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Third Circuit Finds Horse Farm with History of Losses Wasn't Operated for Profit

(Parker Tax Publishing March 2023)

The Third Circuit affirmed the Tax Court's judgment that a horse farm that had a history of large losses was not engaged in for profit under Code Sec. 183 and therefore, the owners were not entitled deduct the losses. The court found that, while the Tax Court could have weighed the evidence differently, there was no clear error in the Tax Court's overall application of the nine-factor test in Reg. Sec. 1.183-2(b) in concluding that the horse farm activity was not engaged in for profit. Skolnick v. Comm'r, 2023 PTC 48 (3d Cir. 2023).


Mitchel Skolnick and Eric Freeman owned the Bluestone Farms, LLC (Bluestone), a horse farm in New Jersey. They bought, sold, bred, and raced Standardbred horses. Bluestone lost more than $3.5 million during 2010-2013, the years at issue, and more than $11.4 million between 1998 and 2013.

Mitchel and Eric started Bluestone in 1998, after creating a business plan and a budget. They crafted a second business plan in 2000, hoping to supplement the farm's income by winning horse races and breeder's awards. In 2001, Bluestone received $325,000 from a passive investor, Frank Russo, in exchange for a 15 percent interest. In 2003, Bluestone sold a conservation easement for $869,640. The same year, Mitchel and Eric developed a third business plan. They wrote a fourth (and final) business plan in 2004. Soon after, Mitchel began receiving millions of dollars from an irrevocable trust his parents created. By 2009, Mitchel had received about $10 million from his parents' trust.

During the years at issue, between 15 and 25 horses lived at Bluestone at any given time. Other horses were boarded at out-of-state farms. Bluestone employed 7-10 employees who assisted with the horses and organized the company's records. Over the years, Mitchel and Eric increasingly focused on winning studs. Bluestone owned a 35 percent interest in a successful stallion, Always A Virgin, stabled in Indiana. In 2013, Bluestone paid $50,000 for an interest in a horse sired by Always A Virgin called Always B Miki. Always B Miki earned purses totaling $2.7 million from racing and generated substantial stud fees. In 2016, Bluestone sold interests in Always B Miki for nearly $1.2 million, enabling it to report a modest overall profit in that year.

Bluestone responded to changes in the horse market during the years at issue. New Jersey stopped subsidies to racetracks and decreased the purse structures for breeder's awards. Meanwhile, Pennsylvania had tightened its requirements for awards by requiring breeders to locate mares in Pennsylvania for part of the year. So Bluestone continued its previous partnership with a Kentucky operation, Cane Run Farm, to board horses outside Kentucky, including in Pennsylvania, to capitalize on breeder's awards.

Bluestone paid for many of Mitchel's personal expenses. Mitchel moved to Bluestone in 2008 after he separated from his first wife. His eventual second wife, Brianna, began staying with him around 2009. Beginning in 2010, and for the rest of the years at issue, Mitchel and Brianna lived together rent-free in a renovated farmhouse at Bluestone. The company paid to tear down and rebuild the farmhouse. By 2011, Brianna had a company credit card that she sometimes used for personal expenses. Bluestone also paid for Brianna to keep her horses at the farm. Bluestone also paid expenses, including extensive landscaping, for Mitchel's wedding to Brianna in 2013.

On Mitchel's tax returns for 2010-2013, he claimed losses from Bluestone substantial enough to eliminate any income liability for those years. Eric also claimed losses and reported owning little or no taxes. In 2016, the IRS sent notices of deficiency to Mitchel and Eric, who challenged the notices in the Tax Court. In T.C. Memo. 2021-139, the Tax Court held that Bluestone was not engaged in for profit within the meaning of Code Sec. 183, and therefore the IRS properly disallowed the losses. Mitchel and Eric appealed to the Third Circuit.

Code Sec. 183(a) generally provides that if an activity is not engaged in for profit, no deduction attributable to such activity is allowed. Reg. Sec. 1.183-2(b) lists nine non-exclusive factors to consider in determining whether an activity is engaged in for profit. They are: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.

The Tax Court considered the nine factors in Reg. Sec. 1.183-2(b) and determined that five of them - 1, 6, 7, 8, and 9 - favored the IRS, while the other four were either neutral or favor Mitchel and Eric. Factor 6, Bluestone's history of income and losses, was by far the most important to the Tax Court's analysis, and the Tax Court found that factor weighed heavily against the taxpayers.

On appeal, Mitchel and Eric disputed the Tax Court's analysis of every factor. With regard to factor 6, they pointed to Bluestone's profits after the years at issue, emphasizing the success of Always A Virgin. They also cited adverse events beyond their control, such as the 2008 financial crisis, for the company's lack of profits. With respect to factor 1 (the manner in which they operated Bluestone), Mitchel and Eric contended that the Tax Court erroneously substituted its own business judgment in evaluating how they responded to losses. As for factor 7 (the amount of occasional profits), the taxpayers asserted that the Tax Court overlooked relevant evidence and applied the wrong legal standard when it found that they did not entertain a "reasonable" belief that the success of a few horses would make Bluestone profitable overall.


The Third Circuit affirmed the Tax Court's judgment that Bluestone's horse farm activity was not engaged in for profit under Code Sec. 183. While the Third Circuit found that the Tax Court could have weighed some of the factors in Reg. Sec. 1.183-2(a) differently, the court concluded that the taxpayers failed to establish reversible error on the part of the Tax Court.

With regard to factor 6, Bluestone's history of income and losses, the Third Circuit noted that the company lost more than $11.4 million between 1998 and 2013 and the losses continued essentially unabated after the typical 5-10 year startup phase for horse farms. The Third Circuit also agreed with the Tax Court's finding that Bluestone's profits earned after the years at issue occurred after the IRS selected Mitchel and Eric's returns for audit, and therefore the taxpayers were motivated to generate a profit. Adverse external events did not excuse the company's lack of profitability, in the court's view, considering that its losses during the financial crisis were barely greater than its losses in later years when the economy was recovering.

The Third Circuit agreed with the Tax Court that factor 1, the way the taxpayers operated their horse activity, favored the IRS. The court noted that Bluestone paid for many of Mitchel and Brianna's personal expenses and said that piling theses costs onto Bluestone was inconsistent with claims that the company operated with a profit motive. The Third Circuit observed that the Tax Court made a slight misstep by failing to take into account Bluestone's changing operating methods in response to changes in breeder's award requirements, including partnering with Cane Run and boarding their horses in other states. However, the court said these actions were minor cost-saving measures that were not quite the "abandonment of unprofitable methods" contemplated by Reg. Sec. 1.183-2(b)(1).

The Third Circuit found that Mitchel and Eric raised some persuasive challenges to the Tax Court's analysis of factor 7, the amount of occasional profits. The court remarked that Frank Russo's purchase of a 15 percent interest in the company for $325,000 in 2001, although not generating an overall profit, could have been cited by the Tax Court as evidence that the company was a business. The court also noted that Bluestone sold a conservation easement and earned a profit from the sale of Always B Miki. However, the Third Circuit found that these findings would not have tipped the balance in favor of the taxpayers, since the income from these transactions was appreciably less than Bluestone's consistent losses, which often exceeded $1 million a year.

The Third Circuit also agreed with Mitchel and Eric that the Tax Court applied the wrong legal standard for factor 7 when it found that they did not entertain a reasonable belief that the outsized success of a few horses would make Bluestone profitable overall. The Third Circuit explained that under Reg. Sec. 1.183-2(a), a reasonable expectation of profit is not required; rather, the applicable standard is whether the taxpayers engaged in the activity with the objective of making a profit. The court observed that the statute bars deductibility of losses emanating from activities not engaged in for profit, not activities lacking an expectation of profit. However, the Third Circuit also noted that the Tax Court placed little emphasis on this factor.

For a discussion of determining 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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