Complex New Tax Ruling Is Disappointing
By John Alan Cohan, Attorney at Law

A tax case that I have not previously noted in this column is Musen v. Commissioner, T.C. Memo 2000-288, which involved Richard J. and Melodie D. McKeever of Norco, California. Mrs. McKeever has been involved with horses her entire life. As a child, Mrs. McKeever spent time with horses on her grandfather's and uncle's ranches. When her father was stationed in Barstow, California, Mrs. McKeever cleaned stalls and did other volunteer work at the U.S. Marine Corps stables in exchange for lessons in riding.

Prior to beginning their activity, the petitioners did not have any employment history or business experience in breeding, showing, or selling horses. By the time they began their horse activity, petitioners had acquired only general experience in owning, caring for, and riding horses. They never took any classes or attended any programs regarding the financial or business aspects of horse breeding and showing.

Prior to starting their horse activity, petitioners did not research the marketability of their breed (paso fino) or determine how they were most likely to make money. They did not seek business advice prior to purchasing their first horses. They had no tax opinion letter from a lawyer

Perhaps you can see where this is headed. The court ruled against the taxpayers.

They used a sales consultant for advice, but did not pay him. They purchased 9 mares and a gelding. Some ended up with problems, such as a mare that had severe osteoarthritis due to an injury. However, Mrs. McKeever expected that this horse would still be adequate for breeding purposes. They also purchased six horses in a package deal.

They hired a veterinarian, who gave general advice on improving the quality of their herd. They attempted to expand their herd through breeding, with mixed results. A number of setbacks hampered their attempts to breed their horses. The foals produced as a result of these breedings were all unsatisfactory and eventually sold at or below the cost of stud fees

They sponsored various California horse shows where they showed their horses. They commissioned an oil painting and a portrait of one horse and also rode their horses in parades. They had advertising expenses, had open houses and fun shows at their ranch, but did not list their ranch in the phone book

The taxpayers did not sell any horses. However, their ranch appreciated in value. They kept pedigrees and show records for their horses. They studied bloodlines and pedigrees.

They did not keep health records for their horses, except for copies of veterinary bills and notations made on a small calendar kept in their barn

Petitioners did not prepare written profit and loss projections for the taxable years at issue, nor did they prepare any such projections for future years. They prepared, in consultation with an accountant, a summary of operations for their horse activity for an 11-year period, which they referred to as a business plan. The document summarized various facts related to the horse activity and indicated in very general terms how they plan to improve the profitability of the activity. The court said that the document did not indicate what level of income would be required to achieve profitability or to what extent expenses might be reduced. Although petitioners maintained detailed expense records, the summary of operations, according to the court, did not analyze any of the past expenses to determine whether any adjustments to those expenses could improve profitability

The court noted that they presented no evidence that their records were used to implement cost-saving measures or to improve profitability.

Although petitioners' records were voluminous, the court felt that their record keeping was nothing more than a conscious attention to detail. The records were not used to review and reduce expenses or to enhance the possibility of generating income. For example, Mrs. McKeever testified that there were no written records that provided per-horse information regarding the cost to maintain the horse but that such information existed in her mind such that she could approximate the cost to maintain a horse. She failed to demonstrate, however, that she actually possessed such information, or that she used it in an effort to achieve an economic profit from the horse activity. The court held that the records did not indicate that the activity was carried on with a profit motive

They also failed to prepare any financial statements, profit and loss projections, budgets, breakeven analyses, or marketing surveys, all of which can be significant financial tools to aid in "cutting expenses, increasing profits,and evaluating the overall performance of the operation."

They claimed they changed their activity to focus on different bloodlines, but the court was not convinced that the changes had a material impact on their horse activity's profitability. The court held that they were unprepared for the economic realities of the horse business.

The farm land had appreciated in value, and this was a positive fact, but the court discounted this fact. The court noted that the appraiser merely rendered a conclusionary opinion and did not provide substantiating facts

The court was influenced by a string of losses over an 11-year period totaling $542,751, in concluding that petitioners did not have a profit motive. Also the court held that there were substantial elements of personal pleasure and recreation. That attachment may explain why petitioners devoted so little effort to culling their herd, improving the quality of their horses, and reducing their operating expenses

What are people to do? A tax opinion letter will be helpful in providing expert guidance to help withstand IRS scrutiny. One of the main features of the tax law is whether you consulted experts. In the above case the taxpayers utilized unpaid advisers as well as trainers, but the court felt that they did not prepare for the economic aspects of the activity by study or consultation with experts.

It is harder for taxpayers to withstand IRS scrutiny today than many years ago, and unless you are making two profit years per seven-year period, it is crucial to seek out guidance in the form of a tax opinion letter

[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 at: (310) 278-0203 or by e-mail at johnalancohan@aol.com.]

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