The Seventh Circuit Court of Appeals, reversing the Tax Court, held in the case of Roberts v. Commissioner, CA7, Case No. 15-3396, found that Merrill Roberts had operated his race horse operation with a profit motive for all years and not just beginning in a specific later year.  But in doing so Judge Posner could not resist in pointing out his view on the unworkable nature of the regulations that are provided to guide making the decision.

Mr. Roberts, a successful businessman, had acquired race horses in 1999 but not until 2005 did he decide to build a larger training facility and “ramp up” the business, a business that generated losses.  In the original case the Tax Court found that there was not a business until 2007, so that his losses in 2005 and 2006 were subject to the hobby loss rule.

The appellate panel found that holding at odds with the facts of the case. The opinion notes:

The Tax Court’s ruling that Roberts’ horse-racing enterprise was a hobby in 2005 and 2006 but became a business in 2007 and remained so in 2008, and apparently has been one in every year since given the IRS’s failure to challenge his horse-racing deductions for any year since 2008, is untenable; it amounts to saying that a business’s start-up costs are not deductible business expenses — that every business starts as a hobby and becomes a business only when it achieves a certain level of profitability. Yet Roberts’ 2007 “business” (conceded to be such by the Tax Court) did not begin that year, but rather evolved from his decision in 2005 to build a larger training facility and his attempt to do so on his existing property (which however the City of Indianapolis prevented); the large land purchase that he had made in 2006; and 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 is unsupported and an offense to common sense. He 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 contradict the hobby hypothesis.

But the opinion goes on to criticize the “9 factor” test used in the regulations under Section 183 to make this determination, specifically holding “[w]e mustn't be too hard on the Tax Court. It felt itself imprisoned by a goofy regulation (26 C.F.R. § 1.183-2, Treas. Reg. § 1.183-2: Activity Not Engaged in for Profit Defined; see, e.g., Faulconer v. Commissioner, 748 F.2d 890 (4th Cir. 1984))…”

The Court then goes on to specifically criticize this test:

Notice in the introductory paragraph (the one labeled “Relevant factors”) that “No one factor is determinative” and that not “only the factors described in this paragraph are to be taken into account in making the determination” (emphasis added) whether the taxpayer’s activity is a business or a hobby. In other words, the test is open-ended — which means that the Tax Court was not actually required to apply all of those factors to Roberts’ horse-racing enterprise. It could have devised its own test, with its own factors, as long as it explained why the factors that “should normally be taken into account” were insufficient.

This author notes that the “nine factor” test decisions are often very difficult to reconcile with each other and that, in fact, Judge Posner’s final observation on the point is really what is a more practical way to view this issue:

Considering that most commercial enterprises are not hobbies, the Tax Court would be better off if rather than wading through the nine factors it said simply 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 (and 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. For an analysis along these lines see our decision in Estate of Stuller v. United States, 811 F.3d 890, 896-98 (7th Cir. 2016).