                        T.C. Memo. 1996-499



                      UNITED STATES TAX COURT


         LEE W. YATES AND WENDY S. YATES, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3121-95.                    Filed November 6, 1996.



     Bruce J. Berger, for petitioner.

     Andrew P. Crousore, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION



     PANUTHOS, Chief Special Trial Judge:     This case was heard

pursuant to the provisions of section 7443A(b)(3) and Rules 180,

181, and 182.1   Respondent determined deficiencies in


     1
        All section references are to the Internal Revenue Code
as amended, unless otherwise indicated. All Rule references are
to the Tax Court Rules of Practice and Procedure.
                                  - 2 -

petitioners' Federal income taxes, as well as accuracy-related

penalties, in the following amounts:

                                                Accuracy-Related Penalty
   Year              Deficiency                      Sec. 6662(a)

   1991                $6,098                            $1,220
   1992                 6,794                             1,359


     The issues for decision are:      (1) Whether petitioners'

horse-breeding activities constitute an activity engaged in for

profit for the purposes of sections 162 and 183; and (2) whether

petitioners are liable for the accuracy-related penalty under

section 6662(a).

                             FINDINGS OF FACT

     Some of the facts have been stipulated, and they are so

found.    The stipulation of facts and the attached exhibits are

incorporated herein by this reference.       At the time of filing the

petition, petitioners resided in Clovis, California.

     During the years in issue, petitioners were each employed

full time as registered nurse supervisors.          Since 1991,

petitioners also operated a medical/legal consulting firm.         The

firm reviewed medical charts upon request.          Petitioners reported

combined gross income from this employment during the period 1991

through 1994 in the following amounts:

                      Year                 Amount

                      1991                $105,992
                      1992                 133,572
                      1993                 138,042
                      1994                 145,475
                                - 3 -


Petitioners also reported consulting income on line 23 of Forms

1040 for 1991 and 1992 in the amounts of $2,481 and $1,162.

     In 1985, petitioners bought a horse as a gift for their

daughter.    Prior to purchasing the horse, petitioners attended a

6- to 8-week course on equine care and maintenance.      While

attending the class, they met Dr. Keith Lane, who introduced

petitioners to the Paso Fino, a breed of horse possessing a

smooth gait and agreeable disposition.

     In 1988, petitioners decided to breed Paso Fino horses and

commenced operating the Silk Oak Paso Fino Ranch (Silk Oak).

Petitioners established Silk Oak on 4.84 acres of property where

their personal residence was located.      Petitioners had acquired

the land for $47,500 in 1985 and constructed a residence at a

cost of $113,000 in the same year.      The parties agree that, at

the time of trial, the fair market value of the property was

$295,000.2

     Before beginning the operation of Silk Oak, petitioners met

with several successful breeders of Paso Fino horses, who

convinced petitioners that they could profitably run a Paso Fino

ranch.   Petitioners were advised on such topics as basic horse

care, showing, advertising, cost control, and breeding.



     2
        Cliff Hathaway, an appraiser hired by petitioners,
determined the value of the property by comparing the sale prices
of similar personal residences recently sold in the area.
                                  - 4 -

Petitioners also met with an accountant, who assisted petitioners

in setting up a bookkeeping system and separate checking

accounts.    Petitioners, however, did not draft a detailed

business plan and did not compute any written financial

projections.

       By early 1996, petitioners owned 8 purebred Paso Fino horses

and had owned a maximum of 10.     Petitioners have also sold five

horses since establishing Silk Oak.       The horses owned by Silk Oak

at the date of trial, their acquisition costs, and their

estimated values are as follows:

            Name             Acquisition Cost      Estimated F.M.V.

1.   Mancebo de Coral           $10,000           $12,000--18,000
2.   La Hija del Centaur          4,000             6,500
3.   Vitrina del Dulce           12,000            15,000--18,000
4.   Reya de Seda                foaled             4,000---6,500
5.   El Coete de Seda            foaled             2,500---3,500
6.   Alas de Seda                foaled             2,500---3,500
7.   Elegancia de Seda           foaled             5,000---6,000
8.   Latina de Seda              foaled             5,000---6,000

  Total                          26,000            52,500--68,000

The five horses sold by petitioners, including original

acquisition costs and selling prices, are as follows:

          Name             Acquisition Cost      Sale Price    Gain

1.   Cobre de Seda            foaled              $1,500      $1,500
2.   Noche Caliente              -0-                 250         250
3.   Fernando Bravo           $1,500               4,000       2,500
4.   Tuaca del Centaur         7,000               9,000       2,000
5.   Sombra de Seda           foaled                 -0-         -0-

  Total                        8,500              14,750      6,250
                                - 5 -

       From 1988 to 1994, petitioners reported income and expenses

relating to the operation of Silk Oak on Schedule C in the

following amounts:

Year       Ranch Expenses1    Gross Income      Ranch Losses

1988              ---                ---           ($10,000)
1989              ---                ---            (16,559)
1990              ---                ---            (21,742)
1991          $21,601             $ 500             (21,101)
1992           21,772                250            (21,522)
1993           32,173              4,000            (29,673)
1994           32,183              7,270            (24,913)
                                                   2
  Total                                             (145,510)
       1
        The record does not include information regarding
petitioners' income and expenses for 1988, 1989, and 1990.
       2
        The stipulation of facts miscalculated total losses as
$145,702.

Petitioners deducted the losses resulting from the operation of

Silk Oak.    Respondent disallowed petitioners' deductions for 1991

and 1992, concluding that petitioners did not engage in the

running of Silk Oak with the requisite profit motive.

       Petitioners have hired professional trainers to work with

their horses, averaging 1 to 3 months per horse.       To increase

profitability, petitioners have improved their own abilities to

personally train their horses, thereby mitigating the expenses of

hiring an outside trainer.    In addition, petitioners have sought

to increase profitability by "breeding up"; i.e., breeding their

horses to horses with stronger pedigrees.    Petitioners have

advertised their horses for sale in the local newspaper, have

posted flyers offering their horses for sale or stud services,
                                - 6 -

and have participated in various horse shows.     Furthermore, in

1995 and 1996, petitioners were seeking to sell their ranch in

California and relocate to Texas, where purportedly lower costs

and a better market for Paso Fino horses render profitability

more likely.

                               OPINION

     Taxpayers seeking to deduct expenses under section 162 must

establish that the underlying activity was engaged in for an

actual and honest profit objective.      Dreicer v. Commissioner, 78

T.C. 642, 644-646 (1982), affd. without published opinion 702

F.2d 1205 (D.C. Cir. 1983).    If a taxpayer's activity is deemed

not to be engaged in for the purposes of earning a profit, the

deductibility of expenses resulting from the activity is

restricted by section 183.    Particularly, section 183(b)(2)

provides that expenses which result from an activity not engaged

in for profit, and which would be allowable only if the activity

were engaged in for profit, are deductible only to the extent of

income derived from the activity.    Generally, taxpayers bear the

burden of proving that the activities in question were entered

into for a profit.   Rule 142(a); Golanty v. Commissioner, 72 T.C.

411, 426 (1979), affd. without published opinion 647 F.2d 170

(9th Cir. 1981).

     To determine whether a taxpayer has entered into an activity

for a profit, we must consider all of the facts and

circumstances, placing greater weight upon objective facts than
                                - 7 -

upon a taxpayer's mere statements of intent.      Dreicer v.

Commissioner, supra at 645.    Nevertheless, there is no

requirement that the taxpayer reasonably expect profits from the

activity in question.    Elliott v. Commissioner, 90 T.C. 960, 970

(1988), affd. without published opinion 899 F.2d 18 (9th Cir.

1990).    Section 1.183-2(b), Income Tax Regs., provides nine

factors to be considered when determining whether an activity is

engaged in for profit.    These 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, which are earned; (8) the financial status of

the taxpayer; and (9) the elements of personal pleasure or

recreation that may be present.    No single factor is controlling.

Abramson v. Commissioner, 86 T.C. 360, 371 (1986); sec. 1.183-

2(b), Income Tax Regs.    We will separately discuss each factor.

     1.     The Manner in Which Petitioners Carried On the Horse-
            Breeding Activity

     Taxpayers who carry on the activity in question in a

businesslike manner, and maintain complete and accurate books and

records, are more likely to establish that the activities in
                               - 8 -

question were engaged in for a profit.   Sec. 1.183-2(b)(1),

Income Tax Regs.   The record indicates that petitioners

maintained thorough accounts of revenue and expenditures

connected with Silk Oak's operations, using a computer program

recommended by their accountant.   Petitioners also maintained

separate accounts for Silk Oak's finances.    Respondent concedes

that petitioners maintained books and records in a businesslike

manner.

     Petitioners' detailed bookkeeping does not, by itself,

indicate an intent to generate a profit.     Golanty v.

Commissioner, supra at 426.   A lack of profit motive may exist

where a taxpayer fails to abandon unprofitable methods, change

operations, or adopt new techniques in an attempt to improve

profitability.   Sec. 1.183-2(b)(1), Income Tax Regs.

Accordingly, the maintenance of detailed books and records may

reveal the mere "trappings" of a profit business, particularly

when a taxpayer fails to produce income statements, profit plans,

or business plans created to alter operations in an attempt to

reverse mounting losses.   Osteen v. Commissioner, T.C. Memo.

1993-519, affd. in part and revd. in part 62 F.3d 356 (11th Cir.

1995).

     In this instance, petitioners commenced operation of Silk

Oak with neither expertise in running a profitable ranch nor a

detailed written plan fashioned to enable them to earn a profit.

Petitioners, however, contend that before conducting any ranching
                                - 9 -

activities, they consulted with individuals who have had some

success in breeding Paso Fino horses.   Petitioners also argue

that since commencing operation of Silk Oak, they have attempted

to increase profitability by improving their training techniques,

enhancing the bloodlines of their foals, and proposing a move of

their ranching activities to Texas, where expenses are

purportedly lower.   Respondent asserts that petitioners'

testimony concerning advice received from other Paso Fino

breeders was vague and self-serving and yielded no written

business plan.   Likewise, respondent contends that petitioners

offered no specific evidence to establish that a relocation to

Texas would enhance profit opportunities.   Furthermore,

respondent maintains that Silk Oak's consistent losses indicate

that the changes implemented by petitioners were modest and have

had little impact.

     The record indicates that expenses and losses have steadily

increased over time, and petitioners have not presented a

detailed written profit plan.   Although petitioners sought advice

from several successful Paso Fino breeders, their testimony in

this regard was vague and the meetings yielded no concrete plan

of operation.    Petitioners decided to commence operation of Silk

Oak with little concept of the expenses involved or of the steps

involved to achieve cost efficiency and an eventual profit.

Daley v. Commissioner, T.C. Memo. 1996-259.    Furthermore, in the

face of mounting losses, petitioners have failed to materially
                               - 10 -

alter their operations or their prospects of generating profits.

Golanty v. Commissioner, supra at 428.     With respect to their

proposed move to Texas, petitioners have failed to introduce

specific evidence to indicate that increased profit potential

would result.    For this reason, we regard petitioners'

expectations of enhancing profitability by moving to Texas as

being too speculative to support their position.    Accordingly, we

find that this factor favors respondent.

     2.   The Expertise of Petitioners or Their Advisors

     Preparing to enter into an activity by extensively studying

accepted business, economic, and scientific practices, as well as

consulting with experts, may indicate that the taxpayer has a

profit motive.    Sec. 1.183-2(b)(2), Income Tax Regs.   While we

have found that petitioners have knowledge of Paso Fino horses,

they did not engage in the activity with expertise about running

a profitable ranch.    The record indicates that the 6- to 8-week

course in which petitioners enrolled narrowly pertained to horse

care and maintenance and did not instruct petitioners in regard

to the day-to-day operations of a profitable ranch.      This factor

favors respondent.

     3.   The Time and Effort Expended by Petitioners in Carrying
          On the Activity

     Taxpayers expending substantial amounts of personal time in

conducting an activity, particularly where there is no

recreational element involved, are more likely to be deemed to
                              - 11 -

have engaged in the activity for profit.   Sec. 1.183-2(b)(3),

Income Tax Regs.   While withdrawal from an occupation to spend

more time on the activity suggests a profit motive, taxpayers who

spend limited amounts of time on an activity may nevertheless

possess the requisite profit motive if they use the services of

qualified persons.   Thus, the fact the petitioners were employed

full-time as registered nurses does not necessarily preclude a

finding that they bred horses with a profit motive.   Petitioners

credibly maintain that they and their daughter have averaged a

total of 40 to 60 hours per week on the care and training of

their horses, as well as on the maintenance of Silk Oak.    Silk

Oak is a modest ranch, and we believe that petitioners performed

much of the necessary and unpleasant labor themselves.

Therefore, despite petitioners' full-time employment as

registered nurse supervisors during the years in issue, we find

that this factor favors petitioners.

     4.   The Expectation That Assets Used in the Activity May
          Appreciate in Value

     The term "profit" may contemplate appreciation in the value

of assets, including land, used in the activity.   Sec. 1.183-

2(b)(4), Income Tax Regs.   Petitioners argue that the increased

value of the property where Silk Oak is located should be

considered to offset past losses.   In this instance, however, the

appreciation in value of Silk Oak must derive from petitioners'

ranching activities, rather than from independent factors.
                               - 12 -

Stubblefield v. Commissioner, T.C. Memo. 1988-480; Ruben v.

Commissioner, T.C. Memo. 1986-260, affd. without published

opinion 852 F.2d 1290 (9th Cir. 1988).      Petitioners purchased and

held the property as a personal residence for 3 years before

converting it into a ranch.    Silk Oak still serves as

petitioners' residence, and the valuation in question, stipulated

by the parties, used a market comparison approach to real estate

valuation.    The properties used by the appraiser in comparison to

petitioners' property were residential properties, rather than

ranches.    The appreciation of the real estate in question,

therefore, is based upon its use as a residence, rather than as a

horse ranch.    Ruben v. Commissioner, supra.    Consequently, we

will not consider the real estate as an appreciated "asset" held

by petitioners to offset Silk Oak's losses.      Id.

     Petitioners also argue that they had hoped that appreciation

in the value of their horses would yield a profit in the future.

Petitioners' losses from the operation of Silk Oak total

$145,510.    At the time of trial, petitioners owned eight horses

and had never generated more than $2,500 in profit from the sale

of any one horse.    Even if their entire stock of horses were

liquidated at fair market value, the maximum profit generated

would be $42,000.    It is, therefore, unlikely that petitioners

will generate any profits from the sale of their horses in the

near future that would recoup more than a fraction of the past

losses.    This factor favors respondent.
                                - 13 -

     5.   The Success of Petitioners in Carrying On Other Similar
          or Dissimilar Activities

     The fact that a taxpayer has engaged in similar activities

in the past and converted them from unprofitable to profitable

may indicate a profit motive with respect to the activity in

question, regardless of recent profits.    Sec. 1.183-2(b)(5),

Income Tax Regs.   Before commencing the operation of Silk Oak,

petitioners had never run a profitable ranch and had little

knowledge of the business.   We, therefore, conclude that this

factor favors respondent.

     6.   Petitioners' History of Income and Losses With Respect
          to the Activity

     The presence of consistent losses militates against a

finding that an activity was engaged in for a profit.    Sec.

1.183-2(b)(6), Income Tax Regs.    An activity, however, may be

deemed to be engaged in for profit despite a history of losses in

initial or startup stages.   Id.    Therefore, if losses continue to

be sustained beyond the period which is normally necessary to

bring the operation into profitable status, we will consider such

losses as an indication of a lack of profit motive.     Golanty v.

Commissioner, 72 T.C. at 426.     With respect to horse-breeding, we

stated in Golanty v. Commissioner, supra at 427 (quoting

Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), affd. 379

F.2d 252 (2d Cir. 1967)):

     "the presence of losses in the formative years of a
     business, particularly one involving the breeding of
     horses, is not inconsistent with an intention to
                                - 14 -

      achieve a later profitable level of operation, bearing
      in mind, however, that the goal must be to realize a
      profit on the entire operation, which presupposes not
      only future net earnings but also sufficient net
      earnings to recoup the losses which have meanwhile been
      sustained in the intervening years."

      In this instance, petitioners sustained substantial losses

from their horse-breeding activities for 7 years from 1988 to

1994.     The aggregate net losses over the course of these years

was $145,510.     Losses grew steadily over the first 6 years of

operation.     Petitioners' operating expenses in each of the years

in issue exceeded $21,000, while they have never realized a

profit greater than $2,500 on the sale of any one horse.      It is,

therefore, unlikely that petitioners will generate sufficient

profits from the activity to make up for past losses.     Despite

petitioners' sincere devotion to the operation of Silk Oak, we

find this to be highly probative evidence that petitioners do not

expect their horse-breeding activity to become profitable.      See

id.     This factor favors respondent.

        7.   The Amount of Occasional Profits, If Any, Which Are
             Earned

        The amount of profits generated in relation to the amount of

losses incurred, and in relation to the taxpayer's investment and

the value of the assets used in the activity, may suggest the

taxpayer's intent.     Sec. 1.183-2(b)(7), Income Tax Regs.   From

1988 to 1994, petitioners generated a net gain of $6,350 from the

sale of four horses and two goats and $400 from the use of their

land for grazing.     Petitioners' sporadic revenues from the
                                - 15 -

operation of Silk Oak have been de minimis when compared to the

$145,510 in expenses incurred.     Bischoff v. Commissioner, T.C.

Memo. 1995-34.     Accordingly, this factor favors respondent.

     8.      The Financial Status of Petitioners

     The fact that a taxpayer does not have substantial income

from sources other than the activity may indicate that the

activity is engaged in for profit.       Sec. 1.183-2(b)(8), Income

Tax Regs.     In this case, petitioners' income from their nursing

supervisory activities totaled $105,992 in 1991 and $133,572 in

1992.     Petitioners' income is sufficient to produce a comfortable

standard of living, even upon consideration of the losses

incurred in the operation of Silk Oak.       Golanty v. Commissioner,

supra.    We also note that the losses reported from the operation

of Silk Oak provided petitioners with substantial tax benefits.

Id. at 429.    This factor favors respondent.

     9.      The Elements of Personal Pleasure or Recreation That
             May Be Present

     The presence of personal motives in carrying on an activity

may indicate that the activity is not engaged in for profit,

especially where there are recreational or personal elements

involved.     Sec. 1.183-2(b)(9), Income Tax Regs.    The existence of

personal pleasure for the taxpayer, however, does not compel a

finding that the activity was not engaged in for profit.          Jackson

v. Commissioner, 59 T.C. 312, 317 (1972).       Conversely, the

existence of hard work is not enough to distinguish a profit-

seeking activity from a hobby.     Borsody v. Commissioner, T.C.
                               - 16 -

Memo. 1993-534, affd. per curiam 92 F.3d 1176 (4th Cir. 1996);

Osteen v. Commissioner, T.C. Memo. 1993-519.      The care and

maintenance of horses demands a large measure of laborious and

unpleasant work.   Petitioners were responsible, inter alia, for

mucking and cleaning the stalls, grooming the horses, and caring

for mares which had recently foaled.      However, while we do not

reject petitioners' contention that the day to day operation of

Silk Oak demands a great deal of hard work, we note that

petitioners' introduction into horse breeding was precipitated by

their daughter's love of horses.   We also believe that

petitioners were partially motivated by personal reasons in

engaging in the horse-breeding activities, both enjoying life on

a farm and using the horses for recreational pleasure.      This

factor favors neither party.

     Given a consideration of all relevant factors, we conclude

that petitioners did not engage in the operation of Silk Oak with

the intent of generating a profit.      We, therefore, sustain

respondent on this issue.

Accuracy-Related Penalty Under Section 6662(a)

     Respondent determined that petitioners are liable for the

accuracy-related penalty provided under section 6662(a).      The

accuracy-related penalty is equal to 20 percent of any portion of

an underpayment attributable to a taxpayer's negligence or

disregard of rules and regulations.      Sec. 6662(a) and (b)(1).

The term "negligence" includes any failure to do what a
                                - 17 -

reasonable and ordinarily prudent person would do under the same

circumstances.   Neely v. Commissioner, 85 T.C. 934, 947 (1985).

The penalty does not apply to any portion of an underpayment for

which there was reasonable cause and with respect to which the

taxpayer acted in good faith.    Sec. 6664(c).   Respondent's

determination imposing the accuracy-related penalty is presumed

correct, and petitioners bear the burden of proving that they are

not liable for the accuracy-related penalty imposed by section

6662(a).   Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501,

505 (1989).

     Although we have sustained respondent's determination that

petitioners did not have the requisite profit objective, we find

that petitioners were not negligent.     Petitioners claimed the

deductions relating to Silk Oak with a reasonable and good faith

application of the law.   Accordingly, we do not sustain

respondent's determination that petitioners are liable for the

accuracy-related penalty under section 6662(a).     Connolly v.

Commissioner, T.C. Memo. 1994-218, affd. without published

opinion 58 F.3d 637 (5th Cir. 1995).

     To reflect the foregoing,

                                         Decision will be entered

                                         for respondent as to the

                                   deficiencies and for

                                   petitioners as to the

                                   penalties.
