The Tax Court held that a taxpayer's cutting horse activity was engaged in for profit, allowing the taxpayer to deduct the activity's expenses that exceeded its income. According to the court, the factors of Regs. Sec. 1.183-2(b) supporting a profit motive for the activity outweighed factors that indicated a lack of a profit motive.
Facts: Lowell Den Besten started a seed business in South Dakota with his father in 1964. He sold the business to his son in 2002 in an installment sale; however, he returned to the seed business in 2005 after his son defaulted on the installment note. In 1986, Den Besten also became involved in breeding, raising, boarding, training, and selling registered cutting horses, i.e., horses used to remove a single animal from a herd. He also competed in cutting horse competitions and had two horses named as American Quarter Horse Association world champions.
As a result of this success, Den Besten expanded the cutting horse activity. He purchased an existing facility, the Yellow Rose, which increased his number of horse stalls from 20 to 120. He also hired additional people to assist in general management, training, and breeding. He hosted competitions at the Yellow Rose, advertised his horses under the brand Den Besten, and grew his stock to 20 broodmares and multiple stallions.
In 2005, Den Besten sold Yellow Rose when he downsized the cutting horse operation because the seed business required more of his time and one of his world champion horses died. This reduction continued throughout 2006—2016 as the number of horses he owned was reduced to seven by 2016, although one was a stallion with champion blood lines.
From 2006 to 2010, Den Besten reported annual losses on Form 1040, Schedule F, Profit or Loss From Farming, that totaled $407,805, and annual profits from his seed business on Form 1040, Schedule C, Profit or Loss From Business, that totaled $685,922. The IRS issued a deficiency notice for tax years 2006 to 2010, assessing additional income taxes of $230,694, accuracy-related penalties totaling $46,139, and failure-to-pay penalties of $23,743. Den Besten petitioned the Tax Court for relief.
Issues: Under Sec. 162, taxpayers may deduct ordinary and necessary expenses related to the operation of a trade or business. However, if an activity is not engaged in for profit, Sec. 183 disallows certain deductions related to the activity. The facts and circumstances of each situation determine whether an activity is engaged in for profit, under the nine, nonexhaustive factors of Regs. Sec. 1.183-2(b): (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his or her advisers; (3) the taxpayer's time and effort expended in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the taxpayer's success in carrying on other activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of any profits; (8) the taxpayer's financial status; and (9) the presence of personal pleasure or recreation. The IRS argued that the cutting horse activity was not engaged in for profit under those factors.
Holding: The court first held that Den Besten's seed business and cutting horse activity were two separate activities that could not be combined into a single activity because he had used separate tax schedules for each activity on his tax returns, had kept separate banking and staff records for the two activities, and admitted that they were "altogether different."
The court held the following factors indicated Den Besten's cutting horse activity had a profit motive: He had conducted the activity in a businesslike manner because his informal business plan was evidenced by his actions, his recordkeeping system for the activity enabled him to make educated decisions, he adjusted his operating methods to improve profitability, and he used various advertising methods to promote his brand. Den Besten also had a high level of expertise concerning the care, training, and competing of cutting horses that had resulted in two champion horses. He had spent a great deal of time each year overseeing the breeding of about 12 mares per year and showed a level of commitment much greater than that of "a mere hobbyist." Den Besten also had been successful running the seed business, whose customers often had an interest in cutting horses. Despite recent profits from the seed business, those profits and his current financial status did not enable him to sustain losses from the cutting horse activity without a profit motive. Finally, the court concluded that his profit motive far outweighed the personal pleasure he received from the activity since he did not always care for the horses, which were often trained by hired trainers.
The court found the following factors indicated a lack of profit motive: The horse activity had always reported losses and never reported a profit, much less an occasional one. The court also held that it was unclear whether the horse activity's assets would appreciate in value due to the uncertainty related to past unforeseen events; thus, the court found that factor neutral. In conclusion, the court held the activity had a profit motive because the factors that indicated a profit motive outweighed those that did not.
The court held against Den Besten on an issue of establishing the existence and amounts of net operating losses from prior years and allowed only some claimed deductions that the IRS had disallowed as unsubstantiated, beyond those the IRS had stipulated to and conceded at trial.
With respect to the remaining deficiency, the court found that Den Besten was not liable for the accuracy-related penalty, as he had relied on a CPA with 30 years of experience to prepare his returns and provided the CPA with financial records.
- Den Besten, T.C. Memo. 2019-154
— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.