The U.S. Tax Court is a critically important institution. It is the most common forum in which taxpayers litigate federal tax disputes. The court frequently decides IRS assertions that the taxpayer understated the correct tax liability, resulting in a tax “deficiency.”
Many commentators argue that Tax Court judges are biased in favor of the IRS.
One judge, L. Paige Marvel, has been harsh with respect to the horse industry. In a recent case, Marvel came down hard on a taxpayer’s efforts to run his horse racing venture profitably.
The taxpayer, Jerald Carmody, has owned race horses for more than 20 years, mainly as co-owner with others, and worked full-time as a sales representative.
He owned lower priced horses, which were actively raced in Washington state. Professional trainers were employed. He spent time every day on his horse racing activity, researched horses that would be in competition, and searched for other horses to purchase.
He purchased and improved a 5-acre property with a 4,000 square-foot barn, horse stalls, a 5,000-square-foot arena, indoor horse shelters and nine pastures. He personally cleaned stalls and pastures.
Some of the horses won several races, and one was the all-time race winner at Emerald Downs with 21 wins. Carmody was named Owner of the Year at Emerald Downs. The races entered ranged in purses from $8,000 to $50,000.
During a 10-year period, the taxpayer’s losses were from $16,064 to $81,345, with no profit years. But there was income in each year, ranging from $17,917 to $128,068.
When horses were retired from racing, they were sold or given away. Of 36 horses sold, there was a net gain on only eight of those sales.
Carmody had a horse racing bank account, but paid expenses out of his personal account, as well as the racing account and he kept a folder for each horse with various receipts and documents.
Marvel said Carmody did not use his records to reduce losses or to achieve profitability. The court noted that Carmody had no written business plan, no budgets and no economic forecasts. The court also faulted Carmody for commingling his finances.
The court noted that Carmody realized no profits in a 20-year period and that “he contends he suffered losses because he reinvested his gross receipts back into the horse racing activity and that he used his gross receipts to improve his barns, arena, and other horse racing activity property. Petitioner’s contentions are woefully insufficient to justify or even explain an unbroken string of over 20 years of substantial losses.”
The court concluded that the petitioner did not engage in his horse racing activity with the predominant, primary or principal objective of making a profit.
The only silver lining in this case is that the judge rejected the IRS’ accuracy-related penalties because the taxpayer had reasonably relied on his accountant’s advice in taking the deductions.
One of the important lessons in this case is that taxpayers need to somehow review records so as to reduce expenses or enhance the possibility of generating income. It is important to keep track of expenses on a per-animal basis. And it is important to prepare financial statements, profit and loss projections, budgets, break-even analyses, or marketing surveys, as the IRS considers these to be significant financial tools to aid in evaluating the overall performance of an operation.
