Horse Breeding Activity Not For Profit, Losses Disallowed

Posted by Kim Chen on July 25th, 2019

Donoghue, TC Memo 2019-71
A married couple’s losses from their horse breeding activity were disallowed. The taxpayers failed to show they had a profit motive for the activity.
Background. Taxpayers carrying on a trade or business can deduct ordinary and necessary expenses paid or incurred while carrying on that trade or business. (Code Sec. 162) However, if the taxpayer’s activity is not engaged in for profit, then the taxpayer can only deduct expenses up to the income earned from the activity. (Code Sec. 183) An activity primarily carried on for sport, as a hobby, or for recreation is not carried on for profit. (Reg §1.183-2)
The regs under Code Sec. 183 provide a nonexclusive list of nine factors to consider when evaluating a taxpayer’s profit objective. (Reg §1.183-2(b)) These factors are:
1. How the taxpayer carried on the activity;
2. The expertise of the taxpayer and his or her advisers;
3. The time and effort spent by the taxpayers in carrying on the activity;
4. The expectation that assets used in the activity might appreciate;
5. The taxpayers’ success in similar or dissimilar activities;
6. The activity’s history of income or loss;
7. The possibility of an eventual substantial profit;
8. The financial status of the taxpayers; and
9. The level of personal pleasure or recreation the taxpayer had in the activity. (Reg. §1.183-2(b))
Facts. The taxpayers, Mr. and Mrs. Donoghue, in 1985, started a thoroughbred horse breeding activity called Marestelle Farm, LLC (Farm). Farm was a “virtual farm”. The Donoghues owned the horses but boarded them at farms and stables belonging to other people.
While the Donoghues conducted their horse breeding activity through the Farm, Mr. Donoghue was employed full time as a programmer. Mrs. Donoghue was disabled and received disability benefits.
From 1985 through 2012, the Donoghues owned six horses. However, they did not breed, race, or sell any of their horses during 2010, 2011 or 2012. The last year the Donoghues raced any of their horses was 2008. From its inception in 1985 through 2012, their horse breeding activity incurred expenses totaling $1,008,303, but realized income totaling only $33,691, resulting in accumulated losses of $974,612. From 1985 through 2012, their horse breeding activity never had a profitable year.
The IRS audited the Donoghues’ returns for 2010, 2011, and 2012. In its answer to the Donoghues’ Tax Court petition, the IRS disallowed the claimed losses from their horse breeding activity because the Donoghues did not engage in that activity for profit.
The Donoghues argued that they operated their horse breeding activity in a businesslike manner with the intent to make a profit. Therefore, their losses should be allowed.
Horse breeding activity not engaged in for profit. The Tax Court examined the nine factors in Reg §1.183-2(b) and determined that weight of the factors supported the IRS’s determination that the Donoghues did not have an actual and honest intent to operate their horse breeding activity for profit. The eight factors weighing in the IRS’s favor were:

• Manner in which they conducted their horse breeding activity. During 2010, 2011 and 2012, the Donoghues did not breed, race, or sell any of their horses. The Tax Court found it was not reasonable for the Donoghues to claim that they were engaged in a thoroughbred horse breeding business when it was not engaged in breeding or racing horses.
• Expertise of their advisors. There was no evidence in the record that the Donoghues acquired, or even sought, more expert advice about the economics of profitably running a horse breeding activity than an enthusiast would seek.
• Time and effort devoted to the activity. The Donoghues created two spreadsheets during the audit that listed the time they spent on horse breeding activities for 2010 and 2011. However, the Tax Court found that these spreadsheets were untrustworthy because they were created from recollection and the estimated hours reflected were not associated with actual dates, but with activities performed. Moreover, there was no contemporaneous documentary evidence corroborating the hours reported by activity.
• Expectation that assets used in the activity may appreciate. The Donoghues’ only assets were their horses since they operated their horse breeding activity as a “virtual farm”. However, there was no evidence in the record about the value of their horses. Therefore, the Donoghues failed to show that their horses would appreciate so much they would come close to recouping the significant losses they accumulated over the nearly 30 years of operating their horse breeding activity.
• History of the activity’s income and losses. The horse breeding activity did not earn a profit for any year since its inception in 1985. By 2010, the horse breeding activity was in its 25th year of operation and, therefore, long past the start-up phase. Moreover, while the Tax Court recognized that the horse breeding activity may have been harmed by the Great Recession, the recession could not account for the long history of losses that predated the recession.
• Occasional profits. The horse breeding activity never had a profitable year in its nearly 30 year history, let alone a year with a substantial profit.
• Taxpayer’s financial status. The Donoghues received more than $100,000 of income for each year at issue. However, the losses generated by the horse breeding activity reduced their income tax to $538 for 2010 and zero for 2011 and 2012.
• Personal pleasure and recreation. The possibility for profit was small compared with Mrs. Donoghue’s personal gratification. The Donoghues clearly loved horses and started their horse breeding activity when Mrs. Donoghue found her dream horse, but they left the most grueling aspects of caring for the horses to paid professionals.
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