Originally published on Forbes.com. Nov 21st, 2014
If you are going to have a money-losing business that shelters your other income, the worst thing to pick is Amway. Horses probably come in second. Not so much because horse-related businesses have a lower audit profile. Rather horse people often win, although not always. That’s one of the things I like about horse cases – the suspense.
Mel Annuzzi is in the concrete business, which is pretty profitable. He had a salary of $1,182,698 in 2009 and $854,897 in 2010. He also owns, races, and breeds thoroughbred horses. Not so profitable. Actually there have been consistent losses for long enough that the IRS didn’t think he was really trying to make a profit. That is why he and his spouse Jean were in Tax Court over deficiencies for 2009 and 2010 totaling just over $50,000.
I don’t know about you but when I read Tax Court decisions I’m always trying to predict how they are going to come out. I’m often rooting for one side or the other, usually the taxpayer. Usually, I can tell how it is going to go. For example “purport” is judgespeak for “liar, liar, pants on fire” . Any form of the word “purport” is a good indication that the taxpayer will lose. Well, there was no purporting in this case. It was, in fact, a real nail biter. You might want to go read the case so you can experience the suspense, I did not know how it would turn out till I got to the end.
Mr. Annuzzi has co-owned thoroughbreds with trainer Terry Knight since 1981. They make money through purses, reselling horses that they have purchased, and selling horses that they breed. Only not so much. Since 1981, there have only been five profitable years. Cumulative net losses are over $500,000. The Court ran through the classic nine factors. I’ll keep score as we go along.
Manner In Which The Activity Is Conducted
The Annuzzis seemed to have portrayed the combination of thoroughness and ruthlessness that is the hallmark of a horse owner winning a hobby loss case.
Petitioners kept thorough and accurate records of their thoroughbred activity. Jean maintained detailed spreadsheets that enabled petitioners to determine the profitability of each horse on the basis of its original cost, expenses of training and upkeep, purses won, and potential for breeding. Petitioners used these records, in consultation with Mr. Knight, to reduce losses by culling unprofitable horses. If a horse became injured or raced poorly, petitioners disposed of that horse unless it had significant breeding potential. (Emphasis added)
The IRS brought up the lack of a business plan, which is usually a real killer, but the Tax Court seems to be shifting in its attitude on business plans.
The evidence established that formal cashflow projections for a horse racing business would be speculative. It is nearly impossible to predict whether a particular horse, however promising, will finish first, second, or third in future races. It is equally difficult to predict whether a promising horse will suffer an injury that will suddenly end its moneymaking career. Petitioners established that they were able to run ACS, a profitable concrete business, without a written business plan or formal income projections. Their decision to forgo the creation of such documents for their thoroughbred activity does not evidence the lack of a profit objective.
So the first factor goes to the Annuzzis.
Taxpayers 1 IRS 0.
Expertise of the Taxpayers or Their Advisers
Taxpayers were strong on this factor also.
Petitioners constantly sought and received advice from Mr. Knight, an indisputable expert in thoroughbred racing. The consistency of petitioners’ reliance on him is shown by the hiatus in their thoroughbred activity during 1985 and 1986, when he left California temporarily and was unable to train their horses. Not only did petitioners seek Mr. Knight’s expert advice; they also purchased most of their horses in conjunction with him. Coownership of thoroughbreds with an expert trainer suggests a profit objective.
Taxpayers 2 IRS 0
Taxpayers Time And Effort
The Court was a little skeptical about the amount of time that the Annuzzis spent, but noted their intense reliance on Mr. Knight.
Mainly because of Mr. Knight’s intense involvement, we conclude that this third factor favors petitioners, but only slightly.
Taxpayers 3 IRS 0.
Expectation of Appreciation In Value
They were also very strong here.
Given their relatively low acquisition costs, the good bloodlines of their horses, and the expert training that Mr. Knight provided, petitioners could—and did—expect to realize significant appreciation in the value of their thoroughbred assets.
Taxpayer 4 IRS 0.
Taxpayers Success in Other Activities
This ended up being a push.
Petitioners assert that their extraordinary success in growing their concrete business points this factor in their favor. But prior success in business does not necessarily imply a profit objective for a new activity that might be a hobby or sport; indeed, this will be the pattern in most section 183 cases. There is little synergy between petitioners’ concrete business and their thoroughbred activity; entrepreneurial skills do not appear central to success in horse racing; and there is no evidence that petitioners are “turnaround experts” skilled at reforming a losing business into a profitable one.
Score remains 4-0.
History of Income And Losses
No surprise here. We go to Taxpayers 4 – IRS 1.
Amount of Occasional Profits
Petitioners have yet to win a purse exceeding $100,000. But that is exactly the nature of a speculative business—its outcomes are uncertain. Despite the minimal profits that petitioners have earned from their thoroughbred activity over the years, we conclude that this seventh factor favors them slightly.
That brings us to 5 to 1, but like time and effort, this one was weak.
Taxpayers Financial Status
The IRS almost gets bonus points on this one.
Petitioners’ concrete business was quite profitable, enabling Mel to derive an annual salary averaging about $1 million during the tax years at issue. The losses flowing from petitioners’ thoroughbred activity generated substantial tax benefits. And as discussed below, petitioners derived considerable pleasure from the recreational aspects of this activity. All in all, this eighth factor strongly favors respondent.
Elements of Personal Pleasure
IRS gained ground here.
…..petitioners clearly derived immense pleasure from their thoroughbred activity. They took regular vacations to the Del Mar Thoroughbred Club, visiting the track every morning and attending races every afternoon, and they traveled annually to Las Vegas to watch the Kentucky Derby on the big screen. They watched their horses train almost daily. They enjoyed conversation with fellow owners at the track and in other social settings. They did devote many hours to mundane activities like recordkeeping. But activities that might seem mundane to some—such as reviewing sales catalogs, negotiating purchases, and discussing horse flesh with Mr. Knight—appeared to have been, if not a source of pleasure to petitioners, far from its opposite.
That brings us to 5-3-1 for the taxpayers, but the taxpayers were very weak on a couple of their wins and the IRS was rather strong on the last two, so really we are balanced on the edge of the knife. The suspense was killing me.
Good To Have Somebody Who Knows What He Is Doing Involved
The Tax Court noted that there each side had three factors clearly going for it, two factors slightly favoring taxpayers and one neutral. It did not however make its decision by merely toting up factors. Central to its conclusion was the involvement of Mr. Knight not only as a trainer but also as a co-owner.
Central to our conclusion is Mr. Knight’s involvement, not only as the trainer, but also as the coowner of petitioners’ horses. In a very real sense, he and petitioners embarked on a joint venture to own, train, race, and sell thoroughbred horses. The evidence clearly established that Mr. Knight embarked on this venture with the intent to make a profit. We conclude that petitioners’ motivation was the same as his.
Is There A Blueprint Here?
Although not entirely new, the Court’s unconcern with taxpayer’s lack of a written business plan and expert advice on achieving profitability seems to be a new trend. The Court is becoming aware of the nature of somewhat speculative businesses. There was a similar observation in the Susan Crile decision
Petitioner does not need an economics degree to know how to sell art.
By, in effect, partnering with a trainer the Annuuzzis convinced the Court that they were trying to make money, even though they were having a good time. It might have been even easier if they had actually formed a partnership since then the determination might be made at the partnership level.
I would still argue that it is a good idea to have a written business plan that is modified regularly since where you really want to win is on audit and revenue agents are accountants who like to have workpapers.