Originally published on Forbes.com.
Remember Rafalca, who played a small role in the 2012 election. I rather irreverently referred to Rafalca as Romney’s Olympic dancing horse and was incredibly embarrassed when I got the sports piece of the tax story wrong. Rafalca was owned by Rob Rom Enterprises, LLC which flowed to the Romney return and had people discussing hobby loss rules, while it took my esteemed editor Janet Novack to set everyone straight on why the Rob Rom losses were limited on Romney’s 2010 return – passive activity rules (Code Section 469) not hobby loss (Code Section 183). On the 2011 return PWC passed on the Rafalca loss, along with lots of charitable contribution, because – well- because.
The “sport” in which Rafalca was an Olympian is “dressage” – “the highest expression of horse training“, where “horse and rider are expected to perform from memory a series of predetermined movements.” I’m reviewing all this because last month is when I first noted a hobby loss case involving dressage. The case involved Dr. Sarah Thayer, a distinguished surgeon and competitive dressage rider and owner. The case was decided by the Massachusetts Appellate Tax Board, where Doctor Thayer was represented by Stephen Politi, author of CCH’s Guidebook To Massachusetts Taxes.
Can Massachusetts Audit An Issue That IRS Has Cleared?
Although Massachusetts has some unique wrinkles in arriving at taxable income, the state pretty much follows federal rules in determining what goes into adjusted gross income. Because of that after a federal audit, a Massachusetts taxpayer is required to report and pay any additional state tax that would logically flow from the federal changes. One might reason that if there is a federal audit on an issue that results in no change, you should be home free as far as Massachusetts goes. So one might reason, but sadly for Doctor Thayer, the Massachusetts Appellate Tax Board does not agree.
The appellant offered into evidence a copy of the audit file of the Internal Revenue Service’s (“IRS”) examination of her federal returns for the tax years at issue.4 The IRS auditor determined that the appellant was conducting Simply the Best Baroch for profit and therefore no change was made to the appellant’s federal business expense deductions. As described further in the following Opinion, the Board found and ruled that the IRS auditor’s determination was not dispositive for purposes of Massachusetts income tax. Furthermore, the Board found the IRS auditor’s workpapers to be of limited probative value.
Massachusetts is not the only state that might pursue a hobby loss case, missed by the IRS. Last year I wrote about a ranch in Montana that was picked up by those state auditors, but there was no indication that the IRS had cleared them.
The Hobby Loss Analysis
For the years in question 2006, 2007, and 2008, Doctor Thayer had posted total losses of $466,366. During that period she had sequentially owned three horse, “Simply the Best”, who for a variety of reason turned out not to be so great, “Nautica” and “Charleston 26”, for whom she had high hopes. Charleston 26 had been purchased for $100,000 and the plan was to lease Charleston 26 to Dr. Cesar Parra, an Olympic level rider, to compete in the Pan Am Games. The estimate was that if Charleston 26 did well in the games, he might sell for $500,000. One thing I have learned about any type of horse business from reading tax cases is that it tends to be one GD thing after another. The leasing plan fell through when one of Dr. Parra’s main sponsor for the Pan Am event backed out. Charleston 26 then had some major health problems.
Beginning in 2008, Dr. Thayer characterized her business as being a “comparative medical consultant”.
Dr. Thayer testified that her experiences with her horses’ various medical treatments led her to realize that there was a gap between the medical knowledge and technology of veterinarians and medical doctors and specialists who treat humans. Recognizing, given her background as a surgeon, that doctors have insight that would be valuable to veterinarians, Dr. Thayer testified that she was able to connect veterinarians involved with the care of her horses to relevant specialists.
Unfortunately for her case, she was not able to show that she had gotten any money for doing that.
The Board ended up harping on Dr. Thayer not revising her initial business plans for the horses in order to take into account changed circumstances.
Two things really stood out as the Board ran through the traditional nine factor analysis (Manner activity carried on, expertise, time expended, expectation of appreciation, success in similar activities, history of income or loss, occasional profits, financial status, and personal pleasure).
Dr. Thayer testified that she prepared projections, which she claimed were produced at the time she purchased each animal, giving the estimated net profit which could be realized depending on when the horse was ultimately resold. Even assuming these projections were made contemporaneously and were reasonable at the time they were first completed, the succession of calamities which befell Simply and Charleston after purchase and the associated expenses soon rendered them woefully inaccurate. While unforeseen circumstances may affect any business, a prudent business person would be expected to revise his or her projections to account for those circumstances.
and
There is little indication in the record that the appellant made any serious effort to develop expertise in the economics of training, leasing and selling horses as a business. The appellant argued that her consultations with various professionals demonstrated that she availed herself of the expertise of others in carrying on her activity. The Board found, however, that the lack of record keeping and lack of payment for these “consultations” was not indicative of a bona fide business relationship. In addition, her consultations with accountants were limited to the preparation of tax returns.
Similarly, the appellant failed to present evidence tending to distinguish her consultations with Wadsworth Farm’s owner and head trainer regarding the purchase and sale of her horses from those of an ordinary high-level amateur rider. Ms. O’Connell testified that she did not assist with the preparation of Dr. Thayer’s profit projections. While Ms. O’Connell and Dr. Thayer consulted often about matters of the horses’ training and wellbeing, Ms. O’Connell did not give any testimony that she advised the appellant with respect to the business of profitably training and selling horses.
These observations run somewhat contrary to recent US Tax Court decisions which have placed less emphasis on formal business plans and a recognition that speculative businesses like horse breeding and art do not necessarily require deep economic thought. In the Crile case, the Tax Court judge remarked:
While conceding that petitioner and her advisors have the requisite artistic expertise, respondent contends that she lacks expertise in the economics of being an artist. But petitioner does not need an economics degree to know how to sell art.
In the end, the Board found against Dr. Thayer
Having considered the above factors, recognizing that no one factor is controlling, and analyzing the record as a whole, the Board found and ruled that the appellant did not meet her burden of proving that she was engaged in her equine activity with the profit objective required and that she therefore was not entitled to deduct the expenses associated with her activity as a business expense.
I don’t know if the dollars involved ($27,293 in tax) are enough to justify an appeal. We can only hope, since it might make for an interesting decision.