7th Circuit Court of Appeals Reverses Tax Court Decision

TBracehorse-cohanAn appeals court reversed the Tax Court’s decision in a Thoroughbred owner/trainer’s case. • Courtesy of John Alan CohanIn a remarkable decision, the 7th Circuit Court of Appeals reversed a Tax Court opinion dealing with a Thoroughbred racehorse owner’s activities. The case, Roberts v. Commissioner, concluded that the taxpayer’s horse racing activities were entered into for profit. The Court characterized the Tax Court decision as untenable, in that it in effect concluded that a business’s start-up costs were not deductible business expenses and that every business starts as a hobby and becomes a business only when it achieves a certain level of profitability. The 7th Circuit opinion was an embarrassment not only for the Internal Revenue Service (IRS), but for the Tax Court judge in the case, Judge Elizabeth C. Paris.

The taxpayer, Merrill Roberts, was a successful owner and operator of restaurants, bars and nightclubs in Indianapolis. In the 1990s, he began withdrawing from the business, becoming a consultant instead, and learned about the financial aspects of the horseracing business.  In 1999, he bought two horses for $1,000 each, and in the first year netted $18,000 in purses. He built a horse track on a farm and increased his stock of racehorses to 10, plus a breeding stallion. In addition, Roberts passed the state’s trainer’s test and obtained his license to train racehorses.

In 2005, Roberts acquired a larger property and invested in improvements for the training of racehorses. He trained the horses himself. He lobbied the Indiana legislature on behalf of horse racing, pushing for legislation to permit slot machines at racetracks, which ended up being enacted. He took on leadership roles in two professional horseracing associations.

Roberts spent upwards of 12 hours per day working with the horses on race days and about eight hours a day on other days.

During the years at issue, Roberts’ expenses significantly exceeded his earnings. The Tax Court held that Roberts’ activity was a hobby in 2005 and 2006, but that it became a bona fide business in 2007. Accordingly, the Tax Court held that Mr. Roberts’ business expense deductions for 2005 and 2006 were denied.

The 7th Circuit reversed the ruling and said that the activity evolved from his decision in 2005 to build a larger training facility, and to make substantial improvements to the property: “The Tax Court’s finding that his land purchase and improvements were irrelevant to the issue or profit motive until he began using the new facilities is unsupported and an offense to common sense.”

The 7th Circuit added, “The judge seems not to have understood that the decision to build the facility, and its construction, are also indications of a profit motive.”

The 7th Circuit found the Tax Court’s opinion confusing and contradictory. The 7th Circuit characterized the IRS regulations on the horse industry as “goofy,” and commented that the Tax Court would be better off if, rather than “wading through” the factors in the IRS Regulations, that before deciding, “the court must listen to the owner’s protestations of business motive.”

Most of the hobby loss cases that end up in Tax Court involve losses of large sums of money year after year that the taxpayer deducts from other conventional sources of income. Sometimes the Tax Court will fail to properly evaluate the taxpayer’s genuine intention to be engaged in an activity for profit. In some instances, the taxpayer fails to introduce evidence of significant changes in operation, adoption of new techniques or abandonment of unprofitable methods.

It is extremely rare for a hobby loss case to be appealed to the Circuit Court of Appeals, which rarely reverses the Tax Court. It is not only an expensive undertaking, but also takes a long time. The Tax Court handed down the Roberts decision in April 2014 and the 7th Circuit issued its ruling in April 2016, two years later.

John Alan Cohan is an attorney representing people in federal and state tax disputes, IRS appeals, and Tax Court litigation, and is a long-standing author of a legal advice column published in numerous sporting magazines. In addition, he advises organizations on compliance with newly enacted laws and regulations. Cohan is also author of the book, Turn Your Hobby Into A Business — The Right Way. He can be contacted at 310-278-0203, [email protected] or johnalancohan.com.