Osteen v. Comr. of IRS

United States Court of Appeals,

Eleventh Circuit.

No. 94-2371.

Harry E. OSTEEN and Gail M. Osteen, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Aug. 25, 1995.

Appeal from a Decision of the United States Tax Court. (No. 17391-
92), Daniel J. Dinan, Judge.

Before BLACK and BARKETT, Circuit Judges, and RONEY, Senior Circuit
Judge.

RONEY, Senior Circuit Judge:

Harry and Gail Osteen (taxpayers) appeal the United States Tax

Court's decision disallowing certain tax deductions attributable to

their farming and horse breeding operation on the grounds that this

activity was not engaged in for profit and assessing tax

deficiencies and penalties for a substantial tax understatement.

We hold that the Tax Court's factual findings that the Osteens

lacked a profit objective are not clearly erroneous and affirm its

decision on that issue. We reverse the Tax Court, however, on its

assessment of the understatement penalty because there was

substantial authority for the taxpayers' position.

The facts of this case are discussed in detail in the Tax

Court's memorandum opinion, T.C.Memo. 1993-519, 66 T.C.M. (CCH)

1237, 1993 WL 460546 (1993), and will not be repeated here. During

the years at issue, Harry Osteen was employed full-time as a bank

executive. His wife, Gail Osteen, was a full-time registered

nurse. The Osteens became interested in breeding and raising
Percheron horses in Florida. Percherons are a breed of large draft

horses that originally were bred for moving or towing heavy objects

before the advent of tractors. There were no Percheron horse

breeders nor was there an established market for Percherons in

Florida at the time. The Osteens' intent was to breed the horses,

train them by showing them and using them to operate a

horse-powered farm, and then to sell the horses. For several

consecutive years, the Osteens generated losses from the horse

breeding activity.

Profit Objective

A taxpayer who is carrying on a trade or business may deduct

ordinary and necessary expenses incurred in connection with the

operation of the business. I.R.C. § 162. An activity constitutes

a "trade or business" within the meaning of section 162 if the

taxpayer's actual and honest objective is to realize a profit.

Dreicer v. Commissioner, 78 T.C. 642, 645, 1982 WL 11080 (1982),

aff'd 702 F.2d 1205 (D.C.Cir.1983). The courts have relied on

factors set forth in section 183 in making the requisite profit

motive analysis under section 162. Brannen v. Commissioner, 722

F.2d 695, 704 (11th Cir.1984).

Section 183 specifically precludes deductions for activities

"not engaged in for profit," such as pursuing hobbies or generating

losses to shelter unrelated income. I.R.C. § 183(a); S.Rep. No.

552, 91st Cong., 1st Sess. (1969), reprinted in 1969 U.S.C.C.A.N.

1645, 2133 (legislative history of § 183). Although the taxpayer's

expectation of profit does not have to be reasonable, objective

facts and circumstances must indicate that the taxpayer's intent
was to make a profit. A taxpayer's subjective statements of intent

to make a profit are not sufficient. Treas.Reg. § 1.183-2(a)

(1972). The regulations list nine factors to guide courts in

determining whether an activity is engaged in for profit. These

are not exclusive considerations, however, and no single factor or

mathematical preponderance of factors is determinative. Treas.Reg.

§ 1.183-2(b) (1972).

In an opinion in which the Tax Court comprehensively analyzed

the objective facts and circumstances of this case against the

backdrop of each of the relevant factors, the court concluded that

the Osteens did not engage in their horse breeding activity with an

actual and honest objective of making a profit. This is a factual

finding of the Tax Court due to be affirmed unless clearly

erroneous. Mayrath v. Commissioner, 357 F.2d 209, 212-13 (5th

Cir.1966); Faulconer v. Commissioner, 748 F.2d 890, 895 (4th

Cir.1984).

A review of the record reveals that the Tax Court properly

followed the nine factors listed in the regulations, viewed all

facts and circumstances of the case, and was not clearly erroneous

in determining that the Osteens engaged in the Percheron breeding

business without a bona fide profit motive. The Tax Court relied

on facts such as the taxpayers' inexperience in breeding Percheron

horses and their failure to hire experienced assistants or bring in

experienced partners, the lack of any profitability assessment of

breeding Percherons in Florida, the limited time spent managing the

operation, the string of consistent losses, and the significant

income Osteen earned as a bank executive which allowed him to
tolerate such losses.

Substantial Understatement Penalty

The Osteens appeal the Tax Court's assessment of section 6661

understatement penalties. The Osteens do not dispute that their

tax understatements for the two years in question met the

definition of "substantial understatements" under this provision.

The Osteens contend, however, that they had substantial authority

to believe they could claim the farming and horse breeding losses,

an exception to the imposition of understatement penalties.

26 U.S.C. § 6661, applicable during the years at issue,

provided that:

(a) Addition to tax.—If there is a substantial
understatement of income tax for any taxable year, there shall
be added to the tax an amount equal to 25 percent of the
amount of any underpayment attributable to such
understatement.

For our purposes, section 6661(b)(2)(A) defines the

"understatement" as the excess of:

(i) the amount of the tax required to be shown on the
return for the taxable year, over

(ii) the amount of the tax imposed which is shown on the
return....

The understatement, for the purposes of imposing the addition,

shall be reduced "by that portion of the understatement which is

attributable to [ ]the tax treatment of any item by the taxpayer if

there is or was substantial authority for such treatment...."

Section 6661(b)(2)(B)(i) (emphasis added).

The application of a substantial authority test is confusing

in a case of this kind. If the horse breeding enterprise was

carried on for profit, all of the deductions claimed by the Osteens
would be allowed. There is no authority to the contrary. If the

enterprise was not for profit, none of the deductions would be

allowed. There is no authority to the contrary. Nobody argues,

however, not even the Government, that because the taxpayers lose

on the factual issue, they also must lose on what would seem to be

a legal issue.

The Tax Court in this case, as it seems to do in most of the

cases, gives little explanation as to why there is substantial

authority in one case, but not in another: "Based on the

discussion above, we are convinced that there was not substantial

authority for petitioners' position." Order at 15, 1993 WL 460546.

Cf. Harston v. Commissioner, T.C.Memo. 1990-538, 60 T.C.M. (CCH)

1008, 1990 WL 154693 (1990) ("Although [the taxpayers] were not

successful enough to show that they were entitled to the [§ 183]

losses claimed, petitioners have convinced us that they had

substantial authority for their position.")

There are no court decisions that give us guidance, and the

regulations themselves, although speaking in terms of a test, are

unsatisfactory in application to an all or nothing case of this

kind.

If the Tax Court was deciding that there was no substantial

authority because of the weakness of the taxpayers' evidence to

establish a profit motive, we reverse because a review of the

record reveals there was evidence both ways. In our judgment,

under the clearly erroneous standard of review, the Tax Court would

be due to be affirmed even if it had decided this case for the

taxpayers. With that state of the record, there is substantial
authority from a factual standpoint for the taxpayer's position.

Only if there was a record upon which the Government could obtain

a reversal under the clearly erroneous standard could it be argued

that from an evidentiary standpoint, there was not substantial

authority for the taxpayer's position.

If the Tax Court was deciding there was not substantial legal

authority for the deductions, we reverse because of the plethora of

cases in which the Tax Court has found a profit motive in the horse

breeding activities of taxpayers that were similar to those at

hand. E.g., Engdahl v. Commissioner, 72 T.C. 659, 1979 WL 3705

(1979) (profit motive found; taxpayer had businesslike operation,

consulted experts, kept quarterly records, showed horses, and did

physical labor and menial chores); Holbrook v. Commissioner,

T.C.Memo. 1993-383, 66 T.C.M. (CCH) 484, 1993 WL 325083 (1993)

(husband and wife engaged in horse breeding for profit; activities

conducted in businesslike manner; wife kept detailed records while

husband developed expertise in horse breeding); Scheidt v.

Commissioner, T.C.Memo. 1992-9, 63 T.C.M. (CCH) 1726, 1992 WL 810

(1992) (same effect for farm owner's stallion breeding syndicate);

Stephens v. Commissioner, T.C.Memo. 1990-376, 60 T.C.M. (CCH) 197,

1990 WL 102239 (1990) (businesslike operation showed profit motive

in horse breeding operation despite consistent losses caused by

death of horses and poor economic conditions in industry); Mary v.

Commissioner, T.C.Memo. 1989-118, 56 T.C.M. (CCH) 1515, 1989 WL

25031 (1989) (losses allowed for physician engaged in horse

breeding/racing activity; taxpayer followed expert advice to

increase revenues and decrease costs and devoted many hours towards
gaining personal expertise); Eisenman v. Commissioner, T.C.Memo.

1988-467, 56 T.C.M. (CCH) 330, 1988 WL 98369 (1988) (profit motive

found; taxpayer had businesslike operation, consulted experts,

kept quarterly records, showed horses, and did physical labor and

menial chores); Hopcus v. Commissioner, T.C.Memo. 1988-181, 55

T.C.M. (CCH) 717, 1988 WL 39088 (1988) (deductions for horse

breeding and boarding operation allowed for taxpayer who was

employed full time by telephone company; operation was handled in

businesslike manner); Seebold v. Commissioner, T.C.Memo. 1988-183,

55 T.C.M. (CCH) 723, 1988 WL 39086 (1988) (deduction allowed for

losses from horse farming activity; taxpayers kept adequate

records, discontinued unprofitable branch of operations, and

developed expertise); Harvey v. Commissioner, T.C.Memo. 1988-13,

54 T.C.M. (CCH) 1508, 1988 WL 667 (1988) (husband and wife engaged

in horse breeding for profit; activities conducted in businesslike

manner; wife kept detailed records while husband developed

expertise in horse breeding); Snyder v. Commissioner, T.C.Memo.

1987-539, 54 T.C.M. (CCH) 953, 1987 WL 49151 (1987) (profit

objective found for physicians engaged in horse breeding, training,

showing and selling operation even though consistently lost money);

Cronhardt v. Commissioner, T.C.Memo. 1986-399, 52 T.C.M. (CCH) 287,

1986 WL 21609 (1986) (retiree allowed horse ranch losses;

pre-opening efforts to gain experience, business-like operations

and substantial time and effort expended showed profit motive

despite initial losses and large drop in income); Yancy v.

Commissioner, T.C.Memo. 1984-431, 48 T.C.M. (CCH) 872, 1984 WL

15080 (1984) (even though taxpayers lost money every year they
remained in business, they had actual and honest objective of

making profit; business was not hobby, was financed from current

wages and household did not use horses for personal pleasure in

riding or at horse shows); Ellis v. Commissioner, T.C.Memo. 1984-

50, 47 T.C.M. (CCH) 991, 1984 WL 15415 (1984) (businesslike

operation showed profit motive in horse breeding operation despite

consistent losses caused by death of horses and poor economic

conditions in industry); Fields v. Commissioner, T.C.Memo. 1981-

550 42 T.C.M. (CCH) 1220, 1981 WL 10938 (1979) (taxpayer's profit

objective shown in cattle breeding/farming operation through

expectation of gain and working on farm most weekends); Appley v.

Commissioner, T.C.Memo. 1979-433, 39 T.C.M. (CCH) 386, 1979 WL 3478

(1979) (bona fide expectation of profit found for horse breeding

and raising activities although corporation continually operated at

loss for many years).

Although it can be properly argued that those cases are

distinguishable from the case at hand, as well they are because the

ultimate facts were found for the taxpayer rather than against the

taxpayer as in this case, they are not so dissimilar that they must

be discarded as providing no substantial authority for the tax

returns filed in this case.

As a bottom line, we find little distinction between this case

and the Tax Court case of Harston. The imposition of additions to

the tax under § 6661 must turn on some analysis other than the

conclusory decision of the Tax Court. The Tax Court should

articulate some consistent and workable test to justify the

imposition of additions in all or nothing situations of this kind,
otherwise the imposition of the addition is left to the educated

reaction of the particular Tax Court judge hearing the case.

We affirm the Tax Court's finding of tax deficiencies for lack

of a profit motive, but we reverse the Tax Court's imposition of a

penalty for substantial understatement.

AFFIRMED IN PART, REVERSED IN PART.