Originally published on Forbes.com. April 23rd, 2014
Horse cases are usually about Section 183 (hobby loss). Although the heading notes of the case indicate that Stefan Tolin may have been facing a hobby loss challenge, apparently he managed to convince the IRS that he really was trying to make money by finding the appropriate sexual partners for stallion Choosing Choice. The stakes were not that high as these cases go, just over $10,000 in tax for the years 2002, 2003 and 2004. Further lowering the stakes was the fact that the IRS was attacking using Code Section 469 (Passive activities). Had Mr. Tolin lost the case, he would have ultimately been allowed the deductions – probably for the tax year 2009, when, according to this story, he disposed of all his horses.
Why This Case Is Very Important
Code Section 469 requires us to sort our trade or business activities into passive and non-passive. I call the “passive activity” concept an oxymoron because it had nothing to do with interest and dividends which, in other areas of the Code, are considered passive income. You have to have an ownership interest in a trade or business for the rules to apply to you. Then the question becomes whether you “materially participate”. There are a number of ways to meet the material participation standard. The gold standard is 500 hours per year.
The main problem that taxpayers have in meeting the standard is getting the IRS or the Tax Court to believe them. Although the regulations do not have a specific record-keeping requirement, the IRS and the Tax Court have taken to calling reconstructions of time spent “post-event ballpark guesstimates”. Mr. Tolin’s reconstruction stood up which makes the case significant beyond the horse business.
The Story
Pretty much everything I know about the horse breeding business, I’ve learned from reading Tax Court decisions. The appeal of working with animals quite a bit bigger than I who appear to defecate quite a bit escapes me. Also, the stories in the Tax Court lead me to believe that the business consists of calamity following misfortune or as my blogging buddy, Robert Flach would put it, one GD thing after another.
Mr. Tolin’s focus in the years in question was on a stallion named Chosen Choice. Chosen Choice’s racing career had been cut short by injuries, but he had done well enough to have potential in the post-racing career of the successful stallion.
Petitioner believed that Choosing Choice could become a profitable stud horse because of his racing ability. He engaged a thoroughbred consultant who specialized in pedigree analysis, commonly known as “nicking”, to research and analyze Choosing Choice’s pedigree.
I’m surprised that eHarmony.com has not launched a horse division. There is a lot more opportunity for repeat business.
The ultimate success of the thoroughbred activity depended on the racing success of Choosing Choice’s progeny. If some of the foals sired by Choosing Choice became accomplished racehorses, more breeders would pay to breed their mares to Choosing Choice and petitioner would be more likely to earn stallion awards. Moreover, he could earn breeder awards if the foals of his broodmares developed into successful racers. Petitioner was confident that Choosing Choice’s offspring would inherit his speed and that the stallion would become recognized as a proven producer of capable racehorses if petitioner could breed him to at least 15 to 20 mares for five or six consecutive breeding seasons.
Actually, maybe the software they use for AdultFriendFinder , might have more potential. At any rate, Mr. Tolin boarded Chosen Choice in Louisiana, even though he lived in Minnesota. Apparently the horse dating scene is a lot more favorable down there. The arrangement required several trips to Louisiana and a lot of time on the phone,as Mr. Tolin had reserved responsibility for match-making to himself.
How Much Time Does It Take To Get Your Horse _______ ?
Since the IRS had already conceded that expenses were well documented and there there was a profit motive, the only matter in controversy was whether Mr. Tolin passed the magical five hundred hour limit. He made a really strong case, even though he did not have detailed logs.
While the narrative summary is a postevent review of petitioner’s claimed participation in the thoroughbred activity, the parties stipulated his performance of many of the activities described therein, and a significant amount of credible third-party witness testimony and objective evidence indicates that it is an accurate depiction of his thoroughbred activity during the years at issue.
Phone records were a big help.
Petitioner used both the landline at his law office and his cell phone to make calls related to the thoroughbred activity. His cell phone records from April 23, 2003, through December 31, 2004, and his landline records from August 31, 2003, through December 16, 2004, were stipulated by the parties. Petitioner testified that he requested complete telephone records for 2002 through 2004 after respondent’s examination of his returns for those years began, but his service providers no longer had the oldest of the requested records.
Consistent with the witness testimony, the phone records in evidence reveal that petitioner called Louisiana numbers multiple times daily. Petitioner testified that all such calls were related to the thoroughbred activity because he did not call anyone in Louisiana for any other purpose. Combined, the partial records for 2003 show that he made 1,950 long-distance calls to Louisiana numbers that lasted 173 hours (i.e., not including calls he made from his cell phone while in Louisiana). The nearly complete 2004 records show 2,755 long-distance calls to Louisiana lasting a combined 220 hours. The records do not show the origin of any incoming calls; thus they are not helpful in establishing the extent of any calls he received from Louisiana numbers.
There was a lot more including witness statements to support Mr. Tolin’s long days in Louisiana.
The Tax Court still did some nit-picking.
Canterbury Park is Minnesota’s only racetrack. ….. We do not doubt petitioner’s testimony regarding the time he spent at Canterbury Park or his claim that he learned about racehorse injuries and training through his discussions with the owners and trainers. However, we will disregard the time he spent there for purposes of determining material participation because he failed to satisfactorily explain how his trips to Canterbury Park were connected to the thoroughbred activity, i.e., his effort to profit from breeding Choosing Choice.
In the end, it was enough.
The nature and extent of the activities described in petitioner’s narrative summary are corroborated by phone records, third-party witness testimony, the parties’ comprehensive stipulations of fact, and other contemporaneous materials.
Was It Worth It?
In his interview with Blood-Horse, Mr. Tolin was upbeat about the outcome of the case.
During his six-year audit battle Tolin said his health suffered and he had to sell all his horses five years ago to cover his legal costs. He’s glad to be on the winning side with hope of recovering most of his expenses, but he said it more important to the industry to have a court opinion providing clearer guidelines for owners who have substantial investments but don’t own a farm or have their business incorporated.
“Choosing Choice didn’t really pan out,” Tolin said. “But for what he couldn’t accomplish as a stallion, he has made up for to the industry through this case.”
Still, if you have a money-losing side activity, that you think will ultimately be profitable, it is worth considering staying below the material participation guideline and just letting your losses accumulate to shelter your ultimate earnings. Your return will have a much lower audit profile. If the activity, never becomes profitable, you can definitively abandon it in a year when things are going well on your day job and claim the losses in that year. If you are showing the year by year losses, the IRS will likely start off attacking you on hobby loss which might cause you to lose the deductions entirely.
You can follow me on twitter @peterreillycpa.
Note
Lew Taishoff got to the case ahead of me (Being a lawyer and all maybe he is not doing returns in early April). His post is titled “I’ve Got The Horse Right Here.” Don’t know what it is with tax bloggers and show tunes. Probably the influence of George M. Cohan.