Originally published on Forbes.com. Feb 21st, 2013
NFL veteran Bill Romanowski is in the news thanks to a Tax Court decision disallowing his losses from horse breeding activities.
A decision in the case of William and Jamie Pederson handed down the same day has very similar facts but is not getting as much attention since it does not involve any celebrities. If you really think about it, it would occur to you that there must be somebody in the world who is more interested in reading horse breeding tax cases than watching football games. That would be me, the author of this blog. I follow Section 183 (Activities Not Entered Into For Profit), commonly referred to as “hobby loss” rules pretty closely. Section 183 is what was used to disallow losses in both the Romanowski and Pederson cases resulting in large deficiencies – over 1 million for Romanowski and 2 million for Pederson. There was horse breeding involved. Nonetheless, these cases are nothing like the bulk of horse breeding cases and “hobby loss” is a total misnomer for them.
Typical Hobby Loss Cases
In the typical hobby loss case, someone puts a lot of time, energy and money into an activity that could make money, but looks like it might be fun. The taxpayers then have to prove that they were really trying to make money. Most commonly what will determine whether they win the case or not is whether they had a credible business plan that they modified based on changing circumstances. It is important that they show they spent time trying to figure out how to make money racing cars or raising horses – not just figuring out how to make the cars and horses go faster. Horse breeders overall do pretty well in Tax Court. Perhaps the Tax Court has my attitude that caring for very large animals that seem to defecate quite a bit really can’t be that much fun. Win or lose, though, horse breeders in Tax Court are usually people who spend a lot of time with their horses.
Romanowski’s Horses
Apparently, Bill Romanowski learned about the horse breeding program he entered while meeting with a lawyer about a real estate problem. He asked for additional information about the program run by ClassicStar. He received a booklet titled Due Diligence & Mare Lease Information Booklet“. It had lots of neat stuff:
The due diligence booklet petitioners received contained approximately 60 pages of form contracts and other information about the program. In addition, the booklet contained: (1) a 53-page opinion letter from the law firm Handler, Thayer & Duggan, LLC (Handler Thayer), regarding tax aspects of the horse-breeding business; (2) a 22-page opinion letter from the accounting and consulting firm Karren, Hendrix & Associates, P.C. (Karren Hendrix), regarding tax aspects of the horse-breeding business; and (3) a 6-page opinion letter from Karren Hendrix regarding tax aspects of NOLs arising from a horse-breeding business. Each of the opinion letters was addressed to David Plummer, president of ClassicStar. Both the Handler Thayer opinion letter and the 22-page Karren Hendrix opinion letter advised individual ClassicStar participants to consult with their own tax advisers about the tax consequences of participation in the program.
Doesn’t seem like there were any pictures of horses, but it got him interested enough to investigate further.
At some point on or about November 3, 2003, Mr. Romanowski reviewed the materials provided to petitioners by Mr. Atherton. Mr. Atherton and Mr. Romanowski traveled to Kentucky to visit the ClassicStar facilities for a tour and to meet with ClassicStar employees. On November 9, 2003, Mr. Atherton and Mr. Romanowski again traveled to Kentucky. By this time Mrs. Romanowski had reviewed the materials and also made the trip to Kentucky. On the second trip petitioners toured the ClassicStar operation, saw horses, visited horse auction houses, and met with ClassicStar personnel. Petitioners were impressed with what they saw.
Mr. Romanowski, over the objections of his financial advisor decided to commit $13,000,000 to the ClassicStar mare leasing program. The leased mares were boarded by ClassicStar which also selected the pairings. The details actually get pretty ugly from there.
ClassicStar
According to this story ClassicStar did not exactly own all the mares that it was leasing:
In outlining ClassicStar’s mode of operation, Hood said the entity sold leases in mares allegedly owned by ClassicStar. Those mares were to be bred to prominent Thoroughbred stallions, with the mating producing a foal that would be profitable to the investors. Although some breeding did take place, Hood said that ClassicStar sold more leases than it could ever provide foals.The court documents state that investors were told that their investments could be written off by filing claims to the Internal Revenue Service and that half of the investment could be financed through a lender. Although ClassicStar sold more than $600 million in leases to high income individuals, it never owned more than $56 million in horses in any given year, the records state. In order to cover up the difference, ClassicStar substituted Quarter Horse breedings in its statements to investors, although it did not own those mares either.
Why Horses ?
The bottom line is that both the Romanowski and Pederson are really bad tax shelter cases rather than horse breeding cases. It strikes me as odd that somebody who was going to promote a tax shelter would uses horses, since the business already has red flags associated with it. I keep a rough tally in my head of what activities are most likely to win hobby loss cases. Car racing and Amway do not do well at all. Horse breeders, on the other hand, frequently win, although the IRS keeps going after them. Whatever anybody else thinks, I’m not going to count these cases against actual horse breeders.
You can follow me on twitter @peterreillycpa.