Otis and Alma Jordan, of Amissville, Va., persuaded the Tax Court that their horse racing and breeding activity was engaged in for profit. The couple lived on a 20-acre farm on which they constructed a new barn and made other significant improvements. They owned several thoroughbred race horses and acquired their first race horse in l986. They also owned six broodmares that they kept on the farm.
One of their race horses earned modest purses totaling about $6,000. They were planning on mating their broodmares with stallions owned by others and wanted to produce foals that, after appropriate training, would develop into successful race horses. They expected that their main revenue would come from purses.
The Jordans bred one of their mares to a stallion that was the grandson of a Kentucky Derby winner, whose other offsprings earned over $l million in purses. A casualty occurred, however, when the foal ran into a fence and injured its leg.
The petitioners did not maintain formal books of account for their horse racing activity. They paid expenses out of their personal joint checking account or by cash. Cash expenditures were sometimes noted on scraps of paper. They kept receipts of supplies, such as hay and feed bought from vendors. The race tracks provided them with a summary of their earnings and expenses incurred on a horse-by-horse basis.
The facts of the case were fairly weak, but the taxpayers won anyway. Were they lucky or was the judge unusually sympathetic? It’s hard to tell. The court said the test of whether a taxpayer is engaged in a horse activity for profit is whether he or she entered into, or continued, the activity with the actual or honest objective of making a profit.
“The taxpayer’s profit objective must be bona fide, taking into account all of the facts and circumstances.”
The court noted that the IRS had a strong argument against the taxpayers because they had a consistent pattern of losses, which usually suggests the lack of a profit motive. On the other hand, given the nature of the activity involved, the court said it was possible that their losses could be recouped if they had just one successful foal. Many of the foals sired by the stallion to which they had bred ended up competing well as thoroughbreds.
The judge noted that horse racing is a highly speculative venture but that, “An opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.”
The court noted that the petitioners had very little affectionate attachment to any of their horses, and they did not use their horses or farm for recreational purposes. The court concluded that it “simply can see no other reason why petitioners would have engaged in the activity and incurred the resulting expenses unless for profit.”
I think the petitioners were very fortunate to have a sympathetic judge, for not all Tax Court judges are quite this charitable with facts along the lines of this case.
The lessons from this case are:
(1) Even if you have poor business records or commingle funds, you can win if you have a strong breeding program with carefully selected mating decisions.
(2) If you have a history of losses it is important to show that this activity has little or no recreational elements.
(3) It is important to make improvements on the farm property consistent with sound practices of animal husbandry. If you are audited by the IRS, you have many rights and should consult an expert to discuss strategy.
John Alan Cohan is a lawyer who has worked in the horse, livestock and farming industries since l98l. He can be reached by telephone at (3l0) 278-0203, via e-mail at [email protected], or visit JohnAlanCohan.com.