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Tax Litigation: The Week of December 19 – December 25, 2021
William R. Huff and Cathy Markey Huff, v. Comm’r, T.C. Memorandum 2021-140| December 21, 2021 | Urda, J. | Dkt. No. 22604-17.
Short Summary: The main issue in this case is whether the taxpayers’ miniature donkey breeding activity was operated with the intent to make a profit under section I.R.C. 183 during the 2013-2014 period (the tax years).
William R. Huff (the taxpayer), a wealthy financier, engaged in the miniature donkey breeding business with the intention of supplementing the income of her daughter. The venture was carried under Ecotone, an LLC solely owned by the taxpayer and his wife. To engage in the donkey breeding activity he conducted extensive research, and acquired multiple donkeys with the intention of breeding newer ones under 25 inches tall. His business was located in a specified area of his farmland and the business kept separate books and records detailing the donkey purchases and sales. The taxpayer did not obtain a personal pleasure of the business because according to his own words, having the donkeys “it’s a lot of work” and the donkeys are “quite ugly” and look like a “gigantic hairball”.
The business reported losses since its inception and during the tax years, which were reported on the taxpayer’s personal income tax return. The taxpayer had gross income of approximately $21M and $29M during the tax years. The IRS disallowed the losses in the amount of approximately $87k and $47k for 2013 and 2014 on the ground that Ecotone was not a trade or business, and the Notice of Deficiency was issued.
Key Issues: Whether the taxpayers’ miniature donkey breeding activity constitutes a trade or business as provided by section 183 of the I.R.C.
Primary Holdings: The taxpayers’ miniature donkey breeding activity constitute a trade or business under section 183 I.R.C.
Key Points of Law:
The Court determined that the taxpayer was engaged in the business of breeding miniature donkeys, as provided by I.R.C. 183. Section 162 provides that all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. I.R.C. § 183. An activity not engaged in for profit is defined under section 183(c) as “any activity other than one with respect to which deductions are allowable for the taxable year undersection 162…”. I.R.C. § 183(c).
An activity is engaged in for profit “If the activity was entered into with the dominant hope and intent of realizing a profit”. Brannen v. Commissioner, 722 F.2d 695 , 704 (11th Cir. 1984), aff’g 78 T.C. 471 (1982); see, Helmick v. Commissioner, T.C. Memo. 2009-220 , 2009 WL 3012725 , at *7.
Breeding and raising equines may be an activity entered into for profit. For example, Engdahl v. Commissioner, 72 T.C. 659 , 665-666 (1979); Den Besten v. Commissioner, T.C. Memo. 2019-154, at *18. To determine the requisite profit objective, the Court attends to all the surrounding facts and circumstances. See Keanini v. Commissioner, 94 T.C. 41 , 46 (1990); sec. 1.183-2 (b), Income Tax Regs .
The Regulations provide with a list of factors that are relevant to ascertain the existence of the intent to earn a profit. Treas. Reg. § 1.1832(b). In this case, the Court discussed all these 9 factors as follows:
- Manner in which the taxpayer conducts the activity. The activity must be carried in a businesslike manner which may indicate the activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(1). “Businesslike manner” is suggested by the maintenance of books and records and a plausible business plan. Ibid. “Taxpayers operate in a businesslike manner when, among other things, they have a business plan, advertise goods or services, keep complete records, and respond to losses by changing what they do.” Metz v. Commissioner, T.C. Memo. 2015-54 , at *26; see also Helmick v. Commissioner, T.C. Memo 2009-220 , 2009 WL 3012725 , at *8.
In this case, the taxpayer had a business plan which was evidenced by its actions: assemble a team of miniature donkeys with certain attributes, breed them and sell the foal. Other circumstances such as consulting with experts, implementation of major changes to the area where the activities were carried, and purchases of breeding stock confirm the existence of the business plan. Moreover, Ecotone maintained a separate set of books and records different from the taxpayers. Finally, the taxpayers changed aspects of the breeding operation in response to the business’ needs such as feeding changes, alteration to breeding schedules, among others. Under these facts, the Court weighed this factor in favor of the taxpayers.
- Expertise of the taxpayer or his advisers. If the taxpayer consults with industry experts and studies accepted business practices when preparing for an activity, that may suggest a profit motive. Treas. Reg. § 1.183-2(b)(2). In this case, the taxpayers did not have any previous experience in the miniature donkey breeding business. However, the taxpayers undertook deep research into all the factors of the activity and more relevantly, he hired an expert in the breeding activity. The Court found this factor in favor of the petitioners.
- Time and effort spent by the taxpayer in carrying on the activity. Devotion of considerable time to an activity may indicate a profit motive, particularly if the activity does not have a substantial personal or recreational aspect. Treas. Reg. § 1.183-2(b)(3). In this case, the Court recognized the limited amount of time of the taxpayers to directly carry the activity. Thus, the Court focused its attention on whether the taxpayers employed competent and qualified people to carry on the activity. Here, the taxpayers hired various experts in the breeding activity and in the caretaking of the donkeys. This factor weighed in favor of the taxpayers.
- Expectation that assets used in the activity may appreciate in value. Profit includes appreciation in the value of assets, such as land. Treas. Reg. § 1.183-2(b)(4). If the taxpayer engages in farming of the land, the farming and the holding of the land are considered as a single activity only if the farming activity reduces the net cost of carrying the land. Treas. Reg. § 1.183-1(d)(1). In this case, the Court found that although the taxpayers expected the donkeys to increase its value, no evidence was introduced to support this expectation. More relevantly, the fact that the donkeys were sold at a loss suggests that the appreciation of the donkeys was unlikely. Also, no evidence was introduced to support the appreciation in the value of the land. Accordingly, this factor was found in favor of the IRS.
- Success of the taxpayer in carrying on other similar or dissimilar activities. The previous business activities of the taxpayers were not related to horse breeding. This factor was deemed neutral by the Court.
- Taxpayer’s history of income or losses with respect to the activity. “The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises [*14] may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.” Treas. Reg. 1.183-2 (b)(5). The fact that the taxpayer was an accomplished businessman engaged in turning around unsuccessful business to successful ones, was central for the Court to find that he intended to do the same with the donkey breeding activity. Blackwell v. Commissioner, T.C. Memo 2011-188 , [2011 BL 204853], 2011 WL 3444327 , at *7 (“[The taxpayer’s] obvious business acumen and success in business development and management with other companies, along with * * * [his] credible testimony, indicate, to us, an ability, determination, and savvy to make a profit and be successful in * * * [the] horse activity.”).This factor weighed in favor of the taxpayers.
- History of income or losses with respect to the activity. “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.” Treas. Reg. 1.183-2 (b)(6). Despite the losses sustained since its inception, the Court found that the donkey breeding business was within the startup phase and the exception applicable to losses derived of unforeseen circumstances beyond the taxpayer’s control does not preclude a profit motive. Ibid. This factor favored the taxpayers.
- Amount of occasional profits, if any. An occasional small profit from an activity generating large losses, would not generally be determinative that the activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(7). Here, Ecotone did not generate any profit. The factor favored the IRS.
- Financial status of the taxpayer. If the taxpayer has substantial income or capital from sources other than the activity subject to inquiry, it may indicate lack of profit intent. Treas. Reg. § 1.183-2(b)(8). Here, the taxpayers had substantial capital from other sources. The Court considered the taxpayer’s testimony stating that his intend was to give her daughter a business that made money, not a losing one. Under such evidence, the Court found that this factor favored the taxpayers.
- Elements of personal pleasure or recreation. If the taxpayer derives personal pleasure from an activity, or finds it recreational, it may suggest lack of intent of a profit. Treas. Reg. § 1.183-2(b)(9). However, “suffering has never been made a prerequisite to deductibility.” See Jackson v. Commissioner, 59 T.C. 312 , 317 (1972). In this case, the taxpayer did not derive any pleasure form this activity, in his own words, “there is no satisfaction of having these”, because the miniature donkeys are “quite ugly” and look like a “gigantic hairball”. This factor favored the taxpayers.
Based on the above analysis, the Court determined that the taxpayers’ activities were engaged in for profit.
Insight: This case shows that to properly determine the existence of a trade or business, the facts and circumstances surrounding such activity are critical. In this case, the Court surprisingly found that even if the donkey breeding business was sustaining losses, this was not an impediment to determine the existence of a motive profit, because the breeding was characterized as “unforeseen”. In a similar case resolved just a week before this case, the Court did not rest its opinion on such characterization. See Mitchel Skolnick and Leslie Skolnick, et al., v. Comm’r, T.C. Memorandum 2021-139. This subject will still continue to raise questions, specifically in novel scenarios such as cryptocurrency.