Losses from Taxpayer's Cutting Horse Activity Deductible Despite Long History of Unprofitability

(Parker Tax Publishing December 2019)

The Tax Court held that a taxpayer was entitled to deduct losses from his cutting horse activity against income he realized from a seed business because the taxpayer operated the cutting horse activity for profit even though the activity generated losses for every year since 1997. However, the court also concluded that the taxpayer failed to meet his burden of establishing the existence and amount of certain NOL carryforward deductions but held that he was not liable for penalties assessed by the IRS because he established that he acted with reasonable cause and in good faith and reasonably relied on his CPA to prepare his returns. Den Besten v. Comm'r, T.C. Memo. 2019-154.

Lowell Den Besten started in the seed business with his father in 1964. In 2002, he sold the original seed business, which was operating as a C corporation, to his son for $4,283,000 in a corporate stock sale 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, which he began in 1997. However, his son did not succeed in the seed business and defaulted on the installment payments. In 2005, Den Besten returned to the seed business in an attempt to salvage what was left of it. However, instead of operating it as a C corporation, he operated it as a new limited liability company. For years 2006 - 2010, Den Besten 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 he 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.

In addition, over the years, Den Besten achieved national success as a cutting horse competitor. He competed in nonprofessional or amateur classes and earned winnings totaling over $50,000 from 1999 to 2006. In 1997, Den Besten's horse, Rosie O Llama, was named the American Quarter Horse Association (AQHA) World Champion Cutting Horse with earnings totaling over $22,000 as of 2001. Rosie O Llama was a proven sire of champion horses such as Rosies Ark, which won over $45,000 on the amateur circuit. In 1998, Den Besten repeated his success with another AQHA world champion cutting stallion named Si Olena with earnings of $100,000 as of 2000. Si Olena was second generation from a cutting horse dynasty by Doc O'Lena, whose collective progeny had won millions in prize earnings.

Den Besten, along with his daughter, traveled to and participated in approximately 12 competitions per year throughout seven states in the upper Midwest. Following his national success in 1997, Den Besten began to expand his operation. He purchased and remodeled an existing professional facility, the Yellow Rose, which included a 350 x 100 foot arena with a cafe and bar. The facility added 100 horse stalls to Den Besten's existing 20 stalls and he hosted regional cutting horse competitions and sales at the facility. People would travel from all over to purchase cutting horses or compete at the arena. The Yellow Rose was home to the Dakota Classic Cutting Futurity, a cutting horse event similar to what a Triple Crown race is to thoroughbred racing, as well as to six to eight other cutting horse competitions in a given year.

Income from winnings, breeding fees, shows, and arena fees increased from $4,000 in 1996 to an average of approximately $129,000 from 1999 to 2004. However, Den Besten's cutting horse expansion was cut short by the untimely death of his world champion Si Olena and his return to the floundering seed business in 2005. Den Besten 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, he began to scale back the cutting horse activity. While he continued to own, breed, and train horses and compete in cutting horse competitions, Den Besten significantly reduced the operation. At one time, he 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, Den Besten owned approximately 10 horses, and by 2016 he had seven or fewer horses. Among Den Besten's current remaining horses was a champion-bred promising young stallion in training, and Den Besten had high hopes for the horse. Despite Den Besten's nationally recognized cutting horse activity, he reported a loss for every tax year since 1997.

For the years at issue, 2006 - 2010, Den Besten reported Schedule F losses of $93,043, $97,456, $86,730, $73,867, and $56,709, respectively. He also reported various net operating loss (NOL) carryovers for those years. In 2015, the IRS issued Den Besten a notice of deficiency after determining deficiencies in federal income tax and accuracy-related penalties under Code Sec. 6662(a) for 2006, 2007, 2008, 2009, and 2010. According to the IRS, Den Besten did not have a profit motive in operating the cutting horse activity and thus could not deduct the losses from that activity.

After examining all the factors in the Code Sec. 183 regulations that are considered in determining whether a taxpayer is operating an activity for profit, the Tax Court found that six factors favored Den Besten's having a profit objective, one factor was neutral, and two factors favored the IRS. The court said that the two factors that favored the IRS did not outweigh the factors that favored Den Besten having a profit objective. Rather, the court said, Den Besten's actions, coupled with his sincere and credible testimony as to his business goals, overwhelmingly supported his claim that he had a bona fide profit objective. Accordingly, the Tax Court concluded that Den Besten engaged in the cutting horse activity with a profit objective during the years in issue and could deduct the losses from that activity against the income from his seed business.

However, the court also concluded that Den Besten did not meet his burden of establishing both the existence and the amounts of the NOL carryforwards and, thus, those deductions were not allowed.

Finally, the court held that Den Besten was not liable for penalties assessed by the IRS because he established that he acted with reasonable cause and in good faith and reasonably relied on his CPA to prepare his returns. The court noted that Den Besten's accountant was a CPA with 30 years of experience who had prepared Den Besten's returns since the beginning of the horse cutting activity and Den Besten had provided the CPA with all the necessary records he used to keep track of his income and expenses.

For a discussion of the factors which determine whether or not an activity is engaged in for profit, see Parker Tax ¶97,505.

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.

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