A taxpayer, representing himself in Tax Court, was able to convince the Tax Court that, despite years of losses, he operated his cutting horse business with a proper profit motive, escaping the hobby loss rules of IRC §183.[1]

IRC §183 provides the following treatment for expenses for undertakings that fall within its reach:

(a) General rule

In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.

(b) Deductions allowable

In the case of an activity not engaged in for profit to which subsection (a) applies, there shall be allowed—

(1)the deductions which would be allowable under this chapter for the taxable year without regard to whether or not such activity is engaged in for profit, and

(2)a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph (1).

Note that the IRC §183(b)(2) deductions are not listed as being allowed in computing adjusted gross income per IRC §62, meaning they would be itemized deductions. As well, they are not mentioned in the list found at IRC §67(b) as an itemized deduction that is not a miscellaneous itemized deduction.

For the year in question, that would have subjected such expenses to the 2% of adjusted gross income floor for all miscellaneous itemized deductions and no amount would be allowed in computing alternative minimum taxable income. Post-TCJA (at least until 2026), such deductions would be disallowed entirely by IRC §67(g). Note that in both cases, all income from the undertaking would be included in calculating adjusted gross income.

Mr. Den Besten was an accomplished cutting horse competitor. He also had been operating a seed business since 1964. In 2002 he sold the seed business to his son and looked to concentrate on building a complete cutting horse business.[2] His cutting horse operation included breeding, raising, boarding, training, selling and registering cutting horses, as well as showing horses in national competitions.[3]

His ability to concentrate on the cutting horse business did cause those results to improve, but other problems arose before the cutting horse business could turn a profit. The first one was that his son wasn’t able to profitably run the business that had been sold to him. As the opinion notes:

In 2002 petitioner sold the original seed business to his son for $4,283,000 and reported the sale proceeds using the installment method. At the time of sale he intended to focus all his effort, time, and money on his cutting horse activity, but his son did not succeed in the seed business and defaulted on the installment payments on the corporate stock sale. Only three payments — $424,007 in 2002, $42,483 in 2003, and $259,180 in 2004 — were made on the installment sale.[4]

The taxpayer reacted to this situation by returning to the seed business to attempt to bring it back to profitable operations:

In 2005 petitioner returned to the seed business in an attempt to salvage what was left of it. Petitioner was once again in the seed business but now operated it as a new limited liability company. For each year in issue petitioner reported the new seed business on a Schedule C, Profit or Loss From Business, attached to his Form 1040, U.S. Individual Income Tax Return. The first year after petitioner returned to the seed business it reported a $193,371 loss. The seed business subsequently generated net profits of $109,247, $106,552, $234,176, $151,175, and $84,772 in 2006, 2007, 2008, 2009, and 2010, respectively.[5]

In addition, his hopes for the cutting horse business were also negatively impacted by the unexpected death of a champion cutting horse, Si Olena, that he could have expected to have obtained substantial income in the future from breeding.[6]

The taxpayer decided to cut back on the operations of the cutting horse business when faced with this adversity:

Petitioner sold the Yellow Rose facility and invested the proceeds in the assets of the seed business in an attempt to stabilize the seed business. As a result petitioner began to scale back the cutting horse activity. While he continued to own, breed, and train horses and compete in cutting horse competitions, he significantly reduced the operation. At one time petitioner had at least 20 broodmares and multiple stallions. Although he continued to devote considerable time breeding approximately 12 mares per season along with foal delivery and veterinary work, he reduced his livestock numbers after he returned to the seed business, which consumed more and more of his time in his attempt to save it. As of 2006 petitioner owned approximately 10 horses, and by 2016 he had 7 or fewer horses. Among petitioner's current remaining horses was a champion-bred promising young stallion in training, and petitioner had high hopes for the horse. Despite petitioner's nationally recognized cutting horse activity, he has reported a loss for every taxable year since 1997 when he purchased the Yellow Rose.[7]

The Court considered the nine factors found in Reg. §1.183-2(b), but clearly the Court was mainly influenced by the problems that the taxpayer had encountered and his response to those issues, noting:

After his championships in 1997 and 1998, petitioner acquired and remodeled the Yellow Rose, expanding his operation. This significant acquisition enabled him to expand into hosting cutting horse competitions and production sales. It also increased his boarding and training capacities. He sold his seed business in order to increase the effort and time he needed to coordinate these efforts and to train potential foals. The Court concludes these actions are strongly indicative of petitioner’s having a profit motive during this timeframe preceding the years in issue. The actions are consistent with an intent to improve profitability through new operating methods.

Even though petitioner owned and operated the Yellow Rose outside the years in issue, he recognized he had to sell it to generate time and capital to save the seed business. Petitioner reduced his operation on the basis of economic realities and entered into a winding-down period with respect to the cutting horse activity. Petitioner’s realization he needed to scale down his operation is also indicative of a profit motive.[8]

Quite often taxpayers have money losing undertakings they claim as a trade or business from which they derive substantial personal pleasure, suggesting that making money might not be the driving force for continuing the undertaking. While riding horses often is treated as such an activity, in this case the Court found that was not an issue, noting:

Petitioner’s cutting horse activity was physically demanding. He coordinated multi-State production sales and competition events. His breeding operation required constant attention to the mares and stallions for a successful breeding cycle. While he surely derived personal pleasure from the recreational aspects of the cutting horse activity, his efforts went well beyond the leisurely aspects of horseback riding or the routine tasks of caring for horses.

At trial petitioner testified he was born in 1942, so he was approximately 64 years old in 2006, the first year in issue. He was 56 in 1998, when he acquired the Yellow Rose. Though petitioner admitted he enjoyed riding the horses during the years in issue, he also stated that his enjoyment has lessened as he has aged. Additionally, petitioner hired multiple trainers to aid in training his horses; he could not be deemed to have engaged in the cutting horse activity solely for personal enjoyment when the horses were not always in his care.

Petitioner rode to train his horses, not for recreation. He worked to prepare his horses for competitions in hopes of raising profitability and his overall reputation in the cutting horse industry.[9]

As well, another key factor is whether the taxpayer’s financial condition was such that he/she could continue the operation regardless of its profitability. The Court found that such was not the case for the taxpayer:

From 2006 to 2010 petitioner reported average Schedule C business income from the seed business of approximately $137,000. Petitioner’s returns showed substantial tax losses for each year in issue, attributable to claimed NOL carryovers and losses. However, petitioner’s son had defaulted on payments with respect to the 2002 sale of the corporate seed business. Additionally, petitioner sold assets and expended significant funds attempting to salvage the seed business. By 2006 the seed business once again earned profits, so petitioner reported income from the seed business and offset it with losses from the cutting horse activity. However, the Court finds that petitioner was not in a financial position that would have enabled him to continue suffering losses without a bona fide profit motive. Moreover, the Court is not persuaded that petitioner abandoned his profit motive with respect to the cutting horse activity. Petitioner had a promising champion-bred stallion in training. Petitioner genuinely believes that one good horse could turn a profit for his horse activity.[10]

This led the Court to conclude:

…[P]etitioner’s actions, coupled with his sincere and credible testimony as to his business goals, overwhelmingly support his claim that he has a bona fide profit objective.[11]

But not all turned out well for the taxpayer—again the Tax Court reminded us that more than just copies of prior years’ federal income tax returns are necessary to prove the taxpayer’s right to carryovers into the current year. In this case the problem related to net operating losses. As the opinion notes:

The Court may consider facts related to years not in issue that are relevant to the claimed NOLs. Sec. 6214(b). The record is devoid of testimony and other evidence specifying the details pertaining to petitioner’s NOL carryforwards from 2003 and 2005, and the Court is left with only petitioner’s Federal income tax returns. Petitioner’s tax returns set forth only his claim of the NOLs and do not reflect the details needed to establish his entitlement to those NOLs, other than general statements about his seed business losses. See Roberts v. Commissioner, 62 T.C. at 837. Even though the returns are signed under penalty of perjury, the signatures are insufficient to substantiate the deductions claimed. See Wilkinson v. Commissioner, 71 T.C. at 639; Emerson v. Commissioner, T.C. Memo. 2001-186. The Court concludes that petitioner did not meet his burden of establishing both the existence and the amounts of the 2003 and 2005 NOL carryforwards.[12]

[1] Den Besten v. Commissioner, TC Memo 2019-154, November 25, 2019 https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12085 (retrieved November 26, 2019)

[2] Den Besten v. Commissioner, p. 3

[3] Den Besten v. Commissioner, p. 5

[4] Den Besten v. Commissioner, p. 3

[5] Den Besten v. Commissioner, p. 4

[6] Den Besten v. Commissioner, pp. 12, 28

[7] Den Besten v. Commissioner, pp. 12-13

[8] Den Besten v. Commissioner, pp. 23-24

[9] Den Besten v. Commissioner, pp. 35-36

[10] Den Besten v. Commissioner, pp. 34-35

[11] Den Besten v. Commissioner, p. 37

[12] Den Besten v. Commissioner, pp. 41-42