Giles v. Comm'r

T.C. Memo. 2006-15

UNITED STATES TAX COURT

ELIZABETH GILES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16640-03. Filed January 31, 2006.

B. Paul Husband, for petitioner.

Michael W. Berwind, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge: Respondent determined deficiencies of

$7,117, $5,470, and $6,793 and accuracy-related penalties under

section 6662(a) for 1999, 2000, and 2001, respectively (years in

issue).1 After concessions,2 the issues for decision are:

1
Unless otherwise noted, all section references are to the
(continued...)
 - 2 -

(1) Whether petitioner’s horse activity was an activity engaged

in for profit within the meaning of section 183 during the years

in issue; and (2) whether petitioner is liable for accuracy-

related penalties under section 6662(a) for 1999 and 2000.

FINDINGS OF FACT

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

The stipulation of facts, the supplemental stipulation of facts,

and attached exhibits are incorporated herein by this reference.

A. Background

At the time she filed the petition, petitioner resided in

Riverside, California.

Petitioner is a dentist licensed by the Dental Board of

California. Petitioner operates her own dental practice as a

professional corporation, of which she is the sole shareholder.

From 1988 through 2003, petitioner’s average annual income from

her dental practice was $109,547. During the years in issue,

petitioner reported income from her dental practice of $120,500,

$106,250, and $138,250, respectively.

1
(...continued)
Internal Revenue Code, as amended, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
2
Respondent concedes that petitioner has substantiated all
expenses reported on Schedules C, Profit or Loss From Business,
for the years in issue. As a result, respondent concedes that
there is no deficiency in 2001 and petitioner is not liable for
an accuracy-related penalty relating to that year.
 - 3 -

B. Petitioner’s Real Property

1. Falling Water Way

On July 27, 1983, petitioner purchased for $135,000 real

property at 18500 Falling Water Way in Riverside, California

(Falling Water Way). Falling Water Way includes 1.48 acres of

land, a 2,252-square-foot four-bedroom home, a garage, a four-

stall barn with tack room, feed rooms, hay storage, an arena, and

some paddocks.

Falling Water Way is in an area with many horse properties.

Falling Water Way is zoned “Residential Agricultural” by

Riverside County. A Riverside County zoning ordinance allows the

“noncommercial keeping of horses” in Residential Agricultural

zones. The zoning ordinance permits breeding and raising of

horses but prohibits Falling Water Way from being used as a

livery stable or a boarding stable. The zoning ordinance limits

the number of horses that can be kept at Falling Water Way to

four.

Falling Water Way has been petitioner’s principal residence

since its purchase in 1983. Petitioner put Falling Water Way up

for sale in 1991 but did not sell the property.

As of June 15, 2004, Falling Water Way had a fair market

value of $530,000. The fair market value of the horse facilities

and property, other than the house and the garage, was $375,000.
 - 4 -

2. Gavilan Hills

In August 1990, petitioner purchased for $70,000 11.53 acres

of undeveloped ranch land in the unincorporated Gavilan Hills

area of Riverside County, California (Gavilan Hills). Gavilan

Hills is approximately 5 miles from Falling Water Way. Between

August and October 1990, petitioner engaged Wellmaster Drilling,

Inc., to drill two wells at Gavilan Hills.

On October 7, 2003, Gavilan Hills was zoned “Residential

Agricultural.” The new zoning laws allow up to 24 horses to be

kept on the property but prohibit the operation of a livery

stable or boarding stable.

As of June 15, 2004, the fair market value of Gavilan Hills

was $306,000.

3. Rialto Property

Petitioner has operated her dental practice at 350 North

Riverside Avenue in Rialto, California (Rialto property), since

1983. The Rialto property consists of a 1,900-square-foot house

zoned for professional office use.

From 1983 through 1995, petitioner’s professional

corporation leased the Rialto property. On November 17, 1995,

petitioner purchased the Rialto property for $136,500. From 1996

through 2003, except for the year 2000, petitioner’s professional

corporation paid petitioner $24,000 annually for the use of the

Rialto property. In 2000, petitioner’s professional corporation
 - 5 -

paid petitioner $22,000 for the use of the Rialto property. On

her 1996 Federal income tax return, petitioner reported a rental

loss of $12,357 as a result of significant repair expenses

incurred upon acquisition of the property. From 1997 to 2003,

petitioner reported average annual rental income of $7,871.

During the years in issue, petitioner reported rental income of

$7,944, $6,659, and $7,202, respectively.

C. Petitioner’s Horse Activity

1. Background

Petitioner was raised around horses and showed horses as a

child and young adult. In 1984, petitioner purchased her first

horse, Feyras Raehele.

In 1988, petitioner commenced her horse activity at Falling

Water Way under the name “Falling Water Arabians”. Petitioner

dealt only with purebred Arabian horses. At the time she started

her activity, petitioner did not know how many Arabian horse

breeders operated in California.

During the years in issue, petitioner used Falling Water Way

for breeding, training, and working the horses. However, because

petitioner has only 1.48 acres at Falling Water Way, she often

took the horses to Gavilan Hills to exercise and train them.

During the years in issue, petitioner wormed and vaccinated

her horses. Petitioner also ordered supplies and paid bills

related to her horse activity.
 - 6 -

Petitioner maintained a library of horse-related reference

materials, including 15 books, 6 trade journals/periodicals, and

14 video sets. During the years in issue, petitioner spent 6 to

8 hours per month reading trade journals.

Petitioner had a Falling Water Arabians business card

listing the Falling Water Way address as the business address.

However, the business card was prepared in the late 1980s, and

the phone numbers are no longer correct.

Petitioner maintained a checking account with California

Bank & Trust in Moreno Valley, California, under the names

Elizabeth Giles and Falling Water Arabians. From December 16,

1998, to December 3, 2001, the account’s average daily balance

never exceeded $402. A $9 maintenance fee was deducted from the

account monthly. The only other withdrawal taken during this

period was $240 on April 13, 2000, the purpose of which was not

identified. As of April 17, 2001, the account had a negative

balance of -40 cents. The only deposit made before December 4,

2001, was $9, deposited on May 5, 2001, in order to restore a

positive account balance. On December 4, 2001, petitioner

deposited $20,000 received from the sale of Bogaz, as discussed

below.

During the years in issue, petitioner spent 4-1/2 to 6 hours

a day with the horses. In a typical day, petitioner fed,
 - 7 -

watered, administered necessary medications to, exercised, and

trained her horses. In addition, petitioner cleaned stalls.

During the years in issue, petitioner showed two of her

horses, Bogaz and Kart Blanche, five to six times per year. She

did not show her other horses during the years in issue. At the

shows, petitioner often rode the horses herself. Petitioner

received only a few hundred dollars for showing the horses from

1999 through 2001. In 2001, petitioner switched to the show

discipline of dressage.3

During the years in issue, petitioner did not ride her

horses in parades. Petitioner did not attend any social or

charity events relating to horses.

From 1988 to 2003, petitioner did not provide any services

to third parties, including training, coaching, or boarding.

From 1988 through 2000 and from 2002 through 2004, petitioner did

not sell any horses. In 2001, petitioner sold only one horse,

Bogaz.

2. Petitioner’s Horses

In 1999 and 2000, petitioner owned the following horses:

Feyras Raehele, Kart Blanche, Borissa, and Bogaz. Petitioner

3
“Dressage” is a disciplined practice in which the horse
is controlled in certain difficult steps and gaits by slight
movements of the rider. Dressage is a competitive event in the
Olympic Games, the Pan American Games, and other competitions.
There are two introductory levels of dressage, four separate
training levels, and four separate competitive levels.
 - 8 -

also held future income interests, as discussed below, in TF

Silent Reign in 1999, and in TF Silent Reign and Mon Reve in

2000.

At the beginning of 2001, petitioner owned Feyras Raehele,

Kart Blanche, Borissa, and Bogaz and continued to hold future

income interests in TF Silent Reign and Mon Reve. During 2001,

petitioner acquired Censuous by breeding. In December 2001,

petitioner sold Bogaz for $20,000.

Following is a description of petitioner’s horses and

related breeding activity.

a. Feyras Raehele and Kart Blanche

In 1984, petitioner purchased Feyras Raehele, an Arabian

mare4 foaled5 on May 19, 1979. During 1988, petitioner bred

Feyras Raehele. On April 21, 1989, Feyras Raehele produced a

filly,6 Kart Blanche.

b. Borissa, Bogaz, and Censuous

In 1989, petitioner leased Borissa, a mare foaled in 1982,

from Raymond Mazzei of Furioso Farm for breeding purposes. On

4
A “mare” is a female horse of reproductive age.
5
“Foaled” is synonymous with “born”. A “foal” is a baby
horse of either sex. “In foal” indicates that a mare is
pregnant. The gestation period for an Arabian horse is typically
11 months, but can be anywhere from 10 to 12 months.
6
A “filly” is a female horse 3 years old or younger.
 - 9 -

March 1, 1990, Borissa produced a colt7 named VT Kartel. After

seeing VT Kartel, petitioner purchased Borissa for $2,500. VT

Kartel died in 1991.

In 1990, petitioner again bred Borissa, who produced Bogaz

on May 19, 1991. Petitioner did not breed Borissa from 1992

through 1996.

On June 17, 1997, petitioner entered into a breeding

contract with Bishop Lane Farm to have Borissa bred to Bishop

Lane Farm’s stallions.8 Borissa was in foal in 1997, but her

foal died at birth in 1998. Upon the advice of Thomas Hoyme,

D.V.M., Borissa was not rebred in 1998.

In 1999, petitioner sent Borissa to an equine breeding

facility operated by Richard K. Tramp, D.V.M., for the purpose of

breeding Borissa by use of shipped cooled semen. Despite this

attempt, Borissa did not conceive in 1999.

In 2000, petitioner bred Borissa to Concensus, a stallion

from Bishop Lane Farm. As a result, Borissa produced a filly

named Censuous on March 20, 2001.

In 2001, petitioner sold Bogaz for $20,000. On December 4,

2001, petitioner deposited a $20,000 check received on the sale

into the California Bank and Trust account described above.

7
A “colt” is a male horse, not castrated, 3 years old or
younger.
8
A “stallion” is an adult male horse which has not been
castrated.
 - 10 -

Petitioner invested the $20,000 in an individual retirement

account.

c. TF Silent Reign and Mon Reve

Petitioner bought TF Silent Reign in 1989 for $3,500. In

1997, petitioner transferred TF Silent Reign to her daughter,

Michelle Pope (Ms. Pope), for zero dollars. Petitioner and Ms.

Pope had an oral agreement that Ms. Pope would breed TF Silent

Reign and pay all related expenses, and they would split all

future profits, if any, from the breeding.

In 1999, Ms. Pope bred TF Silent Reign to Monogramm, an

Arabian stallion from Bishop Lane Farm. On March 8, 2000, TF

Silent Reign produced a filly named Mon Reve.

3. Petitioner’s Horse Activity Business Plans

a. Annual Business Plans

Ms. Pope is a certified public accountant (C.P.A.). With

the aid of Ms. Pope, petitioner prepared “annual business plans”

for the years 1989 through 1994. Each annual business plan is a

one-page fill-in-the-blank form with handwritten responses. Each

annual plan was prepared in the spring or summer of the year to

which it relates.

In the 1989 annual plan, petitioner listed her long-term

goals as “Sell Borissa’s foal. Estimate value after one year

7,000 to 10,000. Rah’s [Feyras Raehele’s] foal for show estimate

value if National winner approximately 50,000.”
 - 11 -

In the 1990 annual plan, petitioner listed her long-term

goals as “Breeding/Selling” and “Training horses for added

value.” Under “plans for next year,” petitioner listed “Seek

better trainer with better reputation.”

In the 1991 annual plan, petitioner listed her long-term

goals as “Sell * * * [Falling Water Way] to set up business in

* * * [Gavilan Hills] for expansion. Breed, Show, Sell.”

In the 1992 annual plan, petitioner listed her long-term

goals as “Move to Gavilan Hills for expansion.” Under short-term

goals, petitioner listed “TF Silent Reign to Nationals with David

Garrett.” David Garrett is a trainer with whom petitioner

consulted about breeding, training, and showing.

In the 1993 annual plan, petitioner listed her long-term

goals as “Move to Gavilan Hills . . . Breed & Sell.” Under

“Changes/Decisions to Decrease Chances of Failure and Increase

Revenues,” petitioner stated “self train and self vet.”

In the 1994 annual plan, petitioner listed her long-term

goals as “Same as ‘93 Goals.” Under “successes,” petitioner

stated “Found Lou Roper.” Petitioner consulted with Lou Roper, a

national champion in the discipline of trail and hunting

pleasure, on horse training.

b. General Business Plan

Petitioner and Ms. Pope also prepared a “general business

plan” concerning petitioner’s horse activity. Similar to the
 - 12 -

annual plans, the general plan is a one-page fill-in-the-blank

form with handwritten responses. Petitioner listed her

objectives as “Breed, Raise, Show to Increase Value, Sell.”

Petitioner listed areas of opportunity for profit as “Selling

Quality Show horses.” Petitioner stated that she hoped to start

making a profit in 7 years. It is not clear from the record when

the general plan was prepared or whether it related to any

specific years.

4. Income and Expenses From Petitioner’s Horse
Activity

After the close of each year, Ms. Pope compiled canceled

checks and credit card receipts and used these to categorize

expenses and prepare profit and loss statements. The profit and

loss statements do not identify the costs specifically connected

with each horse. The profit and loss statements do not indicate

what accounts the checks were drawn on.

Charles E. Wessman (Mr. Wessman), a C.P.A., used the profit

and loss statements to prepare petitioner’s Schedules C, Profit

or Loss From Business. Petitioner’s Schedules C for 1988 through

2003 reflect the following:
 - 13 -

Veterinary Advertising Total
Year Gross Receipts Expenses Expenses Expenses Profit/(Loss)

1988 $95 $222 $742 $27,782 ($27,687)

1989 3,508 1,304 34 32,244 (28,736)

1990 244 3,410 135 38,197 (37,973)

1991 -0- 1,803 -0- 28,136 (28,136)

1992 3,000 2,434 -0- 32,545 (29,545)

1993 3,200 899 -0- 46,622 (43,422)

1994 4,080 5,322 -0- 38,152 (34,072)

1995 2,500 2,377 -0- 40,703 (38,203)

1996 3,024 1,272 1,837 40,337 (37,313)

1997 260 1,382 25 24,475 (24,215)

1998 500 1,453 -0- 21,568 (21,068)

1999 900 2,614 -0- 23,677 (22,777)

2000 1,000 1,731 -0- 18,649 (17,649)

2001 20,000 947 -0- 19,791 209

2002 -0- 3,101 -0- 27,072 (27,072)

2003 200 1,398 -0- 23,621 (23,421)

Total 42,511 31,669 2,773 483,571 (441,080)

D. Tax Treatment of Petitioner’s Horse Activity

1. Audit of Petitioner’s 1991 and 1992 Tax Returns

In 1994, Internal Revenue Agent W. Dillard conducted a field

audit of petitioner’s 1991 and 1992 tax returns, specifically

examining petitioner’s Schedule C horse activity under the

passive activity rules of section 469. Mr. Wessman handled the

audit on behalf of petitioner. On May 9, 1995, respondent sent

petitioner a letter stating: “We examined your tax return[s]

[for 1991 and 1992] and made no changes to the tax you reported.”
 - 14 -

2. Prior Tax Court Case Involving 1997 and 1998

Respondent audited petitioner’s 1997 and 1998 Federal income

tax returns, specifically examining petitioner’s Schedule C horse

activity under the hobby loss rules of section 183. Respondent

determined that petitioner’s horse activity was not an activity

engaged in for profit and disallowed losses taken from that

activity. Petitioner filed a petition with this Court at docket

No. 10918-02 contesting respondent’s determination. On February

22, 2005, Judge Laro entered his decision for respondent. See

Giles v. Commissioner, T.C. Memo. 2005-28. Petitioner appealed

to the Court of Appeals for the Ninth Circuit, which dismissed

the case on August 11, 2005.

3. The Years in Issue

Petitioner timely filed Federal income tax returns for the

years in issue. These returns were prepared by Mr. Wessman.

Attached to each return was a Schedule C listing “breeding &

competing horses” as the principal business and “Falling Water

Arabians” as the business name.

In 1999, petitioner deducted a Schedule C loss of $22,777

and reported adjusted gross income of $106,583. On the attached

Schedule C, petitioner reported gross income of $900 and total

expenses of $23,677.

In 2000, petitioner deducted a Schedule C loss of $17,649

and reported adjusted gross income of $95,291. On the attached
 - 15 -

Schedule C, petitioner reported gross income of $1,000 and total

expenses of $17,649.

In 2001, petitioner reported Schedule C income of $209 and

adjusted gross income of $145,683. On the attached Schedule C,

petitioner reported gross income of $20,000 and total expenses of

$19,791.

On March 3, 2003, respondent sent petitioner an initial

contact letter asking her to produce books, records, and work

papers used to prepare her Schedule C for 1999. Petitioner did

not produce any books, records, or other work papers in response

to the initial contact letter. Respondent subsequently expanded

the examination to include 2000 and 2001.

On March 18, 2003, respondent sent petitioner a 30-day

letter covering 1999, 2000, and 2001. Petitioner was given the

opportunity to sign a period of limitations extension, but

refused to do so. At the time, petitioner had already filed a

petition with this Court relating to 1997 and 1998. Petitioner

wished to add the 1999, 2000, and 2001 years to the prior case.

In an effort to consolidate the cases, petitioner forewent the

administrative appeal process for the years in issue. The cases

were never consolidated.

On June 26, 2003, respondent mailed petitioner a notice of

deficiency for the years in issue. Respondent determined that

petitioner’s horse activity expenses were not ordinary and
 - 16 -

necessary business expenses. Respondent disallowed petitioner’s

Schedule C losses of $22,777 and $17,649 for 1999 and 2000,

respectively. Respondent also disallowed petitioner’s Schedule C

expenses of $19,791 for 2001. Respondent determined deficiencies

of $7,117, $5,470, and $6,793 for 1999, 2000, and 2001,

respectively. In addition, respondent determined petitioner was

liable for accuracy-related penalties under section 6662(a) for

the years in issue.

On September 9, 2003, petitioner filed a petition with the

Court disputing the notice of deficiency.

OPINION

A. Petitioner’s Horse Activity

The first issue for decision is whether petitioner’s horse

activity was an activity engaged in for profit within the meaning

of section 183 during the years in issue.9

Section 183(a) provides that if an individual engages in an

activity but does not engage in that activity for profit, “no

deduction attributable to such activity shall be allowed under

this chapter except as provided in this section.” In the case of

9
Generally, a taxpayer bears the burden of proving the
Commissioner’s determinations incorrect. Rule 142(a)(1); Welch
v. Helvering, 290 U.S. 111, 115 (1933). However, under sec.
7491(a), the burden of proof may shift to the Commissioner in
certain situations. Petitioner contends that sec. 7491(a)
requires respondent to bear the burden of proof. We need not
decide this issue because our findings and analysis in this case
are based on the record before the Court and do not depend on
which party bears the burden of proof.
 - 17 -

an activity not engaged in for profit, section 183(b)(1) allows

deductions which are otherwise allowable without regard to

whether the activity is engaged in for profit. Section 183(b)(2)

allows deductions that would be allowable if the activity were

engaged in for profit, but only to the extent of gross income

received from the activity. 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.”10

The Court of Appeals for the Ninth Circuit, to which an

appeal of this case would lie absent stipulation otherwise, has

held that for a deduction to be allowed under section 162 or

section 212(1) or (2), the taxpayer must establish that she

engaged in the activity with “the predominant, primary or

principal objective” of realizing an economic profit independent

of tax savings. Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir.

1993), affg. T.C. Memo. 1991-212; see also Skeen v. Commissioner,

864 F.2d 93, 94 (9th Cir. 1988)), affg. Patin v. Commissioner, 88

10
Sec. 162 allows a taxpayer to deduct ordinary and
necessary expenses of carrying on the taxpayer’s trade or
business. Pars. (1) and (2) of sec. 212 allow the taxpayer to
deduct expenses incurred in connection with an activity engaged
in for the production or collection of income, or for the
management, conservation, or maintenance of property held for the
production of income.
 - 18 -

T.C. 1086 (1987); Indep. Elec. Supply, Inc. v. Commissioner, 781

F.2d 724, 726 (9th Cir. 1986), affg. Lahr v. Commissioner, T.C.

Memo. 1984-472.

Factors to be considered in determining whether an activity

is engaged in for profit include: (1) The manner in which the

taxpayer carries on the activity, (2) the expertise of the

taxpayer or her advisers, (3) the time and effort expended 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, which are earned, (8) the financial status of

the taxpayer, and (9) the elements of personal pleasure or

recreation. Indep. Elec. Supply, Inc. v. Commissioner, supra at

726-727; Antonides v. Commissioner, 91 T.C. 686, 694 n.4 (1988),

affd. 893 F.2d 656 (4th Cir. 1990); Golanty v. Commissioner, 72

T.C. 411, 426 (1979), affd. without published opinion 647 F.2d

170 (9th Cir. 1981); sec. 1.183-2(b), Income Tax Regs. No single

factor or group of factors is determinative. Golanty v.

Commissioner, supra at 426; Dunn v. Commissioner, 70 T.C. 715,

720 (1978), affd. 615 F.2d 578 (2d Cir. 1980); sec. 1.183-2(b),

Income Tax Regs. A final determination is made only after

considering all facts and circumstances. Indep. Elec. Supply,
 - 19 -

Inc. v. Commissioner, supra at 727; Antonides v. Commissioner,

supra at 694; Golanty v. Commissioner, supra at 426.

“The proper focus of the test * * * is the taxpayer’s

subjective intent. * * * However, objective indicia may be used

to establish that intent.” Skeen v. Commissioner, supra at 94;

see also Wolf v. Commissioner, supra at 713; Indep. Elec. Supply,

Inc. v. Commissioner, supra at 726. The expectation of making a

profit need not be reasonable. Beck v. Commissioner, 85 T.C.

557, 569 (1985); Dreicer v. Commissioner, 78 T.C. 642, 645

(1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983);

Golanty v. Commissioner, supra at 425-426. However, greater

weight is given to objective facts than to a taxpayer’s self-

serving statement of intent. Indep. Elec. Supply, Inc. v.

Commissioner, supra; Antonides v. Commissioner, supra; Thomas v.

Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256 (4th

Cir. 1986).

Respondent determined that petitioner did not engage in her

horse activity with an intent to derive a profit and therefore

disallowed the Schedule C loss deductions. Petitioner contends

that she engaged in her horse activity with an intent to derive a

profit and is therefore entitled to deduct from her gross income

Schedule C losses relating to that activity. To make our

determination, we address the nine factors found in section

1.183-2(b), Income Tax Regs.
 - 20 -

1. Manner in Which Petitioner Carried On the Horse
Activity

To determine whether a taxpayer carried on an activity in a

businesslike manner, three subfactors may be considered. Sec.

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

a. Complete and Accurate Books and Records

The fact that the taxpayer carries on the activity in a

businesslike manner and maintains complete and accurate books and

records may indicate that the activity is engaged in for profit.

Elliott v. Commissioner, 90 T.C. 960, 972 (1988), affd. without

published opinion 899 F.2d 18 (9th Cir. 1990); Engdahl v.

Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2(b)(1), Income

Tax Regs.

Petitioner asserts that she kept complete and accurate books

and records and argues that respondent’s concession that she

substantiated her Schedule C expenses so indicates. Annual

profit and loss statements were introduced into evidence for the

years 1988 through 2003, including the years in issue. These

statements were prepared by Ms. Pope and used by Mr. Wessman to

prepare petitioner’s Schedules C.

Although petitioner’s annual profit and loss statements were

sufficient to substantiate her Schedule C expenses, these

statements are not indicative that the horse activity was carried

on for profit for the purposes of section 1.183-2(b)(1), Income

Tax Regs. This Court has stated:
 - 21 -

The purpose of maintaining books and records is more
than to memorialize for tax purposes the existence of
the subject transactions; it is to facilitate a means
of periodically determining profitability and analyzing
expenses such that proper cost saving measures might be
implemented in a timely and efficient manner. * * *

Burger v. Commissioner, T.C. Memo. 1985-523, affd. 809 F.2d 355

(7th Cir. 1987); see also Golanty v. Commissioner, supra at 430;

McKeever v. Commissioner, T.C. Memo. 2000-288; Wesinger v.

Commissioner, T.C. Memo. 1999-372. Even though a sophisticated

accounting system is not necessary, “the usage of cost accounting

techniques that, at a minimum, provide the entrepreneur with the

information he requires to make informed business decisions” is

essential. Burger v. Commissioner, supra; see also Golanty v.

Commissioner, supra; McKeever v. Commissioner, supra; Wesinger v.

Commissioner, supra.

Petitioner introduced no evidence that she kept track of

expenses throughout the year. The statements categorized

expenses, but her records did not break down the expenses by

horse, by month, or by any other means. Further, the record is

devoid of any evidence that petitioner used the statements in

making decisions about the operation of her horse activity. We

find that petitioner’s annual profit and loss statements were

nothing more than records compiled at the end of each year and

used exclusively to prepare her Schedules C. Petitioner did not

use the statements to make informed business decisions.

This subfactor weighs in favor of respondent’s position.
 - 22 -

b. Conduct Substantially Similar to That of Other
Profitable Activities

When the taxpayer conducts the activity in a manner

substantially similar to that of other activities of the same

nature which are profitable, a profit motive may be indicated.

Engdahl v. Commissioner, supra at 666-667; sec. 1.183-2(b)(1),

Income Tax Regs. Petitioner presented no evidence on how

profitable horse breeding operations are run. However, generally

relevant indicators may include advertising, maintaining a

separate business bank account, developing a written business

plan, and having a plausible strategy for earning a profit. See

Morley v. Commissioner, T.C. Memo. 1998-312; Butler v.

Commissioner, T.C. Memo. 1997-408; De Mendoza v. Commissioner,

T.C. Memo. 1994-314; Ellis v. Commissioner, T.C. Memo. 1984-50.

In the 11 years prior to the years in issue, petitioner

deducted less than $2,800 of advertising and promotion costs.

During the years in issue, petitioner did not advertise in trade

magazines, journals, or other publications, and she deducted no

advertising or promotional costs on her Schedules C. Petitioner

testified that she felt showing horses was the best form of

advertising and used competitions as her primary method of

promotion.

The Court recognizes that showing horses may be one method

of advertising. However, given that petitioner’s activity is

breeding and selling horses, and that petitioner sold only one
 - 23 -

horse from 1988 through 2003, we find that her failure to

advertise in an attempt to reach a larger customer base is not

consistent with a profit motive. See Dodge v. Commissioner, T.C.

Memo. 1998-89, affd. without published opinion 188 F.3d 507 (6th

Cir. 1999).

Petitioner maintains a separate bank account under the names

Elizabeth Giles and Falling Water Arabians. However, it is clear

from the record that petitioner did not use the account in

conducting her horse activity. From December 16, 1998, to

December 3, 2001, petitioner made a single withdrawal of $240,

not including the monthly deductions for maintenance fees. The

purpose of the withdrawal was not identified in the record. In

addition, Ms. Pope testified that the canceled checks she used to

prepare petitioner’s annual profit and loss statements were not

from the Elizabeth Giles and Falling Water Arabians bank account.

During the years in issue, there were only two deposits into

the account. On May 5, 2001, petitioner deposited $9 in order to

restore a positive account balance. On December 4, 2001,

petitioner deposited $20,000 received from the sale of Bogaz.

Petitioner invested the $20,000 in an individual retirement

account, which is clearly not related to her horse activity. On

the basis of the above, we find that petitioner did not maintain

the bank account in a businesslike manner.
 - 24 -

Petitioner and Ms. Pope prepared annual business plans for

the years 1989 through 1994 and one undated general business

plan. These plans were on fill-in-the-blank forms with hand-

written responses. In each plan, petitioner listed as a long-

term goal to sell horses. In her 1991 through 1994 plans,

petitioner stated that her goal was to move her horse activity to

Gavilan Hills.

While petitioner had business plans for previous years, she

had no business plans for the years in issue. Petitioner

introduced no evidence that she referred to the business plans

during the years in issue. Despite petitioner’s stated goal of

selling horses, petitioner sold only one horse in 2001, 7 years

after the last business plan was prepared. Despite petitioner’s

stated goal of moving her horse activity to Gavilan Hills, from

1991 through the years in issue petitioner took no meaningful

steps to make the property suitable for accommodating the

activity. We find that no positive inference can be drawn from

petitioner’s business plans.

Petitioner continually asserts that she is in the business

of breeding and selling horses and intends to make a profit.

Since 1989, petitioner has bred only Borissa. In that time,

Borissa’s 1990 foal died in 1991, she was not bred from 1992

through 1996, her 1998 foal died at birth, and she was not able

to conceive by artificial insemination in 1999. In 15 years,
 - 25 -

Borissa has produced only two surviving horses, Bogaz and

Censuous. Despite the many breeding problems, petitioner

testified that she considered Borissa to be her best breeding

mare.

Petitioner also testified that she intends to offer services

to third parties, including training, coaching, and boarding.

Yet since 1988, petitioner has offered no such services. In

addition, the zoning restrictions at Falling Water Way and

Gavilan Hills prohibit petitioner from operating boarding or

livery stables on the properties. Petitioner has pointed to

nothing else from which she intends to derive a profit. On the

basis of these facts, we find that petitioner does not have a

plausible strategy for earning a profit.

Petitioner has introduced no evidence that she operated her

horse activity in a manner similar to that of profitable horse-

breeding businesses. None of the generally relevant indicators

described above could lead us to conclude that petitioner

operates her horse activity in a manner consistent with a

profitable venture of any type. This subfactor weighs heavily in

favor of respondent’s position.

c. Changes To Improve Profitability

When a taxpayer changes operating methods, adopts new

techniques, or abandons unprofitable methods in a manner
 - 26 -

consistent with an intent to improve profitability, a profit

motive may be indicated. Sec. 1.183-2(b)(1), Income Tax Regs.

Petitioner argues that she has changed her methods over the

years in an effort to improve profitability. To advance this

argument, petitioner testified that: (1) From 1992 through 1996,

she stopped breeding her horses because she perceived a downturn

in the Arabian horse market; (2) she began vaccinating, worming,

and performing other basic veterinary services to save money; and

(3) in 2001, she switched show disciplines to dressage because

she felt dressage was becoming more popular.

Petitioner introduced no evidence to corroborate her

testimony that there was a downturn in the Arabian horse market

in the mid-1990s. Even if we accept petitioner’s statements as

fact, the halt in her breeding activity would not weigh in her

favor. Petitioner reported the following total expenses from her

horse activity on her Schedules C:
 - 27 -

Year Total Expenses

1988 $27,782
1989 32,244
1990 38,197
1991 28,136
1992 32,545
1993 46,622
1994 38,152
1995 40,703
1996 40,337
1997 24,475
1998 21,568
1999 23,677
2000 18,649
2001 19,791
2002 27,072
2003 23,621

During the period that petitioner stopped breeding her horses,

her total annual expenses were actually higher than during most

years in which she was breeding them. Petitioner testified that

she felt breeding would be unprofitable during the perceived

downturn. However, petitioner did not state how, if at all, her

decision would decrease expenses or otherwise improve

profitability.

In her 1993 annual business plan, petitioner indicated that

she could lower costs by performing basic veterinary work. It is

unclear from the record when petitioner began performing this

work. On petitioner’s Schedules C, she reported the following

veterinary expenses:
 - 28 -

Year Veterinary Expenses

1988 $222
1989 1,304
1990 3,410
1991 1,803
1992 2,434
1993 899
1994 5,322
1995 2,377
1996 1,272
1997 1,382
1998 1,453
1999 2,614
2000 1,731
2001 947
2002 3,101
2003 1,398

There is no discernable pattern to the reported veterinary

expenses that would indicate veterinary costs decreased as a

result of petitioner’s performing some veterinary services on her

own.

Petitioner testified that, in 2001, she switched show

disciplines from western pleasure and trail to dressage because

she perceived a greater demand for dressage horses. Petitioner

presented no evidence that corroborates her perception.

Petitioner did not indicate that her horses were marketed

differently or how the switch in show disciplines would otherwise

affect the profitability of petitioner’s horse activity.

On the basis of the above, we cannot infer that petitioner’s

decisions to halt breeding, perform veterinary services, or

switch show disciplines were made in a manner consistent with an

intent to improve profitability. Petitioner has not shown that
 - 29 -

the changes had or will have a material impact on her horse

activity’s profitability. See Golanty v. Commissioner, 72 T.C.

at 428 (changes must be sufficient to change materially the

prospect of profitability); McKeever v. Commissioner, T.C. Memo.

2000-288. Accordingly, this subfactor weighs in favor of

respondent’s position.

d. Other Considerations

Petitioner has a Falling Water Arabians business card.

However, this card was prepared in the late 1980s, and the phone

numbers are no longer correct. The existence of an out-of-date

business card does not weigh in favor of petitioner’s position.

Petitioner keeps extensive records of health, certification,

and pedigree, as well as promotional materials used in picking

stallions to breed Borissa to, and correspondence with other

parties regarding her horse activity. However, the keeping of

these records is as consistent with a hobby as with a business.

See Golanty v. Commissioner, supra at 430; Burger v.

Commissioner, T.C. Memo. 1985-523. The existence of these

records does not weigh in favor of petitioner’s position.

Petitioner argues that her decision to lease Borissa before

buying her evidences businesslike behavior. Petitioner

introduced no evidence that this is a common practice in

profitable horse-breeding businesses. This decision does not

weigh in favor of petitioner’s position.
 - 30 -

e. Summary

Taking into consideration the above, we conclude that

petitioner did not operate her horse activity in a businesslike

manner. This factor weighs in favor of respondent’s position.

2. Expertise of Petitioner or Her Advisers

Preparation for an activity by extensive study of its

accepted business, economic, and scientific practices, or

consultation with those who are expert therein, may indicate a

profit motive. Engdahl v. Commissioner, 72 T.C. at 668;

Lundquist v. Commissioner, T.C. Memo. 1999-83, affd. 211 F.3d 600

(11th Cir. 2000); sec. 1.183-2(b)(2), Income Tax Regs. Efforts

to gain experience and a willingness to follow expert advice may

also indicate a profit motive. Dworshak v. Commissioner, T.C.

Memo. 2004-249; Lundquist v. Commissioner, supra.

Petitioner has been involved with raising and showing horses

since she was a child. Petitioner has consulted many

professionals regarding breeding and training horses, including

David Garrett and Lou Roper. In addition, petitioner has read

many books and publications regarding the breeding and training

of horses. While petitioner undoubtedly has expertise in

breeding and training, her expertise does not extend to the

economics of the undertaking.

Petitioner testified that, when she started her horse

activity, she had no idea how many Arabian horse breeders there
 - 31 -

were in California. Petitioner presented no evidence that she

was aware of the state of the market or other factors that may

affect profitability. “While a formal market study is not

required, a basic investigation of the factors that would affect

profit is.” Burger v. Commissioner, supra; see also Golanty v.

Commissioner, supra at 432; Wesinger v. Commissioner, T.C. Memo.

1999-372.

Petitioner testified that she discussed aspects of her horse

activity with two C.P.A.s, Ms. Pope and Mr. Wessman, which their

testimony corroborated. However, it is unclear whether they

discussed anything more than petitioner’s expenses in preparing

the annual profit and loss statements and Schedules C. While Ms.

Pope and Mr. Wessman may have expertise in accounting, neither

testified to having experience in running a profitable horse-

breeding business. Since 1988, petitioner has not consulted with

experts regarding the economic aspects of running a profitable

horse-breeding business. Considering petitioner’s long history

of losses, this is not indicative of a profit motive. See

Golanty v. Commissioner, supra at 432; Wesinger v. Commissioner,

supra; Hillman v. Commissioner, T.C. Memo. 1999-255; Dodge v.

Commissioner, T.C. Memo. 1998-89.

None of petitioner’s reference materials and publications

were devoted to the business aspects of horse breeding.

Petitioner testified that only one of the references in her
 - 32 -

library might possibly contain information regarding the business

aspects of horse breeding. She further testified that some of

the monthly publications contained business information.

However, petitioner did not testify to how she used this

information, if at all, in her activity.

On the basis of the above, we conclude that petitioner was

not an expert and did not seek out expert advice regarding the

economic aspects of running a profitable horse-breeding business.

This factor weighs in favor of respondent’s position.

3. Time and Effort Petitioner Expended in Carrying
On the Activity

The fact that the taxpayer devotes much of her personal time

and effort to carrying on an activity may indicate an intention

to derive a profit, particularly if the activity does not have

substantial personal or recreational aspects. Golanty v.

Commissioner, 72 T.C. at 426; Sullivan v. Commissioner, T.C.

Memo. 1998-367, affd. 202 F.3d 264 (5th Cir. 1999); Morley v.

Commissioner, T.C. Memo. 1998-312;11 sec. 1.183-2(b)(3), Income

Tax Regs.

11
Petitioner places heavy emphasis on Morley v.
Commissioner, T.C. Memo. 1998-312, where the Court held that the
taxpayer operated his horse activity for profit. Like
petitioner, Mr. Morley worked 4 days a week in his dental
practice and 7 days a week with his horse activity. However, the
present case is readily distinguishable. Among other
differences, Mr. Morley advertised, created promotional
materials, and was not involved in the recreational components of
horse ownership, specifically riding his horses, to any
significant extent.
 - 33 -

Petitioner often spent 6 hours a day with her horse

activity. Petitioner argues that the activity does not have

substantial personal or recreational aspects. Petitioner places

heavy emphasis on the time spent feeding and watering her horses

and cleaning stalls.

Petitioner asserts that her horse activity did not have any

personal or recreational aspects. While the Court recognizes

that feeding and watering her horses and cleaning stalls may not

be enjoyable activities, unpleasant tasks associated with caring

for horses are required regardless of whether the activity is

pursued as a hobby or a business. See Sullivan v. Commissioner,

supra. Petitioner has ridden and shown horses since she was a

child. Though she does not ride in parades or attend social or

charity functions, petitioner certainly derives some personal

pleasure from riding and showing her horses. However, personal

pleasure derived from an activity will not turn a business into a

hobby. Jackson v. Commissioner, 59 T.C. 312, 317 (1972); see

also McKeever v. Commissioner, T.C. Memo. 2000-288.

Petitioner spends a significant amount of time with her

horse activity. Nevertheless, because the horse activity has

significant personal and recreational components, this factor is

neutral.
 - 34 -

4. Expectation That Assets Used in the Activity May
Appreciate in Value

The expectation that assets used in the activity will

appreciate in value sufficiently to lead to an overall profit

when netted against losses may indicate a profit motive.

Engdahl v. Commissioner, 72 T.C. at 668-669; Lapinel v.

Commissioner, T.C. Memo. 1989-685, affd. 930 F.2d 911 (2d Cir.

1991); sec. 1.183-2(b)(4), Income Tax Regs. Petitioner argues

that the appreciation of Falling Water Way and Gavilan Hills,

combined with the value of her horses, is significant enough to

offset all prior losses.

a. Falling Water Way and Gavilan Hills

Petitioner asserts that Falling Water Way and Gavilan Hills

are held in connection with her horse activity. Respondent, on

the other hand, argues that her holding of real property is an

activity separate from petitioner’s horse activity. To make this

determination, section 1.183-1(d)(1), Income Tax Regs., states:

all facts and circumstances * * * must be taken into
account. Generally, the most significant facts and
circumstances in making this determination are the
degree of organizational and economic interrelationship
of various undertakings, the business purpose which is
* * * served by carrying on the various undertakings
separately or together * * * and the similarity of
various undertakings. * * * The taxpayer’s
characterization will not be accepted * * * when it
appears that his characterization is artificial and
cannot be reasonably supported under the facts and
circumstances of the case. If the taxpayer engages in
two or more separate activities, deductions and income
from each separate activity are not aggregated either
 - 35 -

in determining whether a particular activity is engaged
in for profit or in applying section 183. * * *

Falling Water Way is at the center of petitioner’s

horse activity. Her horses are kept on the property and are

bred, fed, and watered there. Petitioner testified that she

trains her horses in the arena at Falling Water Way.

However, Falling Water Way also includes petitioner’s four-

bedroom house and a garage unrelated to her horse activity.

With the exception of the house and the garage, we conclude

that Falling Water Way is a part of petitioner’s horse

activity. Therefore, any appreciation attributable to the

horse facilities and land at Falling Water Way may be taken

into consideration when determining whether petitioner

engaged in her horse activity for a profit.

Gavilan Hills is approximately 5 miles from Falling

Water Way. Even though petitioner has not made significant

improvements to the property since 1991, petitioner used

Gavilan Hills to exercise and train her horses throughout

the years in issue. Gavilan Hills was not used for any

purpose unrelated to petitioner’s horse activity. We

conclude that Gavilan Hills is a part of petitioner’s horse

activity. Therefore, any appreciation of Gavilan Hills may

be taken into consideration when determining whether

petitioner engaged in her horse activity for a profit.
 - 36 -

b. Petitioner’s Horses

Petitioner’s only evidence of the fair market value of

her horses is based on the testimony of an expert witness,

Janine Esler (Ms. Esler). Ms. Esler is a professional horse

trainer, breeder, bloodstock agent, and business consultant.

She has trained Arabian horses since 1975. Her experience

is sufficient to qualify her as an expert in the Arabian

horse field. However, we find that Ms. Esler’s expert

report does not provide reliable valuations of petitioner’s

horses.

Rule 143(f) states that a witness’s expert report

“shall state the * * * opinion and the facts * * * on which

that opinion is based. The report shall set forth in detail

the reasons for the conclusion.” (Emphasis added.) In her

report, Ms. Esler did not disclose her method of valuation.

At trial, she testified that she used “comparable values of

horses”, but she could not be more specific. Ms. Esler

further testified that a horse’s pedigree, health condition,

training history, and performance history are all factors to

be considered in determining a horse’s fair market value,

yet these factors are not mentioned in her report. In

addition, Ms. Elser testified that it is important to view a

horse from all angles and to watch the horse walking both

towards and away from the observer. However, Ms. Esler
 - 37 -

never personally observed two of the horses valued in her

report, TF Silent Reign and Mon Reve, instead relying on

still-shot photographs.

We find that Ms. Esler’s report does not comply with

Rule 143(f), as it fails to set out in detail the reasons

for her conclusions. We further find that Ms. Esler could

not adequately explain her report at trial and her answers

to many questions raise doubts as to the reliability of her

valuations.

Because petitioner introduced no other evidence

regarding the values of her horses, those values cannot be

considered in determining whether petitioner engaged in her

horse activity for profit.

c. Summary

As outlined above, the fair market value of Falling

Water Way and Gavilan Hills can be taken into account in

considering this factor. Petitioner purchased Falling Water

Way for $135,000 and Gavilan Hills for $70,000. As of June

15, 2004, the fair market value of the horse facilities and

land at Falling Water Way was $375,000, and the fair market

value of Gavilan Hills was $306,000. Falling Water Way and

Gavilan Hills have appreciated substantially, and petitioner

can reasonably expect the properties to continue to

appreciate. Therefore, we find that this factor weighs in
 - 38 -

favor of petitioner’s position. It is important to note,

however, that “An unsuccessful horse-breeding operation

cannot be carried on forever simply because the price of

land in that general area is rising.” Lapinel v.

Commissioner, T.C. Memo. 1989-685.

5. Success of Petitioner in Carrying on Other Similar
or Dissimilar Activities

The fact that the taxpayer has engaged in similar

activities in the past and converted them to profitable

enterprises may indicate that she engaged in the present

activity for profit. Lundquist v. Commissioner, T.C. Memo.

1999-83; De Mendoza v. Commissioner, T.C. Memo. 1994-314;

sec. 1.183-2(b)(5), Income Tax Regs. While petitioner has a

long history of working with horses, she had not previously

engaged in a horse-breeding business. Petitioner runs a

successful dental practice, but she presented no evidence

that she operated her horse activity in a similarly

businesslike manner. See Dodge v. Commissioner, T.C. Memo.

1998-89. Accordingly, this factor is neutral.

6. Petitioners’ History of Income or Losses With
Respect to the Activity

A series of losses during the initial or startup stage

of an activity may not necessarily be an indication that the

activity is not engaged in for profit. Engdahl v.

Commissioner, 72 T.C. at 669; sec. 1.183-2(b)(6), Income Tax
 - 39 -

Regs. However, losses that extend beyond the customary

startup stage may indicate that the activity is not engaged

in for profit. Engdahl v. Commissioner, supra at 669; sec.

1.183-2(b)(6), Income Tax Regs.

From 1988 through 2000, and 2002 through 2003,

petitioner reported total Schedule C losses of $441,289. In

2001, petitioner reported a $209 profit from her horse

activity, due to the sale of Bogaz for $20,000.

Petitioner argues that the history of losses does not

indicate she lacked a profit motive because her activity is

in the startup stage. This Court has recognized that the

startup stage for a horse-breeding activity may be 5 to 10

years. Engdahl v. Commissioner, supra at 669; McKeever v.

Commissioner, T.C. Memo. 2000-288; Dodge v. Commissioner,

supra. Petitioner argues that her startup stage should be

extended because she encountered unforseen circumstances,

including the death of two foals in 1991 and 1998,

respectively, and the depressed Arabian horse market in the

mid-1990s.

The applicable regulations do not provide for an

extension of the startup stage on account of unforeseen

circumstances, and petitioner cites no caselaw to support

her argument. Instead, section 1.183-2(b)(6), Income Tax

Regs., states: “If losses are sustained because of
 - 40 -

unforeseen or fortuitous circumstances which are beyond the

control of the taxpayer * * * such losses would not be an

indication that the activity is not engaged in for profit.”

Even if unforeseen circumstances beyond petitioner’s control

contributed to losses in earlier years, this does not

explain petitioner’s continued losses in 1999, 2000, 2002,

and 2003, nor does it justify extending the long-recognized

5- to 10-year startup stage.

Petitioner began her horse activity in 1988. If we

give her the full benefit of the recognized time period, the

startup stage of petitioner’s activity ended in 1997. In

the 6 subsequent years, petitioner reported losses totaling

$111,987, while reporting a profit in just 1 year of only

$209.

Petitioner also argues that her history of losses does

not indicate she lacked a profit motive because the losses

were steadily declining until 2001, when a profit was

achieved. From 1996 through 2000, petitioner’s losses

declined each year. In 1999 and 2000, petitioner reported

losses of $22,777 and $17,649, respectively. In 2001,

petitioner reported a profit of $209. However, in 2002 and

2003, petitioner reported losses of $27,072 and $23,421,

respectively. In other words, petitioner’s losses in 2002

and 2003 actually increased relative to her losses in 1999
 - 41 -

and 2000. Petitioner’s losses after the years in issue only

confirm the general pattern of losses. See Dodge v.

Commissioner, supra. Given what has occurred since

petitioner reported a profit in 2001, no positive inference

can be made from the decline in losses before 2001.

Petitioner’s history of losses indicates that her horse

activity was not engaged in for profit. This factor weighs

heavily in favor of respondent’s position.

7. The Amount of Occasional Profits, If Any, Which
Are Earned

The amount of profits in relation to the amount of

losses incurred may provide a useful criterion in evaluating

whether the taxpayer engaged in the activity for profit.

McKeever v. Commissioner, supra; Dodge v. Commissioner,

supra; sec. 1.183-2(b)(7), Income Tax Regs. The regulations

go on to state:

substantial profit, though only occasional, would
generally be indicative that an activity is engaged in
for profit, where * * * losses are comparatively small.
Moreover, an opportunity to earn a substantial ultimate
profit in a highly speculative venture is ordinarily
sufficient to indicate that the activity is engaged in
for profit even though losses or only occasional small
profits are actually generated.

Sec. 1.183-2(b)(7), Income Tax Regs. (emphasis added).

Petitioner has not generated a “substantial” profit.

In the 16 years petitioner has operated her horse activity,

she reported a profit in 1 year of only $209, compared to
 - 42 -

total losses of $441,289. The size of her losses compared

to only a small profit is not indicative of a profit motive.

Petitioner argues that she has the opportunity to earn

a substantial ultimate profit through the sale of

potentially valuable horses. Petitioner introduced evidence

that horses of the bloodlines she used in breeding Borissa

have sold for $300,000, $150,000, $140,000, and $120,000.

Petitioner also testified that some purebred Arabian

stallions have been syndicated for multimillion dollar

values. A taxpayer’s belief that she could one day sell a

horse for a substantial amount of revenue and a

correspondingly large profit may be indicative of a profit

motive if that belief is adequately supported. See McKeever

v. Commissioner, supra; Dawson v. Commissioner, T.C. Memo.

1996-417. However, petitioner has never produced a horse of

the caliber that would generate such substantial revenue.

Under the circumstances of this case, the possibility of a

highly speculative profit is insufficient to outweigh the

substantial losses and relatively minuscule gain over a 16-

year period. See McKeever v. Commissioner, supra.

This factor weighs in favor of respondent’s position.

8. The Financial Status of Petitioner

Substantial income from sources other than the activity

may indicate that the taxpayer is not engaged in the
 - 43 -

activity for profit, particularly if the losses generate

substantial tax benefits. Engdahl v. Commissioner, supra at

669-670; sec. 1.183-2(b)(8), Income Tax Regs.

Petitioner is a dentist and runs her own dental

practice as a professional corporation. From 1988 through

2003, petitioner received wage income from her professional

corporation averaging $109,547 annually. In addition, since

1997, petitioner has reported average annual rental income

of $7,871.

Despite her significant sources of current income,

petitioner argues that her lack of investments and other

resources on which to retire indicate that she is running

her horse activity for profit. Petitioner testified that

she is not the owner or beneficiary of any trusts,

annuities, or pension plans, and her only investments

consist of an individual retirement account worth less than

$25,000 and stocks and bonds worth less than $20,000.

Petitioner further testified that she intended her horse

activity to be her source of retirement income.

In making this argument, petitioner disregards the

value of her real property. As of June 15, 2004, the

combined fair market value of Falling Water Way and Gavilan

Hills was $836,000. The fair market value of the Rialto
 - 44 -

property is not in the record.12 In addition, petitioner

disregards the value of her professional corporation, of

which she is the sole shareholder.

While the Court recognizes that, as long as tax rates

are less than 100 percent, there is no “benefit” to losing

money, see Engdahl v. Commissioner, 72 T.C. at 670,

deducting these losses significantly reduced the after-tax

cost of petitioner’s horse activity, see Hillman v.

Commissioner, T.C. Memo. 1999-255; Sullivan v. Commissioner,

T.C. Memo. 1998-367. Given the after-tax economics of

petitioner’s activity, petitioner’s significant annual wage

and rental income supports an inference that the activity

was not engaged in for profit. This factor weighs in favor

of respondent’s position.

9. Elements of Personal Pleasure or Recreation

The presence of personal or recreational motives in

conducting an activity may indicate that the taxpayer is not

conducting the activity for profit. McKeever v.

Commissioner, supra; sec. 1.183-2(b)(9), Income Tax Regs.

However, the fact that the taxpayer derives personal

pleasure from engaging in the activity does not show that

the taxpayer lacks a profit objective if the activity is, in

12
Petitioner did not establish to what extent, if any,
these properties are encumbered.
 - 45 -

fact, conducted for profit as evidenced by other factors.

Sec. 1.183-2(b)(9), Income Tax Regs.

Despite petitioner’s testimony that her horse activity

did not have any personal or recreational aspects,

petitioner certainly derives some personal pleasure from

riding and showing her horses, as discussed above. However,

this does not, by itself, indicate that petitioner lacked a

profit motive. Accordingly, this factor is neutral.

Conclusion

Petitioner repeatedly testified that she intended to

derive a profit from her horse activity and wished to use

the activity as her source for retirement income.

Petitioner’s assertions, however, are not supported by the

facts. In 16 years of operation, petitioner had 1

profitable year. Despite continual heavy losses, petitioner

did not seek out expert advice, or attempt to educate

herself, on the economic aspects of running a profitable

horse-breeding business. Petitioner did not operate the

activity in a businesslike manner. In addition, if not for

her significant annual wage and rental income, petitioner

would have been unable to continue the horse activity at a

loss year after year. The only factor weighing in favor of

petitioner, the appreciation of Falling Water Way and
 - 46 -

Gavilan Hills, is not significant enough to overcome the

other factors.

For these and all other reasons stated herein, we find

that petitioner’s horse activity was not engaged in for

profit within the meaning of section 183. Therefore,

respondent’s determination that petitioner may not deduct

losses from that activity is sustained.

B. Accuracy-Related Penalty Under Section 6662

Respondent determined that petitioner is liable for

accuracy-related penalties under section 6662(a) for 1999

and 2000.13 Section 6662(a) imposes a penalty in the amount

of 20 percent on the portion of the underpayment to which

the section applies. As relevant to this case, the penalty

applies to any portion of the underpayment that is

attributable to any substantial understatement of income

tax. Sec. 6662(b)(2). There is a “substantial

understatement of income tax” if the amount of the

understatement exceeds the greater of 10 percent of the tax

required to be shown on the tax return or $5,000. Sec.

6662(d)(1)

Section 7491(c) requires the Commissioner to carry the

burden of production with regard to penalties. Higbee v.

13
As previously noted, respondent has conceded that
petitioner is not liable for an accuracy-related penalty for
2001.
 - 47 -

Commissioner, 116 T.C. 438, 446 (2001). Once the burden of

production is met, the taxpayer must come forward with

sufficient evidence that the penalty does not apply. Id. at

447.

The tax required to be shown on petitioner’s tax

returns was $26,378 and $19,845, for 1999 and 2000,

respectively. Because 10 percent of the tax required to be

shown is less than $5,000, petitioner’s understatements are

substantial if they exceed $5,000. Petitioner reported

income tax liabilities of $19,261 and $14,375, resulting in

understatements of $7,117 and $5,470 for 1999 and 2000,

respectively. Respondent has satisfied his burden by

showing that petitioner’s understatements of tax, which

exceeded $5,000, were substantial.

The accuracy-related penalty is not imposed, however,

with respect to any portion of the understatement if the

taxpayer can establish that she acted with reasonable cause

and in good faith. Sec. 6664(c)(1). The decision as to

whether the taxpayer acted with reasonable cause and in good

faith depends upon all the pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.

Circumstances indicating that a taxpayer acted with

reasonable cause and in good faith include “an honest

misunderstanding of fact or law that is reasonable in light
 - 48 -

of all of the facts and circumstances, including the

experience, knowledge, and education of the taxpayer.” Id.

Petitioner asserts that she acted with reasonable cause

and in good faith, pointing out that: (1) In 1994,

petitioner was audited “on this same issue for the same

business” and received a no-change letter; and (2)

petitioner consulted with Mr. Wessman, a C.P.A., who

prepared her Federal income tax returns for the years in

issue.

While petitioner did receive a no-change letter with

respect to her horse activity during 1991 and 1992, the

audit focused on the passive activity rules of section 469.

Because this case focuses on the hobby loss rules of section

183, the no-change letter received in 1994 cannot serve as a

basis for reasonable cause.

Reliance upon the advice of an expert tax preparer may

demonstrate that a taxpayer acted with reasonable cause and

good faith in the context of section 6662(a). Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011

(5th Cir. 1990), affd. 501 U.S. 868 (1991); see sec. 1.6664-

4(c)(1), Income Tax Regs. Petitioner provided Mr. Wessman

with the annual profit and loss statements prepared by Ms.

Pope. Respondent has conceded that these statements were

adequate to substantiate all of petitioner’s claimed
 - 49 -

expenses for the years in issue. Mr. Wessman’s testimony

that petitioner provided him with all the necessary

information is bolstered by respondent’s concession. Mr.

Wessman further testified that he believed petitioner’s

returns were correct as filed. Petitioner credibly

testified that she relied on Mr. Wessman in determining the

tax treatment of her horse activity.

Petitioner did not produce any books, records, or other

work papers in response to respondent’s initial contact

letter. Additionally, petitioner did not agree to extend

the period of limitations or participate in the appeal

process. However, Mr. Wessman credibly testified that such

actions were taken in order to expedite the review process

so that the years in issue could be consolidated with the

prior Tax Court case. Given the circumstances, we find

petitioner did not act in bad faith.

We conclude that petitioner acted with reasonable cause

and in good faith. Accordingly, we hold that petitioner is

not liable for the accuracy-related penalties under section

6662(a).

In reaching our holdings, we have considered all

arguments and contentions made, and, to the extent not

mentioned, we conclude that they are moot, irrelevant, or

without merit.
 - 50 -

To reflect the foregoing and the concessions of the

parties,

Decision will be

entered under Rule 155.