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Court's Rejection of IRS Position on Horse-Related Activity Saves Taxpayer $800,000.
(Parker Tax Publishing May 8, 2014)

Horse breeding and horse racing activities are often seen by the IRS and courts as hobbies, the losses from which are not deductible against other income. However, every now and then, a partial victory or total win by the taxpayer occurs and can be instructive to others as to what actions a taxpayer can take to turn a loss into a win. One such case is the recent Tax Court decision in Roberts v. Comm'r, T.C. Memo. 2014-74 (4/29/14).

While the taxpayer was not entirely victorious, he prevailed enough to avoid over $800,000 in taxes and did not have to pay any of the accuracy-related penalty the IRS had assessed on him due mainly to his reliance on a CPA. In the end, for the later years at issue, the court was won over by the taxpayer's significant changes in operation, his adoption of new techniques, his abandonment of unprofitable methods and the fact that he learned to navigate the complex regulations and financial possibilities of horse racing.

Background

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, Merrill reopened the business as a bar. The bar was near an airport and attracted airport employees at the end of their shifts. Specifically, "airport controllers" would often patronize Merrill's bar to celebrate passing certification tests. The airport controllers asked Merrill to arrange for exotic dancers to perform at the celebrations, and he complied. Soon thereafter, the nights featuring exotic dancers became popular and well attended events.

Although Merrill recognized the financial potential of operating a gentlemen's club, he chose to sell the business for moral reasons around 1973. However, a year or two later, Merrill reclaimed the bar because the buyers failed to make payments. Merrill continued to operate the bar as a gentlemen's club called Dancers. He actively participated in trade organizations that supported the nightclub industry and eventually ascended to multiple leadership roles within the organizations. He became president of the Indiana Licensed Beverage Association for four years and president of the Indiana Nightclub Association for eight years.

Merrill 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. Merrill recognized there was a small income potential from the stable but actually intended to capitalize on the land by creating a 95-acre contiguous plot and through appreciation, not through stable rental receipts.

Involvement in Horse-Related Activities

In the mid-1990s, Merrill eased out of the nightclub industry, selling all of his shares of the nightclub business to his three grown children. Around 1999, the Indiana Thoroughbred Owners and Breeders Association invited Merrill--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 breeders association presented basic information about horse racing and the potential financial gains associated with the activity. Merrill 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 Merrill some initial basic horse skills, and Merrill decided to acquire his owner's license. In 1999, Merrill 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, Merrill's net income was around $18,000 from his two horses.

While recognizing the ease of accounting for only two horses, Merrill was also enticed by the profit potential of racing more horses. He decided he liked the activity and bought more horses. Merrill used several trainers in his first few years of horse racing and learned more about the industry. 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, the 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, Merrill 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, Merrill felt comfortable with his knowledge of horse racing and wanted to build his own horse training facility. He purchased 180 acres and invested over $500,000 in building improvements for a horse training facility. He asked his trusted blood stock agent to help design the new training facility, and the bloodstock agent advised Merrill 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.

In the 2005 through 2008 tax years, Merrill was involved in multiple aspects of the race horse industry, including boarding, breeding, training, and racing horses. Merrill primarily raced horses in Indiana but also raced at least 11 races per year in Kentucky and intermittently raced in other states including Ohio, Louisiana, North Dakota, Minnesota, and West Virginia. 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 Merrill worked at the training facility. Merrill structured the arrangement so that he collected fees when his trainer performed services for third parties. Merrill did most of the manual labor to keep the facility in "excellent condition," while his assistant coordinated each horse on race day.

Merrill'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 required matching the attributes of a horse to the requirements of each race. If Merrill erred, he could have been fined for not meeting race requirements. But more importantly, because many of the races were "claiming races," his horse might have been purchased cheaply if the horse was worth more than the claiming amount. Thus, finding the right race for the right horse was the secret to the horse racing business, and it took him some time to learn the skill. To ensure compliance with racing regulations and entry strategy, Merrill would often confer with his assistant trainer about race entries. This strategy has produced some successful horses, and one of Merrill's horses was nominated to run in the Triple Crown Races.

Merrill 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, Merrill joined several professional horse racing associations, and from 2005 through 2008 he served as a board member for two of the organizations. In 2007, Merrill ran for and was elected to a leadership position within the Indiana Horsemen's Benevolent and Protective Association (HBPA). The HBPA, in addition to other missions, was responsible for allocating broadcasting funds and negotiating race purse structure.

Merrill's Recordkeeping and Use of a CPA

Merrill continuously used the same CPA for his accounting needs for over 20 years, including representation during two audits before the tax years in issue. Neither of the prior audits resulted in an increased tax deficiency, and he continued to seek the CPA's tax advice on tax matters. Merrill used a rudimentary accounting system for all of his businesses, including his horse-related finances. Merrill gave his CPA receipts for cash expenditures and relied on canceled checks and bank statements to track expenses. For gross receipts, Merrill partly relied on a complex Internet database devoted to horse racing records. The Internet database was extensive and tracked each horse, trainer, owner, and jockey and kept detailed records of each horse's history, complete with total earnings, earnings per start, and earnings per year.

Tax Returns for 2005 through 2008

For tax years 1999 through 2006, Merrill reported horse-racing income, expenses, and deductions from his horse-related activities on Schedules C, Profit or Loss From Business, of his personal income tax returns. In addition, he reported what was described as the horse farm portion of the income, expenses, and deductions on Forms 1120S for an S corporation he owned, Merrill C. Roberts, Inc. Merrill then reported the net ordinary income or loss and any separately stated items reported by the S corporation on its corporate income tax returns on various schedules to his personal income tax returns for the corresponding years. Merrill switched his tax reporting in 2007. Beginning in 2007, he began reporting all of the horse-related income, expenses, and deductions on the S corporation forms.

On his 2005 Schedule C, Merrill reported a loss of $98,000 for his horse-related activities. The 2005 Form 1120S reported a loss of $56,000 in horse-related activities. On his 2006 Schedule C, Merrill reported a profit of $15,000 and his Form 1120S showed a loss of $45,000. The 2007 and 2008 Forms 1120S showed losses of $98,000 and $292,000, respectively. In addition, in 2008, while preparing his 2007 tax return some of Merrill's financial records were permanently lost when a former girlfriend burned the records in a fireplace. As a result, Merrill did not file his 2007 tax return on time.

IRS Position

The IRS disallowed the losses relating to Merrill's horse activities for 2005 2008, saying he was not engaged in his horse-related activities for profit. The IRS pointed to Merrill's accounting methods to show he was not carrying on the activities in a businesslike manner. Primarily, the IRS suggested that Merrill's disorganization and reliance on an accountant was not businesslike.

The IRS also contended that Merrill developed an expertise only with respect to the actual boarding, breeding, and training of horses, but developed no expertise in the financial aspects of the horse-related activities.

The IRS assessed additional taxes of almost $1.2 million, penalties of over $275,000 and a penalty of approximately $17,000 for the late filing of the 2007 tax return.

Tax Court's Decision

The Tax Court held that Merrill did not conduct his horse activities for a profit in 2005 and 2006 but did conduct those activities for a profit in 2007 and 2008.

The court noted that, in 2007, Merrill demonstrated significant changes in operation, adoption of new techniques, and abandonment of unprofitable methods when he moved his horse racing activity from one property to a larger property. The court cited the fact that Merrill recognized that the Morris Street property was not suitable because the buildings were in disrepair and building a new facility at that location was cost prohibitive because of the city's building codes. The larger property, the court said, allowed him to build substantially larger and better new facilities and the increased size also allowed him to reduce his fixed feeding costs by growing his own hay and renting out part of the property.

The court also observed that, while Merrill did not undertake any business studies, he did significantly change his business model when he hired an assistant trainer after moving to the larger property. Instead of balancing a schedule between the racetrack and the training facility, Merrill could delegate tasks and potentially increase profitability by hiring a full-time assistant trainer. The court also cited the fact that Merrill earned additional income from trainer's fees when his assistant trained third-party horses. These significant changes in operating methods suggested to the court that Merrill engaged in horse racing activities for profit once his new facility was placed in service starting in the 2007 tax year.

With respect to the IRS's argument that Merrill developed an expertise only with respect to the actual boarding, breeding, and training of horses but developed no expertise in the financial aspects of the horse-related activities, the Tax Court said the IRS was omitting an important aspect of Merrill's horse-related activities: racing. The court noted that to enter a horse into a race, the decision maker whether trainer or owner must have an in-depth understanding of the financial aspects of the proposition. If a superb horse enters into a low-claim claiming race, the court observed, the horse may be bought cheaply from the owner and the owner will lose money. If an outmatched horse enters a stakes race, the owner will not earn back the entry fee. Merrill, the court said, learned about how to enter races and how to pick a horse for a specific race to maximize his potential prize. Thus, to navigate the complex regulations and financial possibilities of horse racing, Merrill was required to gain expertise in the financial aspects of his horse-related activities.

According to the court, Merrill credibly testified that he spent significant effort and time to match the right horse to the right race. He spent this time matching each horse to a race with the expectation of making a profit. He admitted that it took time to learn this skill but that it was the "secret" to the business. The court found that Merrill's custom-tailored entry strategy showed he was an expert in the financial aspects of his horse-related activities.

With respect to the penalties assessed by the IRS, the court found that Merrill demonstrated reasonable cause through good faith reliance on his CPA for years 2005 and 2006 and thus no penalty applied.

Finally, the court did uphold the penalty for Merrill's failure to file his 2007 tax return on time. Merrill argued that he had reasonable cause and cited a case where a taxpayer was not held liable for a late-filing penalty where a hurricane destroyed critical tax documents. The court rejected his argument saying that, while the wrath of a former girlfriend may be a formidable force, it was not analogous to a hurricane-like natural disaster, and did not constitute a reasonable cause outside Merrill's control. (Staff Editor Parker Tax Publishing)

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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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