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Treas. Reg. § 1.183(2)(b) lists some of the relevant factors to be considered in determining whether an activity is engaged in for profit. These factors include: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisers; (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 loss with respect to the activity; (7) the amount of occasional profit, if any, which is earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. The issue is one of fact to be resolved not on the basis of any one factor but on the basis of all the facts and circumstances. Treas. Reg. § 1.183-2(b). Greater weight is to be given to objective facts than to petitioners' mere statement of their intent.
At the time of filing their petition, petitioners Theodore N. and Adeline M. Engdahl were residents of Santa Clara County, Calif. Dr. Engdahl has been a practicing orthodontist since 1946. Net income from his practice for 1971, 1972, and 1973 was $ 88,661.14, $ 87,296.46, and $ 81,766, respectively. Petitioners have no substantial income other than Dr. Engdahl's orthodontic practice. At the time of trial, Dr. Engdahl was 62 years old and his wife was 63. Petitioners have four children -- one son and three daughters. Petitioners became involved with saddle-bred horses in 1951 when their oldest daughter started riding lessons. Subsequently, petitioners purchased several saddle horses which were shown by their daughter at various horse shows in California. Petitioners boarded their horses at a stable and hired a professional trainer to train the horses. In 1964, petitioners realized that Dr. Engdahl's retirement from his orthodontic practice was imminent, and began considering what business they might enter to supplement Dr. Engdahl's retirement income. Petitioners consulted with their trainer, their two veterinarians, and other people in the horse-breeding business as to the possibility of setting up a horse-breeding operation. The veterinarians were of the opinion that the future looked very promising locally for breeding, raising, and showing American saddle-bred horses. Petitioners decided in 1964 to establish a horse-breeding operation, and began with four horses. At that time, petitioners did not own facilities for keeping horses on their own property, so they boarded the horses and had them trained off their premises. In order to make their operation more profitable, petitioners were advised to purchase a ranch on which they could board their horses. After searching for a year, petitioners located suitable property (the ranch) in Morgan Hill, Calif. They purchased the property in 1967, and have conducted their horse-breeding activities there since. Their residence occupies approximately one-fifth of the 2 1/2-acre ranch. The remainder is used for the horse operation. Upon purchase of the ranch, petitioners constructed a 7-stall stable (convertible to 12 stalls), a tack room capable of storing 7 to 8 tons of hay, five fenced pastures, and a holding corral. In addition, petitioners planted the pasture and installed an irrigation system for the pasture land. The installation of the irrigation system, much of the fencing, and a two-stall addition to the barn were constructed by petitioners. From 1964 through 1973, petitioners registered 10 purebred American saddle-bred horses with the American Saddle Bred Registry in Louisville, Ky. In 1973, petitioners had nine horses. Of these, two mares and a stallion were purchased, while five mares and a stallion were foaled by petitioners' brood mares (two of which were sired by stallions owned by others, and four were sired by petitioners' own stallions). Together, petitioners spend an average of 35 to 55 hours per week caring for the horses and maintaining the improvements on the ranch. Petitioners employ high school students part-time to help with the heavy work around the barn. Neither petitioner rides horses. Both petitioners view their efforts in connection with the horse operation as jobs which have to be done; neither petitioner has any affection for the horses themselves.
At all times since 1964, petitioners maintained books and records of their horse operation following procedures suggested by their certified public accountant. Petitioners maintained one checking account from which checks for personal use, Dr. Engdahl's orthodontic practice, and the horse operation were drawn. The allocation of each check to one of the above three purposes was noted on the check stub; expenses were subsequently distributed to accounts on separate ledgers maintained for the orthodontic practice and the horse operation. Income from the horse operation was deposited in a savings account separate from other personal savings accounts maintained by petitioners. Petitioners' accountant reviewed petitioners' recordkeeping and summarized the books quarterly. At the end of each year, the accountant prepared a summary recapitulation of the horse operation showing expenses broken down by item for each month. This enabled petitioners to keep track of monthly variations in their expenditures. Dr. Engdahl and the accountant then discussed the summary sheet, reviewing what petitioners spent during the year for training, feed, horse shows, veterinary costs, etc. Petitioners' accountant was of the opinion that this bookkeeping system was appropriate for petitioners' operation. Petitioners’ business showed high operating losses and minimal gain from 1964 through 1975. Petitioners attribute their unprofitability to a combination of adverse factors beyond their control, such as increase in maintenance costs, sickness and death of horses, low demand, and failure in training. As of December 31, 1977, the fair market value of the Morgan Hill ranch, including improvements, was approximately $ 225,000; petitioners' cost was $ 83,146. In addition, petitioners' remaining four horses had appreciated in value by approximately $ 18,750. On their income tax returns, petitioners deducted losses of $ 17,617.52 in 1971, $ 17,009.94 in 1972, and $ 18,526 in 1973 resulting from their horse-breeding operation. Petitioners claimed investment tax credits attributable to their horse operation of $ 12.13 in 1971, $ 190.98 in 1972, and $ 24.13 in 1973. In his notice of deficiency, the Commissioner of Internal Revenue disallowed these losses and the claimed investment tax credits based on his conclusion that petitioners' horse operation was an activity not engaged in for profit.
Are petitioners’ American saddle-bred horse operation was an activity not engaged in for profit within the meaning of Section 183(a)?
What is relevant is whether petitioners maintained complete and accurate books and records, whether the activity was conducted in a manner substantially similar to other comparable businesses which are profitable, and whether changes were attempted in order to improve profitability. In this case, petitioners kept complete records of their horse operation. Although petitioners maintained one checking account for their horse operation, Dr. Engdahl's orthodontic practice, and their personal use, the horse activity expenses were posted to a separate ledger maintained solely for the horse operation. Receipts from horse breeding and sales were deposited in a savings account separate from other personal savings accounts maintained by petitioners. Petitioners' certified public accountant reviewed this recordkeeping and summarized the books quarterly. At the end of each year, petitioners' accountant prepared a summary recapitulation showing expenses broken down by items for each month which enabled Dr. Engdahl to keep track of monthly variations in expenses. Together, Dr. Engdahl and his accountant reviewed the summary sheets. It was the accountant's opinion that this accounting procedure was suitable for petitioners' operation.
Petitioners advertised their operation by exhibiting their horses at shows, advertising in horse show programs, newspapers, and a horsemen's magazine, and by word of mouth. Petitioners advertised their horses both for sale and breeding. Petitioners' horses participated in 10 shows during the years in issue; petitioners relied on their professional trainer to show a horse after the horse's training was complete. While petitioners' reliance on their trainer may have been misplaced, these facts do not indicate a lack of dedicated intent to make a profit.
Moreover, the record demonstrates that petitioners made changes in their operating methods in an effort to increase profitability. After boarding their horses for 3 years, petitioners purchased the Morgan Hill ranch to reduce expenses. Petitioners disposed of horses that did not meet petitioners' show or breeding expectations. In an attempt to upgrade the quality of their stock, petitioners bred their mares to champion stallions owned by others and in 1965 bought a mare for $ 6,500. When petitioners became aware that their trainer was not using his best efforts to breed or show their horses, they brought the horses with which he was working back to the Morgan Hill ranch. Because petitioners could not afford to invest in the most expensive horses, they attempted to diversify by purchasing horses on speculation for resale. In light of these facts, it is clear that petitioners' manner of operation indicates an intent to make a profit.