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You win some, you lose some

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The Tax Court recently denied a deduction claimed by legendary pro football linebacker Bill Romanowski. But the court exercised its “booth review” and overturned the “call on the field” by refusing to uphold an accuracy-related penalty flag dropped by the IRS. 

In 2003, Romanowski invested $13 million in a horse-breeding business. The program involved leasing mares from a company called ClassicStar, which in turn would provide boarding and care for the mares and breed the mares to stallions. Any foals produced from the breeding would belong to Romanowski. 

Despite the fact that ClassicStar had promised Romanowski 68 pairings of thoroughbreds, more than 90 percent of the pairings involved quarter horses. Regardless, Romanowski chose to continue with the program, explaining to the court that he had reached an oral agreement from ClassicStar under which it would substitute an unknown number of thoroughbred pairings for the quarter horse pairings.

Romanowski received an income and expense summary for 2003 from ClassicStar that showed no income and total expenses of $13,092,732. The resulting loss offset his 2003 income, and he carried back net operating losses to 1998, 1999, 2000, 2001 and 2002, resulting in a federal tax refund of nearly $4 million. The IRS denied the loss, arguing that Romanowski did not enter into the horse-breeding activity for profit. 

The regulations under Internal Revenue Code Section 183 (the so-called hobby loss rules) provide nine factors that, if answered in the affirmative, are indicative of a for-profit business:

1. The manner in which the taxpayer carries on the activity. Does he complete accurate books? Were records used to improve performance?

2. The expertise of the taxpayer or his advisers. Did the taxpayer study the activity’s business practices? Did he consult with experts?

3. The time and effort expended by the taxpayer in carrying on the activity. Does he devote much of his personal time and effort?

4. The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?

5. The success of the taxpayer in carrying on similar or dissimilar activities. Has he converted other activities from unprofitable to profitable?

6. The taxpayer’s history of income or losses with respect to the activity. Has the taxpayer become profitable in a reasonable amount of time?

7. The amount of occasional profits. Even a single year of profits can indicate that an activity is not a hobby.

8. The financial status of the taxpayer. Does the taxpayer have other income sources being offset by the losses from the activity?

9. Does the activity lack elements of personal pleasure or recreation? If the activity has large personal elements, it is indicative of a hobby.

The Tax Court analyzed these factors and concluded that Romanowski did not enter into the breeding arrangement with the intent to make a profit (William T. Romanowski and Julie I. Romanowski v. Commissioner, T.C. Memo 2013-55, Feb. 20, 2013):

  • Romanowski kept no records. Rather, he relied on ClassicStar to do everything.
  • He neglected to fight for the bargained-for number of thoroughbreds, which caused the court to conclude that he was not carrying on the activity in a businesslike manner.
  • He never consulted with industry experts.
  • He used the resulting $13 million loss to wipe out all current-year income and generate a $4 million tax refund. 

One interesting aspect of the case was the court’s handling of the 20 percent accuracy-related penalty. The penalty does not apply if taxpayers establish that they (1) had reasonable cause and (2) acted in good faith. 

The Supreme Court has stated that it is reasonable to rely on the advice of an accountant or attorney on a matter of tax law. In this case, Romanowski’s tax lawyer had a conflict of interest, which was disclosed. However, the court felt that Romanowski’s mere awareness that the lawyer received a financial benefit from his participation in the program was “not sufficient to show that [Romanowski] could not rely on him in good faith.” 

The court was also impressed that the tax lawyer had Romanowski hire an independent CPA who:

  • Had a master’s in tax law
  • Was familiar with the rules for claiming net operating losses from farming activities
  • Had no prior relationship with the tax lawyer
  • Discussed ClassicStar with another accountant in his firm who was familiar with it
  • Told Romanowski that the ClassicStar-related expenses were tax-deductible