Originally published on Forbes.com.
Sometimes it seems that the IRS hates horses. You will find hobby loss cases (Section 183 – Activities not engaged in for profit) that cover a wide variety of activities. I have written about motocross racing, painting, a musician, Amway, restoring Fifties Plymouths even blogging – travel blogging, not tax blogging – and many others. But horses seem to account for a disproportionate number of the cases and certainly the aggregate dollars at stake. There are many ways to make a fortune, but there is no better way to lose a big piece of it than the horse breeding business. The pain can be eased by the losses being deductible, which is why the IRS hates horses.
And Finis R. Welch and Linda J. Waite just won a stunning victory in Tax Court. The IRS asserted tax deficiencies totaling over $3.6 million for the years 2007, 2008 and 2009 on the couple’s return. And $ 1.3 million on Dr, Welch’s 2010 return. They divorced in 2010, having married in 2007. The Center Ranch, which is the source of the losses and the deficiency notices, was Dr. Welch’s project alone. I think that I would have advised Dr. Waite (They are both Ph.ds) to file separately. Had the IRS won and Dr. Welch not anted up the whole deficiency, this matter might have resulted in the mother of all innocent spouse cases.
About The Center Ranch
The Center Ranch in Centerville, TX is a complicated diversified operation. Dr. Welch started it in 1987 with the idea of growing hay as a cash crop. There is a lot more going on now. According to the website
Over the past twenty-five years, Center Ranch has grown from a 130 acre property to a 8,800 acre thriving hay operation, cattle business, training facility, and equine veterinary center. The Ranch has balanced a combination of traditional Texas cattle ranching with some of the most technologically advanced agricultural services available to make it a leader in the ranching industry.
Center Ranch’s experience, selective breeding, and equine care have allowed them to produce and sell top quality cutting and ranch horses to their clients. NCHA Hall of Famer, Ronnie Rice manages the 2 and 3 year-old training program giving each of the started cutting prospects and ranch horses, as well as the riders who ride them, a distinct advantage in the cutting arena and on the ranch.
Cutting Horses?
Ever since I got it wrong about Rafalca‘s, Mitt Romney’s dancing horse, status in the Olympics, I get very nervous when I touch on sports. I know less about sports, than the average American male and ]cutting is a sport that an East Coast city slicker is unlikely to encounter. Its origin is a task that cowboys have to do on the open range – separating out individual calves from the herd. You really don’t want to know what they do to them after they are separated out. Trust me.
The practice has evolved into an equestrian competition where a horse and a rider strive “to demonstrate the horse’s athleticism and ability to handle cattle during a 2 1⁄2 minute performance, called a “run.”” The sport is a really big deal. You can tell that by noting that the National Cutting Horse Association, the sport’s governing body, grossed over $23 million in 2014. Compare that to the United States Chess Federation which grossed $3.8 million in its year ending May 31, 2015. (NCHA changed its fiscal year so the most recent 990 available is a short year making it not comparable). So at least in that regard, cutting is bigger than chess.
They are both dwarfed by golf, which seems to be the preferred “sport” of the ruling class, which might account for many of our problems. Picturing a world run by cowboys and chess players, I see an immediate problem with gender diversity, but really with LPGA grossing less than 10% of what PGA grosses, golf is not that much better in that regard. Back to tax.
About Woody B Tuff
Woody B Tuff is the key to Dr. Welch’s case that there is a big payday potential from the operation. Woody B Tuff is a stallion that Dr. Welch purchased in early 2008 when Woody was seven. Woody was a superior cutting horse. Now he has a different job – producing, well, semen. Woody should be able to handle his new job for all of the next decade and longer. It doesn’t seem as sweet gig as being a thoroughbred racing stud as the newfangled breeding technologies are not allowed there, but you can’t rule out that horses don’t really know the difference between an artificial mare and a real one.
As Woody’s progeny perform well in the cutting competitions the value of Willy’s output rises. Arguably he is world-class as it is now being frozen and shipped to Australia and Brazil. Judge Paris explained in her decision:
It will take five to six years before there is credible information about a stallion’s breeding capabilities and his ability to pass on vital cutting horse traits to his progeny. A stallion’s stud fees will increase over time if his progeny are successful. Although he was a proven stallion bringing in lifetime earnings of over $340,000, during the years in issue Woody Be Tuff was a yet unproven stud for a breeding program—his stud fee was no more than $1,500. But by 2013 his stud fee had increased to $2,000 plus a chute fee, and by 2014 it had increased to $5,000 plus a chute fee.
You may know what a chute fee is, but I had to go hunting for it and found this.
Chute fees are charges that cover the expenses and labor to collect a stallion for A.I.. These fees are usually charged in addition to the actual stud fee. For shipped semen fresh or frozen, the stud is usually taken into “the breeding chute”. This is an area that will have a tease mare and a dummy that the stud mounts for collection. Chute fees cover this area and the preparation of the semen for shipment.
You have to wonder whether they gave this case to Judge Paris, because she grew up in Tulsa, OK. Quickly scanning a few of the Tax Court judges, I don’t see any others from cattle country.
One Activity
Judge Paris first took on the issue of whether Center Ranch constituted one activity for purposes of Section 183. It was pretty clear that it was.
All of Center Ranch’s operations had a high degree of organizational and economic interrelationship. There was one ranch manager who oversaw all of its operations and employees, and he reported directly to petitioner. Many ranch hands worked in more than one of Center Ranch’s operations.
Among other things this allowed Judge Paris to dispose of a nitpicky criticism of Center Ranch’s accounting system, namely that it did not allocate overhead among the various activities.
Respondent argued that one such mistake—petitioner’s inability to allocate overhead costs of each operation—made clear that Center Ranch was not carried on in a businesslike manner. Because the Court finds that Center Ranch’s operations were one activity, the allocation of overhead costs between operations, e.g., salaries of ranch hands who worked in both the hay and cattle operations, is of little concern.
I still have a vague memory of my cost accounting course back in the olden days. As I often remark, you learn all the math you need to do tax work by the fourth grade. Overhead allocation of this operation would be an exception to that rule with the same staff working on all three major operations and the hay going to feed the cattle and the horses and the calves being used to help train the horses. They don’t mention it but I wonder if the major byproduct of the cattle is used to fertilize the hay field. I think you need simultaneous equations or maybe linear algebra to solve the problem and I don’t believe either of those is a grammar school subject.
Judge Paris then moved onto the classic nine factor test.
The Factors
How businesslike is the business?
Number one – manner in which the taxpayer carries on the activity – was a slam dunk for Dr. Welch.
Center Ranch’s activity was carried on in a businesslike manner. Petitioner kept books and records for each of Center Ranch’s operations to determine their incomes and expenses. Indeed, petitioner used resources from his other endeavors—namely, Welch Consulting—to keep track of such information. Respondent tried to make much of the fact that there were mistakes in petitioner’s books and records. The fact that there were some mistakes in the books and records of a multimillion-dollar activity does not negate that the activity was carried on in a businesslike manner. Center Ranch also had separate bank accounts, which is indicative of an activity being carried on in a businesslike manner.
Pay attention there. Don’t even think of trying this at home without separate bank accounts. Not only will it help will your hobby loss case, it will help your accountant stay sane.
Does somebody know what the heck they are doing?
Number two – Expertise of the taxpayer or his advisers – was another winner for Dr. Welch. He himself has been involved in agriculture since middle school days. His ability to have a career in the field was limited by a tragic car accident, so he made his fortune elsewhere and the ranch manager and veterinarian were top-notch.
Is the taxpayer really trying?
Number three – taxpayer’s time and effort expended in carrying on the activity -The IRS thought they had him there as he only works at the ranch on weekends, but Judge Paris did not buy that as he was putting in three full days a week, so he won on this one also.
Is there gold in them hills?
Dr. Welch won on number four – expectation that assets might appreciate. There was some problem with Dr. Welch’s expert on this issue, but again it was more nitpicking. The IRS did not hire its own expert – perhaps a sign of budget problems.
How has he done with other things?
This was a push. Dr. Welch was an economics professor, built a very successful consulting firm, was a partner in a successful software firm and more. None of that was a lot like ranching though, which is why it was considered neutral.
Was there ever a good year?
Despite the continuous very large losses, the IRS obvious wins on the sixth and seventh factors (history of income and loss and amount of occasional profits) were discounted by Judge Paris, because it is too early to tell whether the horse breeding operation might turn things around
Center Ranch’s wholesale change to a new type of cattle operation restarted the clock for the startup period for that operation. ……
Therefore, the Court finds that the activity’s history of income and losses and the amount of occasional profits, if any, favor respondent, but it will not give these factors as much weight because the cattle and horse operations were in their startup phases during the years in issue.
Are we having fun yet?
On the eight and ninth factors – taxpayer’s financial status and elements of personal pleasure and recreation – Judge Paris noted Dr. Welch’s substantial wealth from other sources which have allowed him to pour nine million dollars of capital contributions into the ranch. Dr. Welch’s injuries from an automobile accident limit his ability to do the fun stuff like manual labor (Seriously?) and ride the horses. So factors eight and nine end up neutral.
How About The Business Plan?
The Tax Court used to love business plans but seems to have dropped that emphasis. Judge Paris noted that Dr. Welsh has never had a business plan for any of his ventures many of which have been quite successful. She also noted approvingly that he changed the operation several times seeking the elusive profitability of ranching and related endeavors.
A good comparison is the Susan Crile decision, which is about as far from cattle country as you can get.
Although petitioner did not have a written business plan, she had a business plan and she pursued it consistently. Petitioner understood the general factors that affect the pricing of art —a history of sales, gallery representation, solo exhibits, positive critical reviews, and prestigious awards, fellowships, and residences. She then worked to enhance her credentials and professional stature in each of these respects, in an effort to increase the value of her art.
I would still recommend a business plan that is regularly revised since it is probably still on the agent’s checklist and it is better to win at the audit or appeals level than in Tax Court.
Would An S Corporation Have Been Better?
It is not apparent from the decision whether the operation was leveraged which would have created drawbacks for an S corporation rather than the Schedule F that Dr. Welch filed, but it might have lowered the audit profile a bit.
Summary
Judge Paris ruled in Dr. Welch’s favor with a cautionary note and a pun.
…… the Court finds that petitioner was engaged in Center Ranch as a for-profit activity during the years in issue. In so holding, the Court is not declaring Center Ranch a for-profit activity ad infinitum. If Center Ranch’s future losses cannot be reined in, petitioner may again find his profit motives before this Court.
In some ways, it might be argued that this case is sui generis. I would argue that it is very important. It is not the magnitude of the losses that matters. What matters is that if you are not profitable, you change your ways. And if the new ways are not profitable, you find newer ways. Also, note the mention of a separate bank account. It would have been absurd to try to run an operation like Center Ranch without a separate bank account, but it still was noted. People racking up lesser losses should take note.
Oh and it’s just me, but if your spouse has something like this going, consider filing separate.
Other Coverage
You know Lew Taishoff could not miss this one. He has Meanwhile Back At The Ranch. Mr. Taishoff notes that Judge Paris found the cliche irresistible when she wrote:
Meanwhile, back at the ranch in Texas Fridays and Saturdays were work days, with the ranch being relatively quiet on Sundays.
Mr. Taishoff notes the importance of the separate bank account.
Clearly, this is a big deal, so you horsey types take heed and get on down to the bank. Even if they don’t give you a toaster or fifty bucks, open the account. And get horse pictures on the checks.
Earlier this month I had the pleasure of meeting Mr. Taishoff. I spent the day in Manhattan and managed to arrange a lunch with him at a little French place where I had Le Burger. I managed to grab the check and Mr. Taishoff nodded approvingly as I wrote his name on the back of the credit card receipt before starting the long walk to the statue of George M. Cohan who did not have to concern himself with such things.
Tax Notes has something behind its paywall, but you should know by now what a big spender I am.
Update
I heard from George W. Connolly of Chamberlain Hrdlicka who represented Dr. Welch. Likely knocking on wood, he indicated that he believes an IRS appeal is unlikely. He wrote to me:
Needless to say, I am happy with the outcome. The “clock” on filing a Notice of Appeal has not begun to run, as no Decision has been entered. Because Section 183 cases tend to be intensely factual, overturning them on appeal requires the party to meet the “clearly erroneous” standard, which is a difficult hurdle in any case. As I am sure you know, just disagreeing with the opinion is not enough: the appealing party has to show that there was no basis in fact for the outcome. I can’t predict what the Govt is likely to do, but I am sure they are cognizant of that standard.
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