I have had an unusual number of calls from people all over the country saying they are being audited by the I.R.S. for their horse activities, and a surprising number of these involve activities in the early start-up phase. It is not entirely clear why the I.R.S. would seek to go against taxpayers who are just starting a horse activity, since the tax regulations make it clear that it is necessary to look at the “big picture” as it were, to see if a taxpayer can show two profit years in a seven year period. All of my clients have been careful to document their activity and to seek expert guidance and written opinions.
In a new case, Victor and Marion Prieto of San Mateo, California, lost their Tax Court case regarding their horse activities because they did not engage in those activities for profit–according to the judge who heard their case. [T.C. Memo 200l-266] Dr. Prieto is an orthopedic surgeon, and has run a successful medical practice in San Francisco since l988. Mrs. Prieto also worked in her husband’s medical office. In the years at issue, from l99l to l998, their joint income was over $5 million, and their losses averaged over $300,000 per year.
Mrs. Prieto had a background in horses from childhood, having grown up on a farm, and Dr. Prieto also enjoyed horses. Their daughters enjoyed riding horses. The taxpayers claimed that they started their horse activity for the purpose of purchasing, training, showing and selling hunter, jumper and equitation horses. They used the same ponies that their daughters rode for pleasure to start the horse activity. Then they purchased more horses–Welsh ponies, being the same type of horse that their daughters were riding. The Court felt that Dr. and Mrs. Prieto were involved in riding and showing activities because of the recreational riding and showing activities of their daughters.
On a positive note, the taxpayers consulted professionals such as veterinarians, other owners, they hired professional trainers and assistant trainers, and read periodicals about hunter and jumper horses. They also owned books on the industry, attended seminars, clinics, and award banquets put on by horse organizations.
There were various problems. They did not have a written business plan or a budget for the horse activity. They did not have bills of sale for every horse they owned. They insured only some of their horses and failed to explain why that was the case. They did not enforce promissory notes from people who owed money to them on sales of horses. They sold some horses, but invariably at prices lower than the original purchase price.
They incurred $l,676,963 of losses from l99l to l995, and $2,555,935 of losses through l998. During those years the average loss from the horse activity was $3l9,492 per year.
The Court was apparently influenced by the fact that the taxpayers’ children would ride and take lessons on the horses, and enjoyed riding horses. Mrs. Prieto also rode the horses for pleasure.
The Court ruled against them because they did not have bills of sale for all their horses, and their records appeared to be faulty. The Court found fault with the testimony of the taxpayers that their “business plan” was to buy, train, show and sell horses. The court said, “This is not a plan; this is merely a statement of what the horse activity did.”
The Court found that the taxpayers in effect had no significant experience with horses prior to starting the horse activity, and that they failed to really find out how to conduct a horse activity to make it profitable, how to train horses, or how to manage the horse activity.
The Court noted that there was one profit year, but that this apparently was due to the incorrect reporting of expenses for that year, and the likely effect of the understatement of expenses was to create the appearance of a profit for the horse activity when none in fact existed.
The Court said that the taxpayers and their children derived substantial pleasure from the horse activity. Finally, the Court noted that the taxpayers finally decided to terminate the horse activity within months of one daughter’s leaving the country and their younger daughter turning l8. The Court concluded that they did not engage in the horse activity with the primary, predominant, or principal purpose and intent of making a profit within the meaning of the Tax Code. The Court, however, did not impose a penalty on underpayment because it was concluded that the taxpayers’ treatment of the horse activity as business expenditures was reasonable and in good faith because they relied on their accountants to determine whether they, as a legal matter, were entitled to deduct the horse activity’s expenses.
[John Alan Cohan is a lawyer who has served the horse industry since 1981. He serves clients in all 50 states, and can be reached by telephone at (310) 557-9900 or via e-mail at [email protected].]