Estate of Stuller v. United States: Lessons for all businesses from a hobby loss case

At first glance, Estate of Stuller v. United States, No. 14-1545, Case No. 3:11-CV-3080-RM-TSH (Jan. 26, 2016), looks like a standard hobby loss case. In short, the Seventh Circuit affirmed the District Court’s ruling that, based upon the application of the nine factors established in section 1.183-2(b), a horse-breeding farm was not an activity engaged in for profit. A closer reading of the case, however, uncovers some important insight regarding the need to consult with experts and who qualifies as such.

The petitioners operated a horse-breeding farm from 1994 through 2009. In all but one year during that period, the farm reported significant losses that ranged from $130,000 to $190,000. Upon exam, the IRS determined the horse-breeding farm was not an activity engaged in for profit and, therefore, disallowed the farm’s losses. The Seventh Circuit affirmed the District Court’s holding that eight of the nine factors indicated the farm did not operate with a profit motive. For instance, the petitioners did not maintain records, the farm failed to change its operations despite years of losses, and the petitioners derived great pleasure from horse breeding. The only factor that implied a profit motive was the reasonable expectation the land on which the farm was located would appreciate in value. In totality, the factors suggested the petitioners had no profit motive.

The petitioners appealed to the Seventh Circuit, in part, because the District Court excluded certain testimony from the farm’s horse trainer. More specifically, the District Court granted the government’s motion to preclude the horse trainer’s testimony regarding whether the horse-breeding farm was operated with a profit motive. The Seventh Circuit agreed with the District Court that the horse trainer was not an expert on how to run a horse-breeding business. The horse trainer had no knowledge of the farm’s finances and had never attempted to breed or race horses for profit. The Seventh Circuit referred to the horse trainer as “at most a lay witness to the operations of the farm.” For these reasons, the horse trainer’s expert testimony was limited to items such as the hard work required to breed and train horses and he could not opine on the petitioners’ profit motive.

The determination of whether an activity is operated with a profit motive is subjective. Taxpayers who operate a business that could be recharacterized as a hobby should be mindful of the nine factors established in section 1.183-2(b). For instance, taxpayers should maintain records in a business-like manner, adopt a formal business plan, and review that plan at least annually. Estate of Stuller stands for the proposition that taxpayers should also consider consultation with individuals who have experience operating a similar business. Had the petitioners in Estate of Stuller consulted with professionals with knowledge of the section 183 requirements, the farm’s losses may have been sustained at exam or IRS Appeals. Once again, we see that taxpayers who desire to enter high-risk activities, such as horse breeding or auto racing, must consult with business as well as industry experts.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

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