By John Alan Cohan, Attorney at Law
A recent case that seemed to rule correctly against a taxpayer was the Tax Court decision holding against Sandra J. Brannon of Southwest Texas with regards to her quarter horse breeding activity. The case also denied her depreciation deductions with respect to 4 emus because she was unable to prove she had purchased an interest in them, so could not show that she had a tax basis in the animals.
Brannon’s activity involved six quarter horses with modest Schedule C losses ranging from about $l2,000 to $34,000 per year over an eight-year period. She claimed that she was engaged in the activity for profit, but failed to keep accounting records to reflect expenses, profits or losses, although she maintained a “file folder” in which she “kept receipts.” She calculated her expenses, income and net losses for income tax purposes only and appeared to engage in no strategic planning.
During the years in question, she lived with her parents and engaged in horse breeding as a full time activity, holding no other jobs. She never paid rent or subsidized her parents for her living accommodations. She received some financial assistance from her parents, as well, which was used to help defray the costs of her horse activity.
She and her father leased a farm located 25 miles from her parents’ residence, and she kept her horses there. The property consisted of a pasture with some trees and a barn.
For the first few years, Brannon focused on raising Quarter Horses for Western pleasure and halter, and then she decided that her chances for profit would be greater with cutting horses, so she changed her operation to that speciality.
She regularly attended horse shows, was a member of various associations, had business cards and advertised in trade journals and newspapers. Her sales of horses, however, were minimal.
Brannon believed that she could market her horses in Mexico, but changed her mind when the Mexican peso declined in value. She attributed her overall losses to the fact that she did not have a sufficient number of broodmares, and that the bloodlines of her horses were not of the quality that were in demand. She thought that her chances of success could be better by switching to cutting horses, and said that she had the goal of producing a $l00,000 horse. However, to do that, she would have to pay breeding or stud fees of about $l0,000, and her finances did not allow her to do that. During the years at issue, she paid only $750 for stud fees.
The court felt that Brannon’s “sole motivation for engaging in her activity was her love for horses, dating back to her childhood.” The court seemed influenced by the fact that she devoted full time to caring for six horses, that she did not have enough money to implement a plan to breed a potentially valuable cutting horse, and she had no educational training or experience in the business of breeding and training horses, nor did she consult any professionals.
“She made no studies or consultations with professionals with respect to the business aspect of such an activity. She did not maintain a separate bank account for her activity, and she did not maintain formal books and records,” nor did she make “any effort to change the direction of her operation, although she recognized her need to do so.”
Section 183(a) of the Tax Code provides that if an activity is not engaged in for profit, no deductions attributable to that activity may be allowed. The court felt that Brannon did not engage in the activity with an “actual and honest objective of making a profit.”
The court noted that the nine factors listed in the IRS Regulations, such as the manner in which the taxpayer carries on the activity, and the expertise of the taxpayer or the taxpayer’s advisers–“are not merely a counting device, where the number of factors for or against the taxpayer is determinative, but rather all the facts and circumstances must be taken into account, and more weight may be given to some factors than to others.”
The court felt that her activity was simply not conducted in a businesslike manner, although Brannon was “dedicated” to the activity. She had no formal or informal business plan and never sought the advice of experts on how to conduct the activity on a profitable basis.
The court also considered a separate emu breeding business that Brannon engaged in with her father. She had claimed depreciation deductions on four of the birds, but that was disallowed because there was no evidence that she had purchaed any interest in the animals. There was no bill of sale or other evidence to reflect the purchase. Nor was she able to show that she had acquired the emus by gift.
The court also allowed a negligence penalty of 20 percent based on the finding that she “engaged in this activity with the knowledge that it was unrealistic to expect that any profit could be realized in the manner in which she conducted the activity.” The court pointed out that she never sought the advice of professionals who could have advised her on what she should do to make the activity profitable.
Of course, with her limited budget, it is understandable that she could not obtain substantive legal advice on how to operate in accordance with IRS Regulations. My clients who engage me to prepare a tax opinion letter realize that they are investing in legal services that could help them withstand IRS scrutiny should they be audited.
The main lesson from the Brannon case is that if you have ongoing losses and are unable to pay for professional advice, you are likely to have your deductions denied if you are audited, plus be assessed a 20 percent negligence penalty, and that seems to be a fair outcome when compared to many other horse owners who conduct their activity in a more businesslike manner.
John Alan Cohan is a lawyer who has served the horse, livestock and farming industries since l98l. He serves clients in all 50 states and can be reached by telephone at (3l0) 278-0203, via e-mail at [email protected] or at JohnAlanCohan.com.