years in issue. Petitioners had a bona fide expectation of

future profit. See Estate of Baron v. Commissioner, 83 T.C. 542,

553 (1984), affd. 798 F.2d 65 (2d Cir. 1986) (reasonable or

realistic expectation of profit is not required if taxpayer has

bona fide expectation of profit); Dreicer v. Commissioner, 78

T.C. at 643-645.

We are convinced that petitioners had appreciation in their

horses and farm improvements during the years in issue of

approximately the same order of magnitude as their losses in

those years. Thus, we need not decide whether petitioners’

residence and land also increased in value. Accordingly, this

factor favors petitioners.

5. Taxpayer's Success in Other Activities

The fact that a taxpayer previously engaged in similar

activities and made them profitable may show that the taxpayer

has a profit objective. Sec. 183-2(b)(5), Income Tax Regs.

Petitioners have not engaged in similar activities for profit,
 - 25 -

but petitioner had engaged in other successful activities.

Respondent concedes that this factor favors petitioners.

6. Taxpayer's History of Income or Losses

A history of substantial losses may indicate that the

taxpayer did not conduct the activity for profit. See Golanty v.

Commissioner, 72 T.C. at 427; sec. 1.183-2(b)(6), Income Tax

Regs. A taxpayer may have a profit objective even when the

activity has a history of losses, see Bessenyey v. Commissioner,

45 T.C. at 274, because losses during the initial stage of an

activity do not necessarily indicate that the activity was not

conducted for profit, see Engdahl v. Commissioner, 72 T.C. at

669; sec. 1.183-2(b)(6), Income Tax Regs. We have said that the

startup phase of a horse-breeding activity may be 5 to 10 years

for standardbred horses. See Engdahl v. Commissioner, supra;

Burrow v. Commissioner, T.C. Memo. 1990-621; Starr v.

Commissioner, T.C. Memo. 1969-35. A period of 5 to 10 years for

the startup phase of an Arabian-breeding operation is not

unreasonable. See Phillips v. Commissioner, T.C. Memo. 1997-128

(losses incurred in years 7 through 9 from the taxpayers’ Arabian

horse activity were incurred in the startup phase of the activity

and were due in part to unforeseen circumstances; losses did not

indicate that the activity was not engaged in for profit). In

the instant case, the years at issue are years 5 through 7 of

petitioners’ activity. Because petitioners’ losses were during
 - 26 -

the startup period of their activity, we conclude that this

factor is neutral.

7. Amount of Occasional Profits, If Any

The amount of any occasional profits the taxpayer earned

from the activity may show that the taxpayer had a profit motive.

See sec. 1.183-2(b)(7), Income Tax Regs. Petitioners did not

make a profit in any year. Petitioners concede that this factor

favors respondent.

8. Financial Status of the Taxpayer

The receipt of a substantial amount of income from sources

other than the activity, especially if the losses from the

activity generate large tax benefits, may indicate that the

taxpayer does not intend to conduct the activity for profit. See

sec. 1.183-2(b)(8), Income Tax Regs.

Respondent points out that petitioners had other sources of

income available to offset their losses from the horse activity.

Respondent points out that petitioners’ losses reduced their

taxable income by half in the years in issue.

Petitioners’ other sources of income totaled $57,596 in

1994, $60,215 in 1995, and $55,969 in 1996. They spent 40-50

percent of their income on their horse activity in the years in

issue. Of their losses, depreciation accounted for only 17.5

percent in 1994, 10.6 percent in 1995, and 9 percent in 1996.

See Eisenman v. Commissioner, T.C. Memo. 1988-467 (the taxpayers
 - 27 -

had a substantial amount of income from sources other than horse

breeding but did not engage in the activity for pleasure; the

Court viewed the fact that the taxpayers spent 46 and 69 percent

of their adjusted gross income on the activity and derived

insubstantial tax benefits as an indication that the activity was

not a hobby).

This factor favors petitioners.

9. Elements of Personal Pleasure

The presence of recreational or personal motives in

conducting an activity may indicate that the taxpayer is not

conducting the activity for profit. See sec. 1.183-2(b)(9),

Income Tax Regs. A taxpayer's enjoyment of an activity does not

show that the taxpayer lacks a profit objective if the activity

is, in fact, conducted for profit as shown by other factors. See

Jackson v. Commissioner, 59 T.C. 312, 317 (1972); sec. 1.183-

2(b)(9), Income Tax Regs. However, if the possibility for profit

is small compared to the possibility for gratification, the

latter possibility may be the primary motivation for the

activity. See White v. Commissioner, 23 T.C. 90, 94 (1954),

affd. per curiam 227 F.2d 779 (6th Cir. 1955).

Respondent contends that petitioner derived great pleasure

from working with his horses, studying their bloodlines and the

history of the Arabian horse, and showing the horses in
 - 28 -

competition and that this weighs against finding that he engaged

in the horse activity for profit.

We disagree. Petitioners and their family did not ride

their horses for pleasure. Petitioner does not enjoy all the

driving required to participate in horse shows or to go to

McDannald’s to train petitioners’ horses. Petitioners showed

their horses at horse shows as their primary method of

advertising. There is a high correlation between success in

horse shows and success in the marketplace. See Appley v.

Commissioner, T.C. Memo. 1979-433; cf. Engdahl v. Commissioner,

supra at 667; Golanty v. Commissioner, supra at 431 (taxpayers’

failure to show horses indicated that taxpayers were not engaged

in activity with a profit objective). Petitioners do not deny

that they enjoyed many aspects of the horse activity. The fact

that petitioners enjoyed the horse show competitions does not

mean that they did not conduct their horse activity for profit.

See Harvey v. Commissioner, T.C. Memo. 1988-13.

This factor favors petitioners.

10. Conclusion

Considering petitioner’s testimony as corroborated by the

record as a whole, particularly the time and effort petitioners

spent on the activity, petitioners’ reasonable expectation of

profit from appreciation of the assets used in the activity,

petitioner's business plan, and the startup nature of
 - 29 -

petitioners' activity, we find that petitioners engaged in their

Arabian horse activity for profit in the years in issue. Our

holding should not be taken to mean that petitioners would

prevail in any later year without further changes in their

operating methods or results.

C. Whether Petitioners Are Liable for the Penalty Under Section
6662 for Substantial Understatement

Respondent determined that petitioners are liable for the

accuracy-related penalty for substantial understatement for 1994,

1995, and 1996 under section 6662.

Based on our holding that petitioners operated their Arabian

horse activity for profit, petitioners are not liable for the

accuracy-related penalty under section 6662.

Decision will be entered

under Rule 155.