Losses Incurred in Couple's Miniature Donkey Breeding Activity Are Deductible

(Parker Tax Publishing January 2022)

The Tax Court held that a wealthy couple, who began breeding miniature donkeys as a way of helping to supplement the income of their adult daughter, had an actual and honest objective to make a profit and thus were entitled to deduct the losses incurred that activity. The court concluded that, based on the efforts the couple made with respect to the activity, the couple had reason to believe that the breeding operation, once established, would consistently turn a profit. Huff v. Comm'r, T.C. Memo. 2021-140.

Background

William Huff began working in the accounting department of Eberstadt Asset Management in New York after graduating from high school in 1969. He attended college while working at Eberstadt, ultimately graduating with a degree in accounting, finance, and economics. Huff rose from a position paying $90 per week to a position as vice president, managing two of the biggest funds at the firm. In 1984, Huff left Eberstadt to start his own investment management firm, W.R. Huff Asset Management Co., LLC (Huff Asset Management). As of the end of 2019, Huff had brought in approximately $35 billion of business to Huff Asset Management since its founding.

In 1987, the Huffs purchased 31.35 acres in New Jersey, subject to a conservation easement that permitted most equestrian and agricultural uses. In the late 1990s, the Huffs purchased 7-1/2 acres of adjacent property for their daughter, Jennifer. In 2003, Huff took a detour from the world of high finance and founded Doggy Styles, Inc., a dog grooming business in Chatham, New Jersey. He did so at the behest of Jennifer, who wished to open her own canine salon after having worked at a greyhound rescue, in a veterinarian's office, and as a dog groomer. Huff and his employees advised Jennifer on marketing and bookkeeping. Huff's financial support continued during Doggy Styles' first five or six years of operation. While Jennifer was eventually able to pay rent and make payroll, Doggy Styles' tax reporting nonetheless showed a net operating loss each year from 2009-18.

In 2004, Huff and his wife formed and owned a partnership called Ecotone. According to its operating agreement, Ecotone was organized for, among other things, "agricultural and equestrian or equine purposes including, without limitation, breeding and raising animals." Sometime before 2010, the Huffs began to investigate potential uses for his farmland, consulting with Arthur Papetti, a friend and fellow business magnate whose line of business was eggs. Huff and Papetti discussed, among other possibilities, using the land for solar panels or to raise chickens, turkeys, or pigs. These conversations ultimately settled on miniature donkeys. Papetti, who had extensive experience in the field, enticed Huff with the promise of considerable returns for successfully breeding donkeys with desirable attributes.

Huff's research acquainted him with potential benefits under New Jersey law for the breeding of miniature donkeys. If Ecotone were able to generate $2,500 in annual sales and satisfy certain other requirements, it would be considered a commercial farm under the New Jersey Right to Farm Act (Act), which entitled it to certain right-to-farm protections. The Act protected qualifying farms from restrictive municipal ordinances and public and private nuisance actions.

In mid-2010, the Huffs decided to move forward with breeding miniature donkeys. The driving factor was their concern over the relatively modest earnings of Jennifer. Although Huff assisted his daughter in starting Doggy Styles and had purchased land for her, she was otherwise independent from the Huffs.

Huff believed that he could turn the miniature donkey operation over to Jennifer once the breeding program had been properly established, allowing her to benefit from his sweat equity. He was particularly enamored with this idea given Jennifer's passion for animals and the proximity between their farms. During the years at issue, Jennifer had no familiarity with the miniature donkey breeding operation aside from occasionally caring for the donkeys and a general understanding that the operation would be hers if and when it turned a profit.

Ecotone maintained books and records detailing donkey purchases and sales, veterinarian visits, and costs such as equipment, supplies, maintenance, and services. It had its own bank account and credit card, and it maintained business filings as a separate entity. Ecotone also maintained a registry of miniature donkeys and registered each donkey with the Miniature Donkey Registry. The registries included information about each donkey's age, sex, color, size, and pedigree. Ecotone additionally placed microchips in the miniature donkeys for purposes of identification and tracking lineage.

The prices paid by Ecotone when buying miniature donkeys exceeded by a wide margin the prices Ecotone charged when selling them. Breeding proved tricky and some donkeys of smaller stature were simply uninterested in mating, complicating the breeding process. As time went on, a difference of opinion arose between Papetti and Huff regarding the economics underlying a successful breeding operation. Deaths in Ecotone's herd prompted a variety of responses in the care of the donkeys but the breeding operation nonetheless resulted in net losses on Ecotone's partnership returns for tax years 2010 through 2017.

The IRS disallowed the partnership loss deductions taken on the Huffs' 2013 and 2014 tax returns on the ground that Ecotone was not carrying on a trade or business. According to the IRS, the donkey breeding activity was an activity not engaged in for profit. The IRS determined total deficiencies for 2013 and 2014 of approximately $57,000 as well as accuracy-related penalties under Code Sec. 6662(a) of approximately $11,500. The IRS suggested that the Huffs' breeding operation was related to obtaining a "farmland" property tax assessment for the land which carries with it state property tax benefits. The IRS also suggested that the Huffs engaged in the miniature donkey breeding activity to qualify their property for "commercial farm" status under the Act.

Determining Whether An Activity Is Engaged in for Profit

In general, Code Sec. 183 provides that a taxpayer may not deduct expenses associated with activities not engaged in for profit, such as activities carried on primarily as a sport or hobby or for recreation. An activity can overcome the limitation set forth in Code Sec. 183 if it is an activity entered into with the dominant hope and intent of realizing a profit. While breeding and raising equines may be an activity entered into for profit, a majority of Tax Court decisions against taxpayers in this area have involved cases in which breeding horses does not reflect a legitimate profit-making purpose. When the IRS determines that a taxpayer's activity is not engaged in for profit, the taxpayer has the burden of proving that determination incorrect.

Analysis

The Tax Court held that the Huffs met their burden of proving that they operated their miniature donkey breeding activity as a for-profit activity. Thus, they were thus entitled to deduct the losses incurred in the activity. Based primarily on Huff's testimony and his investment background, the court was convinced that the Huffs believed that the breeding operation, once established, would consistently turn a profit, and thereby supplement Jennifer's income. The court noted that the Huffs pursued this profit objective with an approach similar to what they had brought to bear with respect to other successful investments. Despite their failure to achieve similar success, the court was persuaded that in 2013 and 2014 the Huffs, through Ecotone, pursued the breeding operation with the primary purpose and intent of making a profit within the meaning of Code Sec. 183.

The court was further persuaded that during 2013 and 2014, the Huffs continued to believe that they were close to turning a corner, as Huff had experienced many times before. The Huffs' financial wherewithal allowed them to stay the course, the court noted, but it did not alter the end goal of profit. Nor did the court view the Huffs' upfront investment - made possible by their extreme wealth - inconsistent with the pursuit of profit. The court was convinced that, at the start of the business, the Huffs could reasonably conclude that Papetti's plan would allow them to quickly assemble a herd and begin recouping their initial and ongoing expenses on the basis of the annual breeding of all of the herd's female donkeys.

The court rejected the IRS's argument about the Huffs interest in the commercial farm benefits it could obtain under the Act by having a breeding activity. The court noted that Ecotone is bordered by a national park and Jennifer's land, and the Huffs moved from the farm in 2013 or 2014. It did not believe that the commercial farm benefits (such as protection from nuisance suits) would supply sufficient motivation to the Huffs to spend the time and money to launch a miniature donkey breeding enterprise.

The court also noted that there was an absence of personal pleasure or recreation relating to the donkey breeding activity. The court found convincing Huff's testimony that he derived "zero personal pleasure" from the donkeys and that he found them "quite ugly" and that they looked like a "gigantic hairball." Huff also pointed out that, unlike horses, miniature donkeys could not make up for the hard work with the joys of the saddle. Jennifer echoed this point, explaining that her dad was not "the cuddly animal type." Finding Huff's cool personal feelings toward the miniature donkeys believable, the court concluded that this factor also favored the Huffs.

For a discussion of the tax rules relating to "hobby loss" deductions, see Parker Tax ¶97,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com