Deduction Denied for Losses from Horse Breeding Activity but Allowed for Rent to Sons' Corporation

Transcription

1 Deduction Denied for Losses from Horse Breeding Activity but Allowed for Rent to Sons' Corporation Foster, TC Memo The Tax Court has held that a married couple, an attorney and his wife, didn't engaged in a horse breeding activity of quarter horse racing, thoroughbred racing, breeding, and pinhooking (i.e., buying a young horse and training it to the point it can begin racing) with a bona fide profit objective under Code Sec As a result, they couldn't deduct losses from the activity that IRS had sought to bar. However, the Court allowed a deduction for rent payments to an S corporation owned by the taxpayers' sons. Under the hobby loss rule, deductions attributable to a not for profit activity are allowed only to the extent of income from it, or to the extent deductions are allowable regardless of any profit-seeking motive, whichever is larger. (Code Sec. 183, Reg ) All facts and circumstances must be considered in the determination of whether a taxpayer has a profit objective under Reg (b), which enumerates nine factors: (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisors; (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 presence of personal pleasure or recreation. 1

2 No one factor nor a majority of factors necessarily determines the outcome. A court may consider other factors in this determination. (Reg (b)) Logene Foster was a lawyer who has profitably headed his own firm, the Foster Law Firm, for more than three decades. Since '84. Logene and his wife Agnes (the Fosters, or taxpayers) had also operated a horse racing, training, and breeding activity, first as L&A Quarter Horses and later as L&A Racing (L&A). Agnes kept the books for the law firm and the horse activity. Until 2003, the taxpayers owned the building in which the law firm was located. In 2003, they sold the building to an S corporation owned by their sons, both of whom were lawyers who worked as independent contractors for Logene's law firm. Logene did not want to deal with tenants and maintenance of the building any longer, and his sons viewed the sale as a natural step in their father's transition to eventual retirement. The sons obtained bank financing for the purchase, and the bank required that they and the taxpayers personally guarantee the loan. The law firm deducted the rent payments to the S corporation as a business expense. On audit, IRS disallowed the Fosters' loss deductions with respect to their horse activity for 2004, 2005, and Later, IRS also determined that the law firm's rent payments to the sons' S corporation should be disallowed. IRS contended that the sale of the building was a tax-motivated transaction by which the taxpayers transferred an asset to their sons at less than fair market value, increased the depreciable basis of a building that had previously been fully depreciated, and avoided depreciation recapture. Applying the factors set out above, the Tax Court held that the taxpayers didn't engage in their horse breeding activity with the intent of making a profit under Code Sec The Court's analysis of each factor and the key facts supporting its conclusions follow: Manner in which activity carried on. The fact that taxpayers carry on an activity in a businesslike manner may indicate a profit objective. Other than income and expense statements prepared with QuickBooks software and a 2

3 business plan that included only generalized goals for the operation and a year-by-year narrative account of notable events occurring in the horse activity, the taxpayers produced virtually no business records. No records existed before 2002, so the taxpayers couldn't determine their total losses since '84. They did not produce separate records for each of their horses to demonstrate that they tracked breeding results and racing performance. They also did not produce any records that showed that they reviewed each of their specific horse-related activities of quarter horse racing, thoroughbred racing, breeding, and pinhooking to assess which were more profitable. They couldn't show that they added quarter horse breeding, thoroughbred racing, and pinhooking to their initial activity of quarter horse racing to make the activity profitable, rather than for other noneconomic reasons. This factor negated a profit objective. Expertise of taxpayers or their advisers. Preparation for the activity by extensive study of accepted business, economic, and scientific practices or consultation with industry experts may indicate a profit objective where taxpayers carry on the activity in accordance with such practices. The Fosters consulted with persons who were knowledgeable about horse racing, training, and breeding, including professional trainers and veterinarians. While the taxpayers consulted an accountant for business and tax advice, the Court noted that, in the face of mounting losses, it would have been prudent to seek further business advice. This factor slightly favored a profit motive. Time and effort expended by taxpayers. The amount of time and effort that taxpayers spend on the activity may substantiate profit objective. Although the Fosters also were involved in working at the law firm, they spent more than 20 hours during the week and on weekends working in their horse activity. This factor favored a profit motive. 3

4 Expectation that assets may appreciate in value. The word profit can encompass appreciation in the value of assets, such as land, used in the taxpayers' activity. However, the appreciation of the Fosters' horse activity assets didn't begin to approach the amounts of losses they reported since the beginning of their horse activity. Furthermore, the 12-acre property where the horse farm was located was also the taxpayers' principal residence, and much of its appreciation likely was attributable to the residential portion of the property rather than the portion used in the horse activity. This factor was neutral. Taxpayers' history of income or loss. Where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status, such continued losses if not explainable as due to customary business risks or reverses, this may indicate that the activity is not being engaged in for profit. The Fosters realized no profits whatsoever in more than 25 years of engaging in their horse activity. They did not show that their horse activity would have been profitable if events beyond their control (injury, illness, and death of a number of their horses and the failure of legislation allowing slot machines at horseracing tracks) had not occurred. Further, the possibility of a speculative profit in the taxpayers' horse activity from one outstanding horse was insufficient to outweigh the absence of profits for a sustained period of years. This factor strongly negated a profit objective. Taxpayers' financial status. Other substantial sources of income or capital may indicate that taxpayers do not engage in an activity for profit, especially if personal or recreational elements are involved. The Fosters' substantial income from the law firm and other sources allowed them to continue their horse activity in spite of more than 25 years of losses, and the activity also generated generous tax savings in the form of net losses that offset that income. This factor negated a profit objective. 4

5 Taxpayers' personal motives. Having personal motives in carrying on the activity may indicate that taxpayers did not engage in this activity for profit, especially where recreational elements exist. Despite the Fosters' contention that the horse activity was hard work rather than pleasure, the Court did not believe that they and their sons would have continued the losing horse activity for more than 25 years unless they received satisfaction from the work. This factor was neutral. The Tax Court allowed the deduction for the rent payments to the sons' S corporation, rejecting IRS's contention that the transaction should be disregarded as lacking in economic substance because the transaction was purely tax motivated. The sons had income of their own and were required to join their parents in personally guaranteeing the loan used to purchase the building. Except for building payments made by the taxpayers that were treated as rent payments, the S corporation or the taxpayers' sons made the building's mortgage payments, and their sons also took out an additional loan to have improvements made to the building. Testimony established that there was a legitimate business purpose for the sale of the building: Logene was tired of having to deal with tenants and maintenance of the building, and the sons, who were lawyers that worked at their father's law firm, viewed purchasing the building as a natural step in their father's transition to eventual retirement from his law practice. 5