Seventh Circuit lambasts Tax Court on its hobby loss analysis in horse racing decision
Roberts v. Comm., (CA 7, 4/10/2016) 117 AFTR 2d ¶ 2016-629
The Court of Appeals for the Seventh Circuit, reversing the Tax Court, has concluded that a taxpayer’s horse racing activities were entered into for profit.
The Court characterized the Tax Court decision as untenable, in that it in effect concluded that a business’s start-up costs were not deductible business expenses and that every business starts as a hobby and becomes a business only when it achieves a certain level of profitability.
Background. Under the hobby loss rule, deductions attributable to a “not for profit” activity are allowed only to the extent of income from it, or to the extent deductions are allowable regardless of any profit-seeking motive, whichever is larger. (Code Sec. 183, Reg. § 1.183-1) All facts and circumstances must be considered in the determination of whether a taxpayer has a profit objective under Reg. § 1.183-2(b), which enumerates nine factors (discussed below) which may be considered. No one factor nor a majority of factors necessarily determines the outcome. A court may consider other factors in this determination. (Reg. § 1.183-2(b))
Facts. In the mid ’90s, Merrill Roberts, a successful owner and operator of restaurants, bars, and nightclubs in Indianapolis, began withdrawing from the business, although he remained a paid consultant to the new owners. In ’98 or ’99, a thoroughbred racehorse association invited him to a dinner and to a tour of a race track facility, trying to interest him in entering the horse racing business. In ’99, Roberts bought his first two horses, for $1,000 each, and in the first year netted $18,000 in earnings from racing them. He also built a horse track on land that he owned (the Morris Street property). Two years later, his stock of racing horses had increased to 10, and he also had acquired a breeding stallion. The following year he passed the state’s licensed-trainer test (a test described as “rigorous” by the Tax Court) and obtained his horse-training license.
In 2005, Roberts planned to build a bigger and better horse-training facility on his land, but abandoned the plan after meeting with opposition from the city. In the following year, he bought a much larger (180-acre) tract of land (the Mooresville property) for about $1 million.
Between the acquisition of the new land and the end of the year, he invested between $500,000 and $600,000 in improvements for the training of race horses on his property. He trained the horses himself (as a licensed horse trainer), spending 12 hours a day working with the horses on race days and about eight hours a day on other days. He was also involved, though peripherally, in lobbying the State legislature on behalf of horse racing to allow slot machines at racetracks (which would have increased the winning purse). In the same period, he served on the boards of two professional horse-racing associations in what the Tax Court described as “leadership roles.”
Roberts’ horse-racing activities were not profitable in 2005 and 2006; his expenses exceeded his earnings by $153,420 in 2005 and $30,604 in 2006. His losses increased to $98,251 in 2007 and to $291,888 in 2008. He deducted the losses on his tax returns from his other income, mainly income from consulting in the restaurant business and from renting and selling real estate. On audit, IRS denied the deductions as a hobby loss, i.e., a loss from an activity not engaged in for profit.
Tax Court decision. The Tax Court concluded that the taxpayer’s horse racing enterprise was a hobby rather than a business in 2005 and 2006. Accordingly, his business expense deductions for those years were denied. The Court also ruled that his horse racing activities had ceased to be a hobby, and had become a bona fide business, in 2007 and remained so in 2008. (Roberts, TC Memo 2014-74TC Memo 2014-74)
Appellate Court decision. The Seventh Circuit found that the Tax Court’s ruling as to 2005 and 2006 was untenable. It amounted to saying that a business’s start-up costs were not deductible business expenses and that every business starts as a hobby and becomes a business only when it achieves a certain level of profitability.
The Seventh Circuit reasoned that Roberts’ 2007 “business” (conceded to be such by the Tax Court) did not begin that year, but rather evolved from: (i) his decision in 2005 to build a larger training facility and his attempt to do so on his existing property (which the city however prevented); (ii) the large land purchase that he had made in 2006; and (iii) the improvements (enabled by the purchase) in his horse-training facility that he had made that year.
The Tax Court’s finding that his land purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities was unsupported and an offense to common sense. Roberts intended the land and improvements for his horse-racing business, and intent to make a profit is what makes an activity a business. The fact that he became involved in horse racing because he was greatly reducing his involvement in his original business (thus signaling a career change), and the further fact that he assisted in lobbying designed to increase the profitability of horse racing, also contradicted the hobby conclusion.
The Seventh Circuit found the Tax Court’s language and reasoning muddled, careening from profit motive to pleasure motive and back. While the Tax Court found that only two factors favored IRS, it made numerous remarks in its opinion that supported the existence of a profit motive: discussing the taxpayer’s investment of time and effort in the activity, the Tax Court stated that by tax year 2005, Roberts “devoted time and effort appropriate to demonstrate a profit objective for all the tax years in issue”; on Roberts’ increasing his stock of horses from two to ten, the Tax Court said he was “enticed by the profit potential of racing more horses”; on his purchase of the Mooresville property where he started his horse racing enterprise, the Tax Court said he was “contemplating a career change” (a career is not a hobby); on Roberts attending a dinner at the horse racing association, the Tax Court said that he “was interested in the financial prospect of horse racing”; and on his time and effort matching his horses to the right race, the Tax Court said he did so “with the expectation of making a profit.”
Inconsistencies abounded in the Tax Court opinion. The Tax Court said that the taxpayer “did not purchase the [Mooresville] property [in 2006] to have a place to enjoy the golden years of his retirement but instead purchased the property to run a business,” but inconsistently stated later that the taxpayer’s “profit objective was first shown in 2007 when he began operating his horse-related activities at the Mooresville property.” The Seventh Circuit found that the Tax Court judge seemed not to have understood that the decision to build the facility, and its construction, were also indications of a profit motive.
The Seventh Circuit found that the factors in Reg. § 1.183-2(b) overwhelmingly favored or were consistent with Roberts’ claim that, even in 2005 and 2006, his horse racing enterprise was a business:
- The manner in which the taxpayer carried on the activity. Both the Tax Court and the Seventh Circuit found that Roberts conducted his activity in a businesslike way. Both found this factor favored the taxpayer.
- The expertise of the taxpayer or his advisors. Both the Tax Court and the Seventh Circuit found that Roberts prepared by extensive study (to obtain a training license). He also spent significant effort and time to match the right horse to the right race in order to increase their winning potential. Both found this factor favored the taxpayer.
- The time and effort expended by the taxpayer in carrying on the activity. Both the Tax Court and the Seventh Circuit found that Roberts largely withdrew from his previous businesses in order to devote most of his energies to his horse racing enterprise. Both found this factor favored the taxpayer.
- The expectation that assets used in the activity may appreciate in value. While the Tax Court found this factor neutral, the Seventh Circuit concluded that this factor favored Roberts. The Tax Court held that the Morris Street property was an activity separate from the taxpayer’s horse-related activities, and any expectation of appreciation of that property didn’t contribute to a finding that he was engaged in those activities for profit. The Seventh Circuit found that Roberts clearly 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.
- The success of the taxpayer in carrying on other similar or dissimilar activities. Both the Tax Court and the Seventh Circuit found that Roberts built a successful nightclub business from very humble beginnings; he turned a single unprofitable bar into a network of up to six different establishments, employing enough individuals to necessitate creating a staffing company to coordinate shifts. Both found this factor favored the taxpayer.
- The taxpayer’s history of income or losses with respect to the activity. While the Tax Court found this factor neutral, the Seventh Circuit concluded that in, a pattern consistent with his successful restaurant business, he grew the business from a smaller operation to large dimension over time. The Tax Court noted that the start-up phase and unforeseen expenses can result in large losses. The Seventh Circuit noted that a series of losses during the initial or start-up stage of the activity doesn’t necessarily indicate that the activity isn’t engaged in for profit.
……but the amount of occasional profits, if any, which are earned. Both the Tax Court and the Seventh Circuit found that Roberts had expectation of future profits consistent with the existence of a profit objective.
A “substantial profit,” though only occasional, would generally be indicative that an activity is engaged in for profit. The Tax Court awarded this factor to Roberts because he earned money from racing his first two horses, and the growth in the prize purses (owing to the slot machines) could be expected to increase his income in the future; that one of his horses was nominated to run in the Triple Crown Races suggested that his horses might eventually achieve greater success. Both found this factor favored the taxpayer.
- The financial status of the taxpayer. While the Tax Court concluded that the fact that he had other income was a factor that favored IRS (even after conceding that he wasn’t “an excessively wealthy individual”), the Seventh Circuit believed that the existence of other income has little weight when many other factors indicate a profit objective. In 2005 and 2006, Roberts reported adjusted gross income of $297,881 and $1,359,339 even after deducting his horse-racing losses, but he had also sold a large piece of land in 2006. The Seventh Circuit noted that it wasn’t as if Roberts were a billionaire indifferent to the modest profit that probably was all he could expect from horse racing.
- The presence of personal pleasure or recreation. The Tax Court — without listing or describing any social or recreational activities engaged in by Roberts — also found that this factor favored IRS, concluding, contrary to the regs, that, “there is likely no profit objective where the taxpayer combines horse racing with social and recreational activities.” On the other hand, the Seventh Circuit noted that Reg. § 1.183-2(b) says, “An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors whether or not listed in this paragraph.” The Seventh Circuit found that the fact that horse racing may have been a fun business, didn’t convert a business to a hobby; otherwise Facebook, Microsoft, Apple, and Amazon would all be hobbies.
In conclusion, the Seventh Circuit commented that the Tax Court would have been better off if, rather than wading through the nine factors (in what it characterized as a “goofy” reg), the Tax Court had simply said that a business that is in an industry known to attract hobbyists — and horse racing is that business par excellence — and that loses large sums of money year after year that the owner of the business deducts from a very large income that he derives from other (genuine) businesses or from trusts or other conventional sources of income, is presumptively a hobby. Though before deciding for sure, the court must listen to the owner’s protestations of business motive.