Almost immediately after I posted my roundup on Section 183 (hobby loss) developments Judge Lauber, Scholar Al, as Lew Taishoff refers to him, dropped a major hobby loss opinion on us- Mitchel Skolnick TCM 2021-139. IRS was looking to deny over $3,000,000 in losses incurred by Bluestone Farms LLC from 2010 – 2013. As any hobby loss enthusiast would expect this is about horses of courses. Standardbred horses in this case. Standardbred horses are the ones you see in harness racing
Big Stakes
The asserted tax deficiency was over $1,000,000 split unevenly between 85% owner Mitchel Skolnick and Eric Freeman who owned 15%. From 1998 to 2009, Bluestone had never been profitable and it had racked up nearly $8,000,000 in losses during the period. Leaning heavily on the long string of losses, Judge Lauber sided with the IRS in disallowing the losses, but not on the assertion of accuracy penalties. He did sustain a late file penalty for one of the years. Skolnick’s spouses from divorce and remarriage are mentioned in the opinion, but only because he was filing joint returns with them
Bluestone Farms is an impressive operation. You can see for yourself here.
Given the scope and professionalism, I would have expected them to prevail particularly when you consider the precedent set in the Finis Welch case. So this is an opinion worth studying. In discussing the opinion, I will take Judge Lauber’s findings of fact as a given. The taxpayers and their counsel might not agree.
The Factors
You and I have memorized the non-exclusive factors to be used in a 183 determination, but you have to consider the other readers, so I will repeat them just as Judge Lauber did:
(1) the manner in which the taxpayer conducts the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort spent by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation
Judge Lauber laid out the caveats in the regulation about the factors thicker than usual reminding us that no group of factors is controlling nor is it necessary that a majority of factors point to one outcome. He also notes that certain factors may be accorded more weight in a particular case because they have greater salience or persuasive value.
That’s what the regulations say, but it is not a good predictor of judicial behavior. I have studied 314 Section 183 decisions. The judge marches through the factors in 95 of them. There are only two instances in which the factor score does not match the outcome. And there is only one instance, Travis Mathis TCM 2012-294 a cutting horse case, in which the judge found that the taxpayer had behaved in a businesslike manner (Factor 1) and went on to rule that the activity was not entered into for profit.
Judge Lauber was so strong about the caveats, that I was expecting a surprise, but as we will see he followed the crowd.
Businesslike Manner
Judge Lauber notes that Bluestone had voluminous records and separate bank accounts. Nonetheless there were odd gaps. There was no documentation of the initial financial arrangements between Mitchel and Eric and no record of what their original capital contributions were. The ownership had shifted over the years, but the change in ownership was not memorialized until 2017, long after the audit commenced.
They did not make capital contributions proportionately to ownership and did not distinguish between capital and loans. Judge Lauber remarks that this is not how for-profit businesses generally operate. Actually I have seen that sort of thing go on in profitable businesses that are dependent on some but not all partners for liquidity.
Judge Lauber finds that Bluestone ran in a manner that was insensitive to costs. There was a business plan in 2004, but it was long outdated by 2010, the first year under audit. There were no balance sheets, profit-and-loss projections or break-even analysis after 2004. Mitchel and his fiancé/spouse lived at Bluestone. There were no formal agreement among the partners about the financial consequences of that personal use. When Bluestone paid $35,237 for landscaping expenses related to their 2013 marriage there was no reimbursement to the partnership. Then there are the expenses of Brianna’s horses.
Judge Lauber did not discern any inclination to rein in expenses. His conclusion on the important first factor is:
Mitchel and Eric clearly wanted to have a high-quality horse-breeding operation, and they spent generously to demonstrate that they were serious players in the Standardbred universe. But we find little evidence that they conducted this activity in a “businesslike manner,” i.e., in a manner intended to generate a profit. Many hobbyists desire to have a high-quality activity, but that does not necessarily mean that profit making is their goal. We regard this first factor as important in our analysis, and we find that it strongly favors respondent.
Appreciation
Factor 4 (Expectation of Asset Appreciation) rated extended discussion. There were two sources of expected appreciation – land and horses. On the land Bluestone runs afoul of Reg 1.183-1(d) which concerns definition of an activity:
where land is purchased or held primarily with the intent to profit from increase in its value, and the taxpayer also engages in farming on such land, the farming and the holding of the land will ordinarily be considered a single activity only if the farming activity reduces the net cost of carrying the land
That was clearly not the case. So appreciation of the land is not part of the horse breeding activity.
On the horses, much like the Finis Welch case, the taxpayers staked a lot of their argument on one horse – Always B Miki-. Bluestone purchased a 35% interest in 2013 and during the audit it showed great promise. Unlike Woody B Tuff whose reproductive efforts promised to more Welch’s Center Ranch into the black, MIki was not promising enough. Judge Lauber put Factor 4 neutral at best.
The Elephant In The Room
Judge Lauber, in conservation easement cases, has demonstrated a gift for not ignoring the obvious. Factor 6 (History of Income or Loss) plays that role here. He notes that Bluestone’s losses were large and sustained – $11.4 million between 1998 and 2013 without a single profitable year. Further they were unable to point to unexpected adverse events. Losses continued beyond 2013 with 2014-2017 also coming in over $3 million. Judge Lauber does not put much weight on a 1231 gain from Always B Mike in the amount of $281,450, since taxpayers were under the gun to show a profit.
There is an important point here:
This sixth factor strongly favors respondent. We view it as by far the most important factor on the facts of these cases, and we accord it great weight in our analysis. (Emphasis added)
If you can count more than a decade of losses as an overwhelming factor, many horse cases won by taxpayers would turn into losers.
Other Factors And The Final Score
Judge Lauber conceded Factor 2 (Expertise of Taxpayer and Advisers) to the taxpayer. He gives the factor little weight though because serious hobbyists will also seek out experts. Factor 3 (Time and Effort) came up neutral as did Factor 5 (Success in Other Activities). Factor 7 (Amount of Occasional Profit) favored the IRS as did Factor 8 (Taxpayer’s Financial Status) and Factor 9 (Elements of Personal Pleasure or Recreation).
So the final score is 5-1 in favor of the IRS. Nonetheless Judge Lauber minimizes the factor count:
As we have said in prior cases, determining profit motive under section 183 is not a matter of toting up factors but requires evaluating all the facts in a qualitative sense. We conclude that four factors listed in the regulations have the greatest salience and importance given the circumstances of these cases–the manner in which the activity was conducted, the history of losses, the taxpayers’ financial status, and the elements of personal pleasure or recreation. All four of these factors strongly favor respondent. Only one factor favors petitioners–the expertise of the taxpayers and their advisers–and we give it little weight on the facts here.
I spoke with B. Paul Husband who represented taxpayers in the case. Mr. Husband would not comment other than to tell me that they will definitely be appealing. It almost seems that Judge Lauber has issued an opinion that invites an appellate judge to flip some of the factors to the petitioner changing the score, but agree with Judge Lauber on the preponderance of the sixth factor. Such a decision would change the game in horse cases which often have very long strings of losses.
Other Issues
Judge Lauber did not allow the taxpayers to use net operating losses accumulated in prior years to offset the losses they gave up. The judge ruled that they had insufficient substantiation to support the net operating losses. He had disallowed a motion to reopen the record as untimely.
The judge ruled that the advice from the accountants the partners took over the years was enough to avoid over $215,000 in accuracy penalties. A late file penalty of $67,026 for the 2010 return was a horse of a different color. And there is a lesson here for preparers. The reason the return was a year late was because the preparer thinking there was no tax involved didn’t prioritize it. Timely filing is a duty that you cannot delegate to a professional. I’m thinking that somebody’s malpractice insurance might be hit for that penalty and the interest on it, but that is something we will never know.
Other Coverage
Lu Gauthier of the Boston Tax Institute nearly ordered me to jump on this case. It will be a major topic the next time I present my hobby loss seminar for BTI. You can get a brief version with no CPE credit here.
Lew Taishoff has Horsefeathers – Part Deux. He is referring to a previous opinion on the taxpayer’s experts in the case.
Relying on their CPA, Mitch tries to get out of a late-filing add-on for one year. The return was a year late, but the CPA said, because he thought no tax was due, it could wait while he was busy with other matters. Except there’s a personal, non-delegable duty to file on time. But because both Mitch’s and Eric’s respective CPAs have a bushelbasketsful of credentials and years of experience in the horse game, no accuracy chops.
Bloomberg, Law 360 and Tax Notes all have coverage behind their respective paywalls.
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For great value continuing professional education. I recommend the Boston Tax Institute
You can register on-line or reach them by phone (561) 268 – 2269 or email vc@bostontaxinstitute.com. Mention Your Tax Matters Partner if you contact them.
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