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Not a Hobby: Tax Court Disregards Horse Farm's Staggering History of Losses.

(Parker Tax Publishing April 3, 2015)

Focusing on subjective intent, the Tax Court held that because the taxpayers were genuinely optimistic their failing horse farm would eventually be profitable, and were able to attribute poor results to weak economic conditions, millions in losses sustained over a six year period were not hobby losses. Metz v. Comm'r, T.C. Memo. 2015-54.

Background

For over two decades, Henry and Christie Metz owned an Arabian horse farm, Silver Maple Farm, Inc. (SMF), an S corporation specializing in "Straight Egyptian" Arabian horses, prized for their elite genetics.

Despite great effort by the Metzes, the venture was decidedly unprofitable. SMF had only one profitable year, and that was a result of the sale of a piece of real estate used in the business. SMF averaged annual losses in excess of $1,000,000 between 1999 and 2009. Undeterred, the Metzes attempted to outrun these losses, moving the farm several times in the hopes of finding a better market and eventually settling in California.

During its lifespan, SMF lost over $14.5 million, leading the IRS to determine the business couldn't possibly be motivated by a desire to turn a profit. The IRS issued notices of deficiency for 2004 through 2009 disallowing the passthrough losses from SMF, as well as related net-operating-loss carryforwards.

Analysis

To be entitled to business deductions under Code Sec. 162(a), taxpayers must show that they engaged in the activity with an objective of making a profit (Code Sec. 183(a)). Under Reg. Sec. 1.183-2(a), losses are not allowable for an activity a taxpayer carries on primarily for sport, as a hobby, or for recreation.

Reg. Sec. 1.183-2(b) provides a nonexclusive list of nine factors relevant in ascertaining whether a taxpayer conducts an activity with the intent to earn a profit. The factors listed are: (1) the way the taxpayer conducts the activity; (2) expertise of the taxpayer or his advisers; (3) time and effort the taxpayer spends in carrying on the activity; (4) expectation that assets used in the activity may appreciate in value; (5) taxpayer's success in carrying on other similar or dissimilar activities; (6) taxpayer's history of income or losses with respect to the activity; (7) amount of occasional profits earned, if any; (8) taxpayer's financial status; and (9) elements of personal pleasure or recreation.

Noting that courts don't substitute their own business judgment for the taxpayer's, the Tax Court focused on the Metzes' subjective intent in running SMF. The court used the nine factors to establish that intent, ultimately concluding that seven factors were in the Metzes' favor and the other two were neutral.

Six factors strongly favored the taxpayers. Under Factor (1), the court found the Metzes ran SMF in a manner similar to successful horse breeders: they kept businesslike records, wrote annual business plans, conducted extensive advertising and promotion, and also changed their operating methods and adopted new technologies in an effort to improve their profits. The court concluded Factor (2) favored the Metzes, as they demonstrated knowledge and leadership in the Arabian horse breeding industry. Factor (3) also favored the couple as they spent significant time and effort in their management and development of SMF. Taking into consideration land acquisition and ownership in addressing Factor (4), the court concluded the Metzes subjectively expected their assets to appreciate. The court found Henry's previous experience turning an ailing bakery into a profitable business sufficiently demonstrated his business acumen, reasoning Factor (5) weighed in their favor. Further, as a very large proportion of their net worth was attached to SMF, the court concluded that Factor (8) favored them as well.

The court made closer calls on the remaining three factors.

Despite the horse farm's consistent losses, the Tax Court concluded the Metzes did have a subjective, although possibly unreasonable, intent of making a profit, finding that Factor (6) was neutral and Factor (7) ultimately favored the Metzes. In evaluating Factor (6) the court disagreed with the IRS's argument that the Metzes needed a bona fide expectation that future profits would offset the losses, concluding the Metzes' only needed to show a subjective expectation, and found the Metzes' explanation for the losses was reasonable. The Metzes argued the losses were outside of their control, citing the 2008 financial crash, subfertile breeding stock, and significant downturns in the Arabian horse market.

The court further concluded that Factor (7) favored the taxpayers, noting that although they had incurred frequent large losses, they did have a substantial profit in 2004. The court reasoned that the long time frame required for building a multigenerational-breeding program and the low probability any particular horse would be worth a great deal made the Metzes' business very speculative, but the probability existed that they could one day hit the jackpot, and a sale of one horse could offset years of losses. The court noted that the riskiness of the venture alone did not render it a hobby and instead chose to focus on the subjective intent of the Metzes, who optimistically believed that they would one day become profitable.

Finally, the court found that while Metzes enjoyed trips to horse show events and rode horses, those elements alone did not render SMF a hobby, and concluded Factor (9) was neutral.

The court focused heavily on the Metzes' involvement and time spent working on SMF, and despite the staggering $14.5 million of loss, concluded the Metzes did have a subjective intent of making a profit. Thus, the Tax Court held that the losses were not hobby losses under Code Sec. 183 and allowed the Metzes' claimed losses.

For a discussion of the hobby loss rules, see Parker Tax ¶ 97,505. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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