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Expert Trainer's Involvement in Thoroughbred Venture Helps Taxpayers Avoid Hobby Classification. (Parker Tax Publishing November 29, 2014)

The Tax Court gave considerable weight to the involvement of a professional trainer as a co-owner in a thoroughbred racing venture in holding that heavy losses incurred in 2009 and 2010 by the taxpayers were not hobby losses. Annuzzi v. Comm'r, T.C. Memo 2014-233 (11/13/14).

Mel and Jean Annuzzi, operate Annuzzi Concrete Services, Inc. (ACS), in San Francisco. Mel has been the president of ACS for more than two decades. Jean works at ACS part time and has principal responsibility for the company's finances, including bookkeeping and accounting. In the early 1980s the Annuzzis began to buy race horses, hoping to make money by winning purses at horse races, selling race horses at a profit, and breeding foals that could be raced successfully or sold. They do not own or ride horses for pleasure; they do not allow anyone other than qualified professionals to ride their horses; they do not show their horses; they own no farm; and they do not keep horses as pets.

Since the beginning of ACS, the Annuzzis have co-owned most of their horses with Terry Knight, sharing income and expenses. Knight is a highly successful second-generation professional thoroughbred trainer who sits on the board of the California Thoroughbred Trainers Association. Horses he has trained have earned almost $12,7 million. Knight owned more than 50 horses with the Annuzis, in most cases with a 50-50 split. Mel estimated that he spent 30 hours per week on the thoroughbred activity. Knight devoted 10-16 hours a week to training the Annuzzis' horses and additional time to consulting with the Annuzzis about buying, breeding, and selling thoroughbreds. Jean kept the books and records of the thoroughbred activity and estimated that she devoted 25-30 hours a week to these recordkeeping activities.

The Annuzzis had modest profits or losses from the thoroughbred activity from 1981 to 2008. Two factors adversely affected the profitability of the thoroughbred activity during 2009-2010. First was their decision to put greater emphasis on breeding foals, which generates current expenses but defers income. The foals were too young to race in 2009 and 2010. Second, in 2007 most California race tracks introduced synthetic turf, which caused numerous injuries to the Annuzzis' horses in the ensuing years. As a result, the Annuzzis suffered losses of $81,114 and $55,797 in 2009 and 2010 respectively. For those years, The IRS determined that the Annuzzis did not engage in their thoroughbred activity with the intent to make a profit and disallowed the losses under Code Sec. 183.

Code Sec. 162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." To be entitled to such deductions, taxpayers must show that they engaged in the activity with an actual and honest objective of making a profit. 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. Under Ninth Circuit precedent in Wolf v. Comm'r, 4 F.3d 709 (9th Cir. 1993), a taxpayer can escape the Code Sec. 183(a) bar on deductibility only by demonstrating that his predominant, primary, or principal objective in engaging in the activity was to realize an economic profit independent of tax savings.

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) the expertise of the taxpayer or his advisers;

(3) the time and effort the taxpayer spends in carrying on the activity;

(4) the expectation that assets used in the activity may appreciate in value;

(5) the taxpayer's success 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 taxpayer's financial status; and

(9) elements of personal pleasure or recreation.

The Tax Court held that, although overall the factors did not strongly weigh in the favor of either the Annuzzis or the IRS, the preponderance of the evidence indicated that the Annuzzis' predominant objective in engaging in their thoroughbred activity was to realize an economic profit independent of tax savings.

The court determined that factors (1), (2), and (4) weighed strongly in the Annuzzis favor, as they conducted their throughbred activities as a business for profit, had gained expertise over the decades and strongly relied on Mr. Knight's expertise, and had reasonable expectation that the horses would be profitable. The court decided that factors (3) and (7) only slightly favored the Annuzzis, as they had to split their time between ACS and their thoroughbred activities, and because they only made modest profits, if any. Factor (5) was neutral, as there was no credible relation between the success of ACS and their thoroughbred activities. Factors (6), (8), and (9) weighed in the IRS's favor, as the Annuzzis had many years of consecutive losses, generated substantial benefits from these losses, and derived recreational pleasure from these activities.

Central to the court's conclusion was Knight's involvement, not only as the trainer, but also as the co-owner of horses. The court stated that, in a very real sense, he and the Annuzzis embarked on a joint venture to own, train, race, and sell thoroughbred horses. The evidence clearly established that Knight embarked on this venture with the intent to make a profit and the court concluded that the Annuzzis' motivation was the same as his. Thus, the Tax Court held that the losses sustained were not hobby losses under Code Sec. 183.

For a discussion of the hobby loss rules, see Parker Tax ¶ 97,501. (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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