Horse breeding is a favorite target of the IRS, when it comes to the hobby loss rules. Nonetheless, breeders will often beat the IRS in Tax Court. Reading a recent decision I got the sense that William Dodds, a tax accountant, came so close that he could almost taste it. He ended up losing. His case is very instructive and is a must read for anyone affected by this issue. I really hope he appeals.
The case only concerned two years 2007 and 2008. Between tax and penalty the IRS was looking for about a hundred grand for those two years. In determining whether the horse breeding was entered into for profit, though, the whole course of the business is considered. He had started in 1995 and the cumulative net losses were 1.4 million. He was able to afford it because he had a pretty good income as a tax accountant:
Petitioner typically spent 70 to 80 hours a week at his accounting firm during tax season but no more than 20 hours a week the rest of the year. In tax years 2007 and 2008 petitioner earned over $240,000 and over $280,000, respectively, from his work as an accountant.
That sounds similar to the schedule that Robert Flach, The Wandering Tax Pro, claims to maintain. (My blogging buddy, Joe Kristan, calls the Flach version of tax season, a two month death march.) Instead of running a blog where he grumbles about the GD extension and the idiots in Congress making a mucking fess out of the tax law, Mr. Dodds spent all that extra time raising Morgan horses.
He worked over 1,500 hours per year mucking stalls, feeding and grooming the horses, maintaining the property and grounds, administering medicine, arranging artificial inseminations, delivering foals, and making all breeding decisions. His son, daughter, and close friend assisted occasionally with feeding, watering, and bedding the horses.
So he must have really been having a lot of fun when was he was riding those horses ? Actually no.
Petitioner did not ride recreationally, and he did not allow others to ride his horses recreationally. His horses were ridden only by experienced trainers for training and show purposes.
If I was handicapping the outcome of this case based on what I have told you so far, I would have put it at even odds. The Tax Court did the whole nine factor analysis:
(1) whether the taxpayer carries on the activity in a businesslike manner; (2) the expertise of the taxpayer and his or her advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) whether the taxpayer expects that the assets used in the activity might appreciate in value; (5) whether the taxpayer has had success carrying on other similar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the taxpayer’s financial status; and (9) elements of personal pleasure or recreation. All facts and circumstances are to be taken into account, and no single factor is determinative.
Some of it was a little odd. When it came to the “elements of personal pleasure”, the Tax Court did not disbelieve his statement that he and his family never rode the horses, but they reasoned that to pour all that money into the activity for all those years, he must have been getting some sort of satisfaction and rated that factor neutral.
He got dinged on two things, which are highly instructive. I thought the first was pretty petty. Although, the Court acknowledged that he did a good job using Quickbooks to track his expenses, he did not have an account that segregated his horse business. If you are doing business as a proprietor, there is no requirement that you open a separate bank account for the business. It is a really good idea, though. Makes doing your accounting a lot easier. Of course if you are an accountant, like Mr. Dodds, extracting the relevant information from your personal account is no big deal, which may be why Mr. Dodds did not bother with it particularly since he would have needed to keep making transfers into the business account. I really don’t think not having a separate account should have been held against him, but it was. The moral is clear. Open a separate account for the business.
Much more important was the business plan. Mr. Dodds had tried two approaches to breeding Morgan horses.
At first he attempted to breed grade horses, i.e., horses that are a quality below show horses. Petitioner wanted to sell the grade horses locally when they were weanlings so that he could avoid the cost of raising the foals. He also wanted to avoid the high stud fees. Petitioner’s plan was unsuccessful. In 2000 he sought advice from Charles and Cordia Pearson, Morgan breeders, who convinced petitioner to geld his stallion and use their stallion instead. Petitioner used their stallion until 2004.
In 2004 petitioner decided to try to produce world-caliber foals. He stopped using the Pearsons’ stallion and began using all national or world champion stallions or grand national stallions. Petitioner began seeking advice from horse trainer Eileen O’Bradovich, who had started to train petitioner’s horses, as well as from professional horseman Jordy Johns and from a friend who grew up raising Arabian horses. Ms. O’Bradovich helped petitioner pick out the right stallions to breed to his mares.
Whenever I read that I feel really bad for that first stallion. At any rate the new way of doing business was more high stakes since stud fees from the stallions with great potential are high (Don’t like to reflect too much on what happens to the other stallions.)
Petitioner credibly testified that he expected his horses would appreciate because of his successful breeding program and that he believed he could eventually produce a “golden cross” Morgan horse capable of garnering stud fees exceeding $10,000 and a sale price exceeding $100,000.
The Tax Court had a problem with this high stakes game.
Petitioner failed to provide a business plan that included more than just generalized goals. …. Petitioner likewise failed to maintain a budget or to make any financial projections, economic forecast, or other analyses demonstrating financial management or planning. Petitioner used profit and loss statements prepared with QuickBooks, but there is scant evidence that petitioner used them for the important purposes of cutting expenses, increasing profits, and evaluating the overall performance of the operation.
The thing is, it seems to me that for this business, an accountant could pretty well do all that in his head. It just is not that complicated. As long as you are not borrowing or getting investors involved you can watch the burn rate and think through the payoff if things actually work out with a couple of your horses. He in fact switched from one mode of breeding that did not work to another and even invented and patented a device to cut down on feed waste.
As I said, I’m hoping to be reading an appeal on this case. In the mean time, the lessons are very clear. Use a separate account and document your business plan.
You can follow me on twitter @peterreillycpa.
Afternote
The main point of this piece was to help people who might be facing a hobby loss audits, not so much whether the Tax Court is right or wrong. After over 30 years in the business, I don’t have high expectations of taxes being fair or making a lot of sense. The motto is: “It is what it is. Deal with it.” One of my readers, who is perhaps intimidated by the slightly chaotic free wheeling brawls that sometimes develop in my comments section passed the following along to me privately:
….so now the Tax Court has decided that your brain and ideas are not good enough to create a viable business and only having a Business Plan will you the taxpayer be successful. A business plan will lead you in the right direction and make sure you a successful so you can pay your taxes.
Well, I found this article and what would the Tax Court Judges say, how do they explain this?
More by David Williams Aug 1, 2012 – You don’t have decide which is most important….they all are. … I cover how people & organizations work, and how they can work better. … findings was that of the entrepreneurs we surveyed who had a successful exit (that is, an IPO or sale to another firm), about 70% did NOT start with a business plan.
Originally published on Forbes.com Mar 16th, 2013