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Seventh Circuit Reverses Tax Court, Allows Losses from Horse-Racing Activity.

(Parker Tax Publishing APRIL 2016)

The Seventh Circuit reversed a Tax Court decision that disallowed losses resulting from the startup expenses of a horse racing business. The circuit court concluded that the lower court erred in its interpretation of the Reg. Sec. 1.183-2 profit motive factors. Roberts v. Comm'r, 2016 PTC 143 (7th Cir. 2016).

In 2014, the Tax Court held that Merrill Roberts operated his horse-racing business for a profit in 2007 and 2008, but not in 2005 and 2006, Thus, Roberts' losses in 2007 and 2008 were deductible, while his losses in 2005 and 2006 were nondeductible hobby losses. The decision rested on the Tax Court's analysis of the nine factors listed in Reg. Sec. 1.183-2 that indicate whether or not a taxpayer has a profit objective with respect to a business that generates losses. Roberts appealed the denial of 2005 and 2006 losses.

In Roberts v. Comm'r, 2016 PTC 143 (7th Cir. 2016), the Seventh Circuit reversed the Tax Court's decision. According to the Seventh Circuit, the Tax Court's ruling was untenable and amounted to saying that a business's start-up costs are not deductible business expenses - that every business starts as a hobby and becomes a business only when it achieves a certain level of profitability. However, with respect to the Tax Court's analysis of Reg. Sec. 1.183-2, Judge Posner felt compelled to add "we mustn't be too hard on the Tax Court. It felt itself imprisoned by a goofy regulation."

OBSERVATION: The Seventh Circuit noted that the introductory paragraph to Reg. Sec. 1.183-2 provides that no one factor is determinative and that other factors may be taken into account in making a determination as to whether a taxpayer's activity is a business or a hobby. In other words, the court said, the test is open- which means that a court is not required to apply all of the factors to a taxpayer's enterprise. A court can instead devise its own test, with its own factors, as long as it explains why the factors that should normally be taken into account are not sufficient.


In 1969, Merrill Roberts bought an abandoned restaurant in Indianapolis, Indiana, which he turned into a successful steakhouse. After the restaurant closed because of significant fire damage and the insurance settlement was insufficient to rebuild the restaurant, Roberts reopened the business as a successful bar. He actively participated in trade organizations that supported the nightclub industry and eventually ascended to multiple leadership roles within the organizations. Roberts also expanded his business activities by investing in real estate. The former owner of one of the properties he purchased had used the land to board horses, and there was an operational stable on the property. Roberts recognized there was a small income potential from the stable. In the mid-1990s, Roberts eased out of the nightclub industry.

Around 1999, the Indiana Thoroughbred Owners and Breeders Association invited Roberts - as an owner of a horse boarding stable - to attend a free dinner and a tour of Hoosier Park, the first horse racing track to be opened in Indiana. The association presented basic information about horse racing and the potential financial gains associated with the activity. Roberts was interested in the financial prospect of horse racing even though he had been to a horse track only once before the event. He asked a trainer who already worked at his boarding stables to "show him the ropes" of horse racing. The trainer taught Roberts some initial basic horse skills, and Roberts decided to acquire his owner's license. In 1999, Roberts bought his first two young horses for $1,000 each and proceeded to work with his trainer to prepare the young horses for the racetrack. He also bought two horse racing videos to help explain more about horse racing and built his first training track on one of his properties. In his first year of racing, Roberts's net income was around $18,000 from his two horses.

Roberts was enticed by the profit potential of racing more horses. He increased his personal racing stable from two horses in 1999 to 10 horses in 2001 and also bought a breeding stallion. He began working every day to develop the skills needed to become a licensed trainer, and he passed the trainer's license test in 2002. Unlike an owner's license, a trainer's license is much harder to obtain, and the State of Indiana required an applicant to pass a rigorous test on a range of subjects from horse bridle construction to equine medication.

In 2004, Roberts started consulting a specialized professional called a blood stock agent for horse purchasing and breeding advice so he could substantially expand the bloodlines of the horses in his breeding program. By 2005, Roberts felt comfortable with his knowledge of horse racing and wanted to build his own horse training facility on some property he had acquired on Morris Street in Indianapolis. He made some improvements to that property and then sold it and reinvested the proceeds in 180 acre parcel of land in Mooresville, Indiana in 2006. He asked his trusted blood stock agent to help design the new training facility, and the bloodstock agent advised Roberts on many aspects of the new facility. The facility - completed and placed in service in 2007 - includes a large training track, portable horse stalls, unique rehabilitation equipment, several specialized training areas, and small apartments for employees.

From 2005 through 2008, Roberts was involved in multiple aspects of the race horse industry, including boarding, breeding, training, and racing horses. In 2007, he hired a full-time assistant trainer when he started his operations at the Mooresville property. During racing season, the assistant trainer worked at the racetrack while Roberts worked at the training facility. Roberts structured the arrangement so that he collected fees when his trainer performed services for third parties. Roberts did most of the manual labor to keep the facility in "excellent condition," while his assistant coordinated each horse on race day. Roberts's evenings were generally spent choosing the races in which each horse would compete. He spent substantial time studying track condition books and picking specific races for specific horses. This strategy produced some successful horses, and one of Roberts's horses was nominated to run in the Triple Crown Races.

Roberts suffered several mishaps during his first few years of horse racing. Several of his best horse prospects were injured or killed in unfortunate accidents or lost during foaling season. Paralleling his participation in nightclub trade associations, Roberts joined several professional horse racing associations and, from 2005 through 2008, he served as a board member for two of the organizations. In 2007, Roberts ran for and was elected to a leadership position within the Indiana Horsemen's Benevolent and Protective Association.

Roberts' Horse Activity Losses

For 2005, 2006, 2007, and 2008, Roberts reported losses of approximately $154,000, $30,000, $98,000, and $292,000, respectively, for his horse-related activities. The IRS disallowed the losses and assessed additional taxes of almost $1.2 million and penalties of more than $275,000. The IRS has not challenged Roberts' horse-racing deductions for any year since 2008.

Tax Court's Holding

In Roberts v. Comm'r, T.C. Memo. 2014-74, the Tax Court acknowledged that, by 2005, Roberts devoted time and effort appropriate to demonstrate a profit objective for all the tax years in issue but still held that Roberts' horse-racing enterprise deductions on his 2005 and 2006 tax returns were erroneous because the enterprise was a hobby. By 2007, the court said, Roberts' business had ceased to be a hobby and had become a bona fide business. The Tax Court noted that Roberts did not purchase the Morresville property in 2006 to have a place to enjoy his golden years but instead purchased the property to run a business. However, the court found that Roberts' land purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities in 2007.

Seventh Circuit Overturns Tax Court

The Seventh Circuit held that Roberts' horse-related activities in 2005 and 2006 were indeed a business and not a hobby. The Seventh Circuit found the Tax Court's holding that Robert's land purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities to be an offense to common sense. The Seventh Circuit found that the nine factors in Reg. Sec. 1.183-2 overwhelmingly favored Roberts' claim that, even in 2005 and 2006, his horse-racing enterprise was a business. According to the Seventh Circuit, Roberts conducted the enterprise in a businesslike way (factor 1); he studied extensively to obtain a training license (factor 2); he largely withdrew from his previous businesses in order to devote most of his energies to his horse-racing enterprise (factor 3); and he expected to derive an eventual profit from the enterprise, including profit in the form of appreciation of the value of the land and buildings used in the enterprise (factor 4).

The Seventh Circuit noted that, as a young man, Roberts entered the restaurant business on a small scale but grew the business to large dimensions over time, a pattern consistent with his attempting to repeat the process in his horse-racing venture in 2005 and 2006 (factor 5). A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit (factor 6) and the Seventh Circuit found this to be the situation in Roberts' case. Because Roberts earned money from racing his first two horses and the growth in prize purses could be expected to increase Roberts' income in the future (factor 7), this factor was also indicative to the court of a profit motive. The fact that a taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit (factor 8). The Seventh Circuit noted that the Tax Court gave this factor to the IRS because Roberts sold some property in 2006 that generated income. However, the Seventh Circuit said it believed the existence of other income should have little weight when many other factors indicate a profit objective.

Regarding factor 9, the Seventh Circuit objected to the Tax Court's conclusion that there is likely no profit objective where a taxpayer combines horse racing with social and recreational activities, saying this was contrary to what factor 9 states. According to the Seventh Circuit, the Tax Court's statement that Roberts' involvement with professional horse racing associations demonstrated that he engaged in some social aspect of the industry was like saying that serving on a corporate board of directors is a "social" activity.

The Seventh Circuit concluded that all nine factors either supported or were consistent with Roberts' claim that his horse-racing enterprise, even as early as 2005, was a business and not a hobby. It may have been a fun business, the court said, but fun doesn't convert a business to a hobby.

For a discussion of the determination of whether an activity is engaged in for profit, see Parker Tax, ¶97,505.

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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