                                T.C. Memo. 2019-71



                          UNITED STATES TAX COURT



     JAMES P. DONOGHUE AND ELAINE S. DONOGHUE, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 3126-15.                            Filed June 11, 2019.



      James P. Donoghue and Elaine S. Donoghue, pro sese.

      Derek W. Kelley, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      ASHFORD, Judge: Beginning in 1985 petitioners engaged in a

thoroughbred horse breeding and racing activity. They continued to engage in the

activity until 2014 despite reporting a loss for every year of its existence.

Respondent audited petitioners’ joint Forms 1040, U.S. Individual Income Tax

Return, for taxable years 2010, 2011, and 2012 (years at issue) and determined
                                         -2-

[*2] that the loss deductions they claimed related to their horse activity should be

disallowed.1 Consequently, by statutory notice of deficiency dated November 20,

2014, respondent determined deficiencies in petitioners’ Federal income tax and

accuracy-related penalties pursuant to section 6662(a)2 for the years at issue as

follows:

                                                     Accuracy-related penalty
      Year                 Deficiency                     sec. 6662(a)

      2010                   $8,491                            $1,698
      2011                    9,316                             1,863
      2012                   10,353                             2,071

      The issues for decision are whether for the years at issue petitioners

(1) engaged in their horse activity for profit within the meaning of section 183(a)

and (2) are liable for accuracy-related penalties. We resolve both issues in favor

of respondent.

      1
        Respondent also determined that petitioners had unreported short-term
capital gain on the sale of certain securities for each of the years at issue. The
parties now agree that petitioners had unreported long-term (rather than short-
term) capital gain for each of the years at issue. Respondent also made a
computational adjustment to the taxable amount of Social Security benefits
petitioners reported for each of the years at issue.
      2
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. Some monetary amounts are
rounded to the nearest dollar.
                                         -3-

[*3]                           FINDINGS OF FACT

       Some of the facts have been stipulated and are so found. The stipulation of

facts and attached exhibits are incorporated herein by this reference. Petitioners

resided in Massachusetts when they timely filed their petition with the Court.

I.     Petitioners’ Background

       During the years at issue Mr. Donoghue worked full time for W.B. Mason

Co., Inc., as a programmer and Mrs. Donoghue was disabled. Mr. Donoghue has

also previously managed a family construction business, and Mrs. Donoghue has

been a paralegal and an executive in various departments of a corporation. They

both have college degrees--Mr. Donoghue in finance with a minor in business and

Mrs. Donoghue in communication arts.

II.    Petitioners’ Horse Activity

       Mrs. Donoghue fell in love with horses as a child, attributing this to her

grandfather, who was a successful breeder of thoroughbred racing horses and

frequently took her to racetracks and breeding farms when she was young. As she

grew older, she fell in love with the business he ran and she diligently began

reading trade publications on horse breeding and racing.

       In 1985 (in an attempt to follow in the footsteps of Mrs. Donoghue’s

grandfather who had passed away by then) petitioners decided to start their horse
                                         -4-

[*4] activity. They formed an equal partnership named Marestelle Farm to breed

and race world class thoroughbred horses.

      Mrs. Donoghue handled the operations side of Marestelle Farm, i.e.,

studying horse bloodlines, searching for horses to breed with their horses, and

managing the care and training of their horses. In 1993, for example, after

petitioners’ first horse successfully delivered a male foal at Fulmer International

Farm in South Carolina, Mrs. Donoghue spent some time there working with the

foal and as an apprentice for Robert Hall, a licensed thoroughbred race trainer.

      Mrs. Donoghue also served as the bookkeeper for Marestelle Farm. Mr.

Donoghue handled the remaining financial aspects of Marestelle Farm, i.e.,

serving as the controller (including ensuring that Marestelle Farm’s filing

obligations with the Internal Revenue Service (IRS) were met).

      During the years at issue petitioners owned (and Marestelle Farm consisted

of) a total of six horses. They did not, however, breed, race, or sell any of their

horses during these years. The industry norm for racing a horse is 24 races per

year. The last year petitioners raced any of their horses was 2008. They stopped
                                         -5-

[*5] their horse activity in 2014. From its inception in 1985 through 2014, their

activity never had a profitable year.3

      A.     Petitioners’ Horses

      Petitioners owned six horses during the years at issue in connection with

Marestelle Farm: Lilac Domino, Lainies Calliope, Canajorie, Dr. Davies, Run the

Credits, and Whaleman.4

      Lilac Domino, a mare born in 1979, was the first horse petitioners owned

with respect to their horse activity. Mrs. Donoghue spent three years researching

horse bloodlines before petitioners purchased Lilac Domino in 1988. On the basis

of Mrs. Donoghue’s research they thought that Lilac Domino had fantastic

bloodlines, but they were able to purchase her for a bargain price because she was

severely lame. Lilac Domino was Mrs. Donoghue’s dream horse, and she was the

only horse petitioners acquired other than through breeding.

      In 1992, after Lilac Domino was nursed back to health, petitioners bred her

with a stallion named Secretary of State; she successfully delivered a male foal


      3
       For further discussion of Marestelle Farm’s financial performance, see infra
pp. 14-16.
      4
       As discussed infra pp. 5-8, before the years at issue Lilac Domino foaled
Sir Manatee and Lainies Calliope foaled Whaleman, Seal E. Dan, and Fine Artist,
but by 2010 Whaleman was the only one of these foals that petitioners continued
to own.
                                        -6-

[*6] named Sir Manatee at Fulmer International Farm. In 1994 Lilac Domino was

bred with Secretary of State again and successfully delivered a female foal named

Lainies Calliope.5 Lilac Domino died in 2011.

      Petitioners entered Sir Manatee in a couple of races and bred him before

selling him in 2007 for $2,500.6 Petitioners never raced Lainies Calliope; instead

she became petitioners’ “second generation broodmare.” Lainies Calliope

produced six foals for petitioners: (1) Whaleman, (2) Seal E. Dan, (3) Canajorie,

(4) Dr. Davies, (5) Run the Credits, and (6) Fine Artist.

      In 2001 Lainies Calliope foaled Whaleman, a stallion, at Overbrook Farm in

Kentucky. Whaleman’s racing “career” consisted of racing 24 times from 2004 to

2006 at Suffolk Downs racetrack in Massachusetts (which petitioners considered

their local track) and once in 2004 at Belmont Park in New York,7 earning a total


      5
       Aside from Sir Manatee and Lainies Calliope, Lilac Domino successfully
delivered one other horse, but this was at a time when petitioners did not own
Lilac Domino.
      6
       Petitioners did not report this sale on their 2007 joint Form 1040, which
reported income attributable to Marestelle Farm of zero.
      7
       Petitioners most frequently raced their horses at Suffolk Downs. Mrs.
Donoghue secured a license to race their horses in Florida in furtherance of her
dream to participate in the Florida Derby in homage to her grandfather, who had
raced at Gulfstream Park in Florida, but that dream never came to fruition. At a
time not established by the record petitioners also tried racing in New York in
                                                                       (continued...)
                                         -7-

[*7] of $12,850. At the time of trial petitioners were leasing him as a riding horse

in Maine and no longer incurring expenses with respect to him. Petitioners would

like to sell him, but he has a problem with colic.

      In 2002 Lainies Calliope foaled Seal E. Dan, a stallion. Petitioners sold him

in 2005 for $3,500.

      In 2003 Lainies Calliope foaled Canajorie, a stallion. He was diagnosed

with an insect disease and never generated any income. Petitioners put Canajorie

up for sale; but at the time of trial they were no longer trying to sell him because

of the insect disease. Canajorie is in Massachusetts, and petitioners are incurring

expenses for him.

      In 2004 Lainies Calliope foaled Dr. Davies, a mare. Dr. Davies raced 15

times, earning a total of $6,752. Since 2008 or 2009 petitioners have been training

her for sale. They would like to sell her for $30,000; at a time not established by

the record petitioners received an offer of $15,000, but they rejected it.

      In 2005 Lainies Calliope foaled Run the Credits, a mare. She never

generated any income. Petitioners have been trying to sell Run the Credits since

two to three years after her birth.

      7
       (...continued)
pursuit of larger racing purses, but they found the daily fees charged to race in
New York too expensive to continue racing there.
                                         -8-

[*8] In 2009 Lainies Calliope foaled Fine Artist, a stallion. Petitioners, however,

never owned or had any rights to Fine Artist and did not receive a fee for this

breeding.

      B.     Marestelle Farm’s Operations

      Marestelle Farm was a “virtual farm”. Petitioners never actually owned a

farm or a facility where they kept and trained their horses but instead paid other

farms to do so. Although petitioners lived in Massachusetts during all of the years

of their horse activity, the farms they used were in multiple States, including

Massachusetts, South Carolina, Kentucky, Florida, and New York.

      When their horses were in active race training, petitioners paid “day rates”

to these farms for them to feed, care for, exercise, and train their horses.

Petitioners also sometimes entered into special arrangements with these farms to

reduce their boarding expenses. These arrangements included “rough boarding”,

where petitioners traveled daily to a farm for approximately 30 weeks to care for

their horse or horses boarded there, and “performance training”, where petitioners

leased their horse or horses to be used and trained for performance activities in

return for free boarding. Finally, petitioners bartered for boarding expense relief

in exchange for allowing another farm to breed one of their mares and own the

resulting foal.
                                        -9-

[*9] Petitioners used advertising when they attempted to sell or breed any of

their horses during the years at issue. They paid a total of $522 for advertising

services during these years; otherwise they advertised their horses on a free

internet registry.

      Over the years petitioners funded Marestelle Farm through a combination of

their available cash, distributions from an individual retirement account (IRA),

and mortgage borrowing. From 1985 to 2012 the funding amounts included

$399,176 in total cash, $337,527 from IRA distributions, and $271,600 of

mortgage borrowing.

      C.     Time Petitioners Devoted to Marestelle Farm

      Operating Marestelle Farm never developed into a full-time activity for

petitioners, and during the years at issue petitioners kept neither kept a mileage log

nor a contemporaneous time log reporting the hours spent with respect to

Marestelle Farm. However, during the audit of their joint Forms 1040 for the

years at issue petitioners created two spreadsheets--one for 2010 and another for

2011--which reported the total hours they each purportedly spent with respect to

Marestelle Farm. The 2010 spreadsheet reported 1,657 and 1,276 hours spent by

Mrs. and Mr. Donoghue, respectively, and the 2011 spreadsheet reported 1,462

and 1,021 hours spent by Mrs. and Mr. Donoghue, respectively. All of these
                                        - 10 -

[*10] reported hours were estimates, and no actual dates were associated with

them; instead, the hours were reported by activity performed. Petitioners created

these spreadsheets on the basis of their discussions in conjunction with “reviewing

dozens of pendaflex file folder labels contained in the multiple cabinets of files” in

their “business office.” Petitioners did not create a spreadsheet for 2012.8

      D.     Petitioners’ Business Plans and Expert Advice Pertaining to
             Marestelle Farm

      Petitioners had written business plans for Marestelle Farm from 1988 to

2012. Their initial plan included sections titled “Business Executive Summary”,

“Business Objective”, “Business Goal”, and “Business Financials”. Petitioners

reproduced this plan annually, and up through 2006, except for the “Business

Financials” section, the other sections did not change from year to year.

      The “Business Executive Summary” section stated in pertinent part that

“Marestelle Farm is in the business of breeding world class thoroughbred horses

for racing”, “[b]usiness income will be derived from thoroughbred racing purses

and breeding income derived from successful race horse offspring of LILAC

DOMINO”, and “[p]rofits will be produced when race purse and breeding income

exceed business expenses.”

      8
      In their answering brief petitioners state that the hours spent with respect to
Marestelle Farm for 2012 were “similar” to those in 2011.
                                        - 11 -

[*11] The “Business Objective” section stated in pertinent part that “Marestelle

Farm’s objective is to produce well tempered, reliable and trainable thoroughbred

race horses based on * * * selective line breeding * * *, which when put into

service, reduce the risk of race training injury and increase the potential to which

the horse can be trained and ultimately produce generations of winning race horse

stock for profit.”

      The “Business Goal” section stated in pertinent part how the goal of

Marestelle Farm was to produce a profitable breeding race horse stock from a

single foundation broodmare with top bloodlines.

      The “Business Financials” section stated Marestelle Farm’s planned income

and expenses. Never did this section state that Marestelle Farm was projected to

earn a profit. More specifically, petitioners’ 1988-2006 plans stated the following:

       Year          Planned income       Planned expenses         Planned loss

       1988                  0                   $15,000             $15,000
       1989                  0                   15,000               15,000
       1990                  0                   15,000               15,000
       1991                  0                   15,000               15,000
       1992                  0                   15,000               15,000
       1993                  0                   20,000               20,000
       1994                  0                   40,000               40,000
                                         - 12 -

[*12] 1995                  10,000                40,000               30,000
        1996                10,000                55,000               45,000
        1997                10,000                55,000               45,000
        1998                10,000                55,000               45,000
        1999                10,000                55,000               45,000
        2000                10,000                60,000               50,000
        2001                15,000                70,000               55,000
        2002                15,000                70,000               55,000
        2003                30,000                80,000               50,000
        2004                35,000                80,000               45,000
        2005                30,000                50,000               20,000
        2006                35,000                60,000               25,000

        Petitioners’ 2007-12 plans differed from their 1988-2006 plans in that they

no longer included the aforementioned sections; instead, they included sections

titled “Business Activity Plans”, “Racing Plans”, “Sales Plans”, “Training Plans”,

and “Management Plans”. These sections were virtually identical from year to

year.

        The “Business Activity Plans” section stated in pertinent part that

petitioners would “continue to market breeding sales contracts efforts” for Run the

Credits, Dr. Davies, and Lainies Calliope and “continue horse management

activities for all horses in inventory”. The “Racing Plans” section stated that
                                       - 13 -

[*13] petitioners would “wait[] for rumored Casino activities to restore profitable

horse racing” in Massachusetts. The “Sales Plans” section stated that petitioners

would “work on” buyers in performance horse disciplines and thoroughbred

breeding disciplines. The “Training Plans” section recited that petitioners would

“increase value of inventory through performance horse training”. The

“Management Plans” section stated that petitioners would work to “sell horses”,

“lease horses”, “keep all horses healthy”, “keep sales horses in training”, “keep

pensioned broodmare healthy”, “stay abreast of rumored Casino activities”, and

“reduce expenses with horse leases”. None of petitioners’ 2007-12 plans stated

projected income, expenses, or profit/loss for Marestelle Farm.

      Petitioners did not consult with anyone in preparing any of their business

plans. At a time not established by the record Mrs. Donoghue did speak with two

individuals who were training petitioners’ horses for sale about whether to sell

their horses. Their advice to her was to “hang onto your asset to wait for the

economy to turn around”. Apart from this advice, the record is silent as to any

specific business advice petitioners sought or received to make Marestelle Farm

profitable.
                                         - 14 -

[*14] E.     Marestelle Farm’s Books and Records

      Petitioners maintained a separate bank account for Marestelle Farm for at

least part of 2008 through 2011. They kept a listing of Marestelle Farm’s income

and expenses for the years at issue using the computer software program Quicken.

This listing had three categories of income: breeding, sales, and racing; none of

these categories showed income for the years at issue. This listing had various

categories of expenses, such a advertising, boarding (per each horse), equipment,

fees, gifts, postage, shipping, supplies, taxes, training, travel, veterinarian, truck

payment, and life insurance.

      F.     Marestelle Farm’s Financial Performance

      From 1985 to 2012 Marestelle Farm incurred expenses totaling $1,008,303

but realized income totaling only $33,691, resulting in accumulated losses of

$974,612. Petitioners have never earned a profit from their horse activity. On

their joint Forms 1040 for 1997 to 2012 they reported the following losses

attributable to Marestelle Farm:9

      9
        Beginning at least as early as 1997 and continuing through 2008,
petitioners reported their horse activity on Schedules C, Profit or Loss From
Business, attached to their joint Forms 1040, despite the fact that Marestelle Farm
was formed as a partnership in 1985. Additionally, on each Schedule C Mr.
Donoghue was listed as the sole proprietor of their horse activity. For 2009 and
the years at issue petitioners reported their horse activity on Forms 1065, U.S.
                                                                        (continued...)
                                      - 15 -

[*15]                       Year      Net profit/(loss)

                            1997       No gain or loss
                                             reported
                            1998           ($105,513)
                            1999                   (39,391)
                            2000                   (66,236)
                            2001                   (62,864)
                            2002                   (37,800)
                            2003               (171,893)
                            2004               (125,955)
                            2005                   (52,546)
                            2006                   (69,981)
                            2007                   (45,247)
                            2008                   (45,214)
                            2009                   (44,456)
                            2010                   (52,554)
                                               1
                            2011                   (69,719)
                            2012                   (61,028)

        1
        As discussed infra p. 17, petitioners’ 2011 joint Form 1040 and attached
Schedule E reported a loss of $69,785 attributable to Marestelle Farm. However,
Marestelle Farm’s 2011 Form 1065 reported a loss of $69,719, and the notice of
deficiency determined a Schedule E adjustment of $69,719 for 2011. The record
is silent as to what contributes to the discrepancy.

        9
       (...continued)
Return of Partnership Income, and accordingly on Schedules E, Supplemental
Income and Loss, attached to their joint Forms 1040.
                                         - 16 -

[*16] G.     Petitioners’ Tax Returns

      Throughout the history of their horse activity petitioners employed several

different tax return preparation/accounting firms to prepare their joint Forms 1040

(as well as Marestelle Farm’s Forms 1065). At least for the years at issue, despite

employing these firms petitioners did not receive any advice regarding the

deductibility of items relating to their horse activity.

      H&R Block prepared and timely filed petitioners’ 2010 joint Form 1040.

The income section of this form reported wages attributable to Mr. Donoghue of

$84,742, taxable interest of $66, ordinary dividends of $22, taxable refunds,

credits, or offsets of State and local income taxes of $4,981, and Social Security

benefits attributable to Mrs. Donoghue of $17,634 ($7,763 of which was the

taxable amount). The income section also reported a loss of $52,554 for “Rental

real estate, royalties, partnership, S corporations, trusts, etc.” This loss is the loss

attributable to petitioners’ horse activity as reflected on Marestelle Farm’s 2010

Form 1065 and their attached Schedule E. The tax and credits section of the form

claimed itemized deductions totaling $32,348 and two exemptions (one for Mr.

Donoghue and the other for Mrs. Donoghue), and reported total tax of $538 (on

the basis of taxable income of $5,372). Finally, the form reported payments

totaling $9,733 ($9,183 for Federal income tax withheld from Mr. Donoghue’s
                                         - 17 -

[*17] wages and $550 for the making work pay credit), for a total claimed refund

of $9,195.

      H&R Block also prepared and timely filed petitioners’ 2011 joint Form

1040. The income section of this form reported wages attributable to Mr.

Donoghue of $88,468, taxable interest of $37, taxable refunds, credits, or offsets

of State and local income taxes of $2,943, and Social Security benefits attributable

to Mrs. Donoghue of $17,634 (zero of which was the taxable amount). The

income section also reported a loss of $69,785 for “Rental real estate, royalties,

partnership, S corporations, trusts, etc.”, attributable to petitioners’ horse activity

as reflected on Marestelle Farm’s 2011 Form 1065 and their attached Schedule E.

The tax and credits section of the form claimed itemized deductions totaling

$31,909 and two exemptions (again, one for Mr. Donoghue and the other for Mrs.

Donoghue), and reported total tax of zero (on the basis of taxable income of zero).

Finally, the form reported Federal income tax withheld from Mr. Donoghue’s

wages of $10,341, for a total claimed refund of $10,341.

      Mr. Donoghue prepared and timely filed petitioners’ 2012 joint Form 1040.

On this form they reported wages attributable to Mr. Donoghue of $93,099,

taxable interest of $104, taxable refunds, credits, or offsets of State and local

income taxes of $4,022, and Social Security benefits attributable to Mrs.
                                        - 18 -

[*18] Donoghue of $18,275 (zero of which was the taxable amount). They also

reported in the income section of this form a loss of $61,406, attributable to the

$61,028 loss from their horse activity as reflected on Marestelle Farm’s 2012

Form 1065 and their attached Schedule E, and a $378 loss from a partnership

named Global World Shares. In the tax and credits section of the form they

claimed itemized deductions totaling $30,654 and two exemptions (again, one for

Mr. Donoghue and the other for Mrs. Donoghue), and reported total tax of zero

(on the basis of taxable income of zero). Finally, they reported Federal income tax

withheld from Mr. Donoghue’s wages of $10,930, for a total claimed refund of

$10,930.

      H.     Audit and Determination

      Following an audit of petitioners’ joint Forms 1040 for the years at issue

respondent in pertinent part disallowed petitioners’ claimed loss deductions with

respect to Marestelle Farm on the ground that they did not materially participate in

Marestelle Farm10 and asserted accuracy-related penalties against them.

      In his answer respondent asserts, as an additional (and now predominant)

reason for disallowance of petitioners’ claimed losses attributable to Marestelle

      10
       Respondent also disallowed amortization expenses of $29,000 shown on
Marestelle Farm’s Forms 1065 for each of the years at issue due to lack of
substantiation.
                                         - 19 -

[*19] Farm, that they did not engage in their horse activity for profit within the

meaning of section 183.

      The record includes (1) a completed Civil Penalty Approval Form for

section 6662(a) accuracy-related penalties due to substantial understatements of

income tax for the years at issue and (2) a Letter 950, i.e., 30-day letter, to

petitioners reflecting the IRS’ proposed changes to their Federal income tax for

the years at issue, including the imposition of these penalties. The completed

Civil Penalty Approval Form includes a signature on the line provided on the form

for “Group Manager Approval to Assess Penalties Identified Above” dated March

10, 2014, the same date as the 30-day letter and before the issuance of the notice

of deficiency.11




      11
        As explained infra pp. 41-46, we are reopening the record to admit the
Civil Penalty Approval Form and a declaration of IRS Revenue Agent Kimberly
B. McCarthy insofar as it authenticates the Civil Penalty Approval Form for
purposes of Fed. R. Evid. 902(11). As also explained infra pp. 41-46, we are
reopening the record to now admit Exhibit 23-P in its entirety. Exhibit 23-P is
much of the IRS examination and Office of Appeals files pertaining to petitioners
and Marestelle Farm and includes the 30-day letter (in addition to the Civil
Penalty Approval Form). At trial respondent objected to the admission of this
exhibit, and the Court sustained that objection.
                                        - 20 -

[*20]                                 OPINION

I.      Burden of Proof

        In general, the Commissioner’s determinations set forth in a notice of

deficiency are presumed correct, and the taxpayer bears the burden of proving

otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Moreover, tax deductions are a matter of legislative grace, and the taxpayer bears

the burden of proving entitlement to any deduction claimed. INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292

U.S. 435, 440 (1934).

        But when the Commissioner raises a new matter (or raises an increase in the

deficiency or pleads affirmative defenses) in the answer, he bears the burden of

proof as to the new matter (or the increased deficiency or affirmative defenses).

Rule 142(a)(1); Roberts v. Commissioner, 141 T.C. 569, 575 (2013). A new

matter includes “[a] new theory that * * * either alters the original deficiency or

requires the presentation of different evidence.” Wayne Bolt & Nut Co. v.

Commissioner, 93 T.C. 500, 507 (1989) (and cases cited thereat). In his answer

respondent asserted a new theory, to wit, that petitioners did not engage in their

horse activity for profit pursuant to section 183. Respondent concedes that he has

the burden of proof with respect to the section 183 issue.
                                         - 21 -

[*21] As for respondent’s determinations set forth in the notice of deficiency,

petitioners suggest (only in passing in their answering brief) that the burden of

proof should shift to respondent under section 7491(a). Under section 7491(a), if

the taxpayer produces credible evidence with respect to any factual issue relevant

to ascertaining his Federal income tax liability and meets certain other

requirements, the burden of proof shifts from the taxpayer to the Commissioner as

to that factual issue. The record, however, does not establish that the requirements

for shifting the burden of proof have been met; therefore, the burden of proof

remains on petitioners to the extent of respondent’s determinations reflected in the

notice of deficiency.

II.   Section 183

      Generally, the Code allows deductions for ordinary and necessary expenses

paid or incurred during the taxable year in carrying on a trade or business or for

the production of income. Secs. 162(a), 212(1). Under section 183, if an activity

is not engaged in for profit, such as an activity primarily carried on for sport, as a

hobby, or for recreation, then no deduction attributable to that activity is generally
                                       - 22 -

[*22] allowed except as provided for in subsection (b).12 See sec. 1.183-2(a),

Income Tax Regs.

      Taxpayers (such as petitioners) that operate an activity as a partnership must

show that they engaged in the activity with an actual and honest objective of

making a profit at the partnership level. Brannen v. Commissioner, 78 T.C. 471,

505-506 (1982), aff’d, 722 F.2d 695 (11th Cir. 1984); see also Hulter v.

Commissioner, 91 T.C. 371, 392 (1988); Dreicer v. Commissioner, 78 T.C. 642,

645 (1982), aff’d without published opinion, 702 F.2d 1205 (D.C. Cir. 1983); sec.

1.183-2(a), Income Tax Regs. Profit in this context means economic profit,

independent of tax savings. Hulter v. Commissioner, 91 T.C. at 393.

      Whether the requisite profit objective exists is determined by looking at all

the surrounding facts and circumstances. Sec. 1.183-2(b), Income Tax Regs.; see

also Estate of Power v. Commissioner, T.C. Memo. 1983-552, 46 T.C.M. (CCH)

1333, 1338 (1983), aff’d, 736 F.2d 826 (1st Cir. 1984). We accord greater weight

to objective facts than to subjective statements of intent. Sec. 1.183-2(a), Income

Tax Regs.; see also Estate of Power v. Commissioner, 46 T.C.M. (CCH) at 1338.


      12
         Sec. 183(b) allows deductions that would have been allowable had the
activity been engaged in for profit but only to the extent of gross income derived
from the activity (reduced by deductions attributable to the activity that are
allowable without regard to the whether the activity was engaged in for profit).
                                        - 23 -

[*23] In this case we gauge the profit intent of Marestelle Farm from that of

petitioners, its equal partners. Evidence from years outside the years at issue is

relevant to the extent it creates inferences regarding the taxpayer’s requisite profit

objective in the subject years. See, e.g., Smith v. Commissioner, T.C. Memo.

1993-140.

      Pursuant to section 183(d), an activity consisting in major part of breeding,

training, showing, or racing horses is presumed to be engaged in for profit if the

activity produces gross income in excess of deductions for any two of the seven

consecutive years which end with the taxable year, unless the Commissioner

establishes to the contrary. See Wadlow v. Commissioner, 112 T.C. 247, 250

(1999). Marestelle Farm never produced gross income in excess of deductions for

purposes of invoking the presumption. Accordingly, the presumption does not

apply here.

      Section 1.183-2(b), Income Tax Regs., provides a nonexclusive list of nine

factors to consider in evaluating a taxpayer’s profit objective. These factors are:

(1) the manner in which the taxpayer carried on the activity, (2) the expertise of

the taxpayer or his or her advisers, (3) the time and effort spent by the taxpayer in

carrying on the activity, (4) the expectation that the assets used in the activity may

appreciate in value, (5) the success of the taxpayer in carrying on other similar or
                                         - 24 -

[*24] dissimilar activities, (6) the taxpayer’s history of income or loss with respect

to the activity, (7) the amount of occasional profits earned, if any, (8) the financial

status of the taxpayer, and (9) whether elements of personal pleasure or recreation

were involved. Sec. 1.183-2(b), Income Tax Regs.; see also Filios v.

Commissioner, 224 F.3d 16, 21 (1st Cir. 2000), aff’g T.C. Memo. 1999-92. No

single factor or group of factors is determinative and more weight may be given to

some factors than others. Golanty v. Commissioner, 72 T.C. 411, 426 (1979),

aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981); Vitale v.

Commissioner, T.C. Memo. 1999-131, slip op. at 17-18, aff’d without published

opinion, 217 F.3d 843 (4th Cir. 2000); see also Green v. Commissioner, T.C.

Memo. 1989-436, 57 T.C.M. (CCH) 1333, 1343 (1989) (noting that all nine

factors do not necessarily apply in every case); sec. 1.183-2(b), Income Tax Regs.

We examine each of these factors in turn.

      A.     Manner in Which the Activity Is Conducted

      The fact that a taxpayer conducts an activity in a businesslike manner may

indicate a profit motive. Sec. 1.183-2(b)(1), Income Tax Regs. In making this

determination we consider whether the taxpayer (1) maintained complete and

accurate books and records for the activity; (2) prepared a business plan;

(3) conducted the activity in a manner substantially similar to comparable
                                        - 25 -

[*25] activities that were profitable; (4) changed operating procedures, adopted

new techniques, or abandoned unprofitable methods in a manner consistent with

an intent to improve profitability; and (5) in the case of horse breeding and sales,

ran a consistent and concentrated advertising program. Judah v. Commissioner,

T.C. Memo. 2015-243, at *34 (and cases cited thereat); see also Williams v.

Commissioner, T.C. Memo. 2018-48, at *21-*22.

      Petitioners contend that they operated Marestelle Farm in a businesslike

manner because they kept “reasonable” books and records, conducted their horse

activity with professional advisors and in a manner comparable to other profitable

horse businesses in Massachusetts during in particular the “Great Recession”

(which they characterize as beginning in 2007) and the years at issue, maintained

“reasonable” business plans, and made changes to their operating procedures in

response to issues they encountered, such as the Great Recession. The evidence in

the record, however, belies petitioners’ contentions.

      During the years at issue petitioners did not breed, race, or sell any of their

horses. According to Mr. Donoghue, the industry norm for racing a horse was 24

races per year. Yet petitioners never had a horse that raced 24 times in one year,

and the last year that one of their horses raced was 2008. The last year petitioners

bred one of their horses was 2009 (and with that breeding they did not receive a
                                          - 26 -

[*26] breeding fee or own or have any rights to the foal). It stands to reason that a

thoroughbred horse breeding and racing business, if truly a business and not a

hobby, sport, or recreational activity, would be actively engaged in either breeding

or racing horses; Marestelle Farm did neither during the years at issue.

         Although petitioners maintained a separate bank account for Marestelle

Farm for at least part of 2008 through 2011 and kept a list of Marestelle Farm’s

income and expenses for the years at issue using Quicken, their books and records

were far from accurate and complete. For many years petitioners reported their

income and expenses related to Marestelle Farm as if it was a sole proprietorship

owned by Mr. Donoghue alone, despite the fact that since its inception in 1985 it

was actually a partnership. In 2007 petitioners sold Sir Manatee for $2,500, but on

their joint Form 1040 for that year they reported income attributable to Marestelle

Farm of zero. Petitioners also failed to keep a mileage log or a contemporaneous

time log reporting the hours spent with respect to Marestelle Farm for the years at

issue.

         For at least the years at issue petitioners did not maintain their books and

records with the objective of making a profit. As we have previously stated: “A

taxpayer must maintain books and records for the purpose of cutting expenses,

increasing profits, and evaluating the overall performance of the operation”.
                                         - 27 -

[*27] Judah v. Commissioner, at *34 (citing Betts v. Commissioner, T.C. Memo.

2010-164). Marestelle Farm’s net losses during each of the years at issue were

greater than in 2007, 2008, or 2009. In fact, Marestelle Farm never had a

profitable year. Indeed, it is apparent that petitioners did not properly use the

written business plans they had in place from 1988 to 2012. They prepared each

plan on their own without consulting anyone. The 1988-2006 plans did not

change from year to year, and each plan projected a net loss. The 2007-12 plans

were virtually identical, and no financial projections were set forth in these plans.

These plans illustrate that petitioners intended (or at least projected) that

Marestelle Farm would lose money year after year, which, of course, is the polar

opposite of an activity engaged in for profit.

      Petitioners attempt to justify Marestelle Farm’s lack of profit by asserting

that it was in a startup phase or a series of successive startup phases for each

generation of foals from 1985 to 2012. We reject that notion. We have previously

held that the startup phase for a horse breeding activity is 5 to 10 years. See

Engdahl v. Commissioner, 72 T.C. 659, 669 (1979). In this case Marestelle

Farm’s startup phase ended in 1995 at the latest, yet it continued to suffer losses.

      According to petitioners, in order to improve Marestelle Farm’s profitability

they changed its operations and procedures by no longer racing or breeding their
                                        - 28 -

[*28] horses and instead offering them up for sale and also by cutting expenses by

leasing, rough boarding, and putting into training arrangements some of their

horses. However, it is incredible to think that ceasing racing and breeding, no

matter the amount of expenses cut, could lead to profitability.

      Petitioners never ran a consistent and concentrated advertising program. In

attempting to sell or breed their horses they spent only a total of $522 on

advertising during the years at issue; their only other advertising activity was to

list their horses on a free internet registry. See Bronson v. Commissioner, T.C.

Memo. 2012-17, slip op. at 19 (citing Golanty v. Commissioner, 72 T.C. at 431),

aff’d, 591 F. App’x 625 (9th Cir. 2015).

      Accordingly, this factor weighs heavily in favor of respondent’s position.

      B.     Expertise of Petitioners or Their Advisors

      A taxpayer’s own expertise, research, and extensive study of an activity, or

consultation with experts, may indicate a profit objective. Sec. 1.183-2(b)(2),

Income Tax Regs. This factor focuses on whether the taxpayer “received advice

from the experts as to the accepted principles and economics of profitably running

a business and not merely the general advice that a horse enthusiast would seek in

training and showing horses as a hobby.” Betts v. Commissioner, slip op. at 19

(and cases cited thereat).
                                       - 29 -

[*29] As a child Mrs. Donoghue read trade publications on horse breeding and

racing and over several decades has diligently researched horse bloodlines. Mrs.

Donoghue also presumably received some advice and guidance from her

grandfather, who was a successful horse breeder, although this would have been

before petitioners commenced their horse activity as he had passed away by then.

In 1993, after Lilac Domino successfully foaled Sir Manatee at Fulmer

International Farm, she spent some time there as an apprentice for Robert Hall, a

licensed thoroughbred race trainer. Thus, to be sure, she has some training and

likely expertise in the breeding of horses. And Mr. Donoghue has a college degree

in finance with a minor in business. However, there is no evidence in the record

that either Mr. or Mrs. Donoghue acquired, or even sought, expertise as to the

economics of profitably running a horse breeding and racing activity beyond the

advice an enthusiast would seek.

      When petitioners were trying to decide whether to sell their horses, Mrs.

Donoghue received advice from two individuals who were training their horses for

sale. In their answering brief petitioners contend that these two individuals “were

respected expert profession[al]s with ‘international’ family backgrounds, whose

families had been involved with the horse industry for multiple generations, and

EXPERTS in the field of RE-TRAINING and SELLING horse LIVESTOCK” and
                                         - 30 -

[*30] “were also acting as expert consultants who advised * * * [them] on current

MA Horse Industry Economics.” However, there is no evidence in the record of

these so-called advisors’ expertise and what specific expertise or advice they

conveyed to petitioners in order to help make Marestelle Farm profitable. Indeed,

the record instead reflects that these so-called advisors imparted very general

advice (“hang onto your asset to wait for the economy to turn around”), which

clearly did not improve the profitability of Marestelle Farm.

      Accordingly, this factors weighs in favor of respondent’s position.

      C.     Petitioners’ Time and Effort Devoted to the Activity

      The fact that a taxpayer devotes much of his personal time and effort to

carrying on an activity may indicate a profit objective, particularly if the activity

does not involve substantial personal or recreational aspects. Sec. 1.183-2(b)(3),

Income Tax Regs. But the time and effort spent on an activity that has substantial

personal and recreational aspects may be due to a taxpayer’s enjoyment of the

activity rather than an objective of making a profit. Judah v. Commissioner,

at *43.

      Petitioners did not devote the necessary time and effort to establish that they

had the requisite objective of making a profit. They never actually owned a farm

or facility where they kept and trained their horses although during certain periods,
                                         - 31 -

[*31] unclear from the record, they “rough boarded” some of their horses; i.e.,

they traveled to a farm daily and took care of their horse or horses for several

weeks. As indicated infra pp. 38-39, petitioners, Mrs. Donoghue in particular,

clearly derived great pleasure from their horse activity, and they acknowledged

that operating Marestelle Farm never developed into a full-time activity. Indeed,

during the years at issue they did not race, breed, or sell any of their horses.

      Nevertheless, in an effort to show the hours they purportedly devoted to

Marestelle Farm petitioners rely on two spreadsheets--one for 2010 and another

for 2011--that they created during the audit. They did not create a spreadsheet for

2012 but state that the hours spent with respect to Marestelle Farm for 2012 were

“similar” to 2011. The 2010 spreadsheet reported 1,657 and 1,276 hours spent by

Mrs. and Mr. Donoghue, respectively, with respect to Marestelle Farm, and the

2011 spreadsheet reported 1,462 and 1,021 hours spent by Mrs. and Mr.

Donoghue, respectively, with respect to Marestelle Farm. However, these

spreadsheets are not trustworthy as they were created on recollection and the hours

reflected therein were estimates not associated with actual dates (but by activity

performed) and there is no contemporaneous documentary evidence in the record

corroborating the hours reported by activity.
                                        - 32 -

[*32] In their answering brief petitioners also state that their plan was to wait out

the Great Recession in Massachusetts during the years at issue and to wait for

Massachusetts State gaming legislation to improve the State’s thoroughbred racing

industry economics. Other than this waiting, there is no evidence in the record

that petitioners expended any substantial time and effort to make Marestelle Farm

profitable. See Rodriguez v. Commissioner, T.C. Memo. 2013-221, at *31

(holding that taxpayers’ inaction was not consistent with a for-profit business).

      Accordingly, this factor weighs in favor of respondent’s position.

      D.     Expectation That Assets Used in the Activity May Appreciate in
             Value

      An expectation that assets used in the activity will appreciate in value and

therefore may produce an overall profit may indicate a profit motive even if the

taxpayer derives no operational profit. Sec. 1.183-2(b)(4), Income Tax Regs.

However, a profit objective may be inferred from the expected appreciation of

assets only where the appreciation exceeds operating expenses and would be

sufficient to recoup accumulated losses of prior years. Carmody v. Commissioner,

T.C. Memo. 2016-225, at *28 (and cases cited thereat). A vague and

unauthenticated notion that assets are appreciating in value does not constitute a

bona fide expectation that the appreciation will offset past and future losses. La
                                       - 33 -

[*33] Musga v. Commissioner, T.C. Memo. 1982-742, 45 T.C.M. (CCH) 422, 426

(1982).

      Because petitioners operated Marestelle Farm as a “virtual farm”, their only

potential appreciable assets were their horses. There is no evidence in the record

as to the values of their horses. However, petitioners had hoped to sell one of their

horses, Dr. Davies, for $30,000, and there is evidence in the record that they

received an offer of $15,000 for Dr. Davies (which they rejected). There is also

evidence in the record that petitioners sold Seal E. Dan in 2005 for $3,500 and Sir

Manatee in 2007 for $2,500. During the years at issue petitioners owned just five

horses after their dream horse, Lilac Domino, died in 2011. Even assuming that

petitioners had been able to sell their remaining five horses for $30,000 each in

2012 (an expectation they did not have), they would have received only $150,000.

Yet Marestelle Farm had cumulative losses from 1985 to 2012 of $974,612.

Therefore, even using the rather artificial aforementioned expected appreciation

for their horses, petitioners would not come close to recouping the significant

losses they incurred with respect to Marestelle Farm over the nearly 30 years they

operated it; consequently, a profit objective cannot be inferred from any expected

appreciation.

      Accordingly, this factor weighs in favor of respondent’s position.
                                         - 34 -

[*34] E.     Success in Carrying On Other Similar or Dissimilar Activities

      The fact that a taxpayer engaged in similar activities and converted them to

profitable enterprises may indicate that the taxpayer engaged in the present

activity for profit, even though it is presently unprofitable. Sec. 1.183-2(b)(5),

Income Tax Regs.; see also Lundquist v. Commissioner, T.C. Memo. 1999-83, slip

op. at 24, aff’d, 211 F.3d 600 (11th Cir. 2000). Petitioners have not carried on any

other horse activities in the past, and they offered no evidence of successful

dissimilar activities or that they used any business expertise they may have

acquired from other business ventures in their horse activity. See Dodge v.

Commissioner, T.C. Memo. 1998-89, slip op. at 15, aff’d without published

opinion, 188 F.3d 507 (6th Cir. 1999). We consider this factor neutral.

      F.     Petitioners’ History of Income or Losses With Respect to the Activity

      A taxpayer’s history of income or loss with respect to an activity may

indicate the presence or absence of a profit motive. Sec. 1.183-2(b)(6), Income

Tax Regs.; see also Golanty v. Commissioner, 72 T.C. at 426. A series of losses

during the initial or startup stage of an activity does not necessarily indicate that

the activity is not engaged in for profit, but losses that extend beyond the

customary startup stage may. Sec. 1.183-2(b)(6), Income Tax Regs.; see also

Engdahl v. Commissioner, 72 T.C. at 669. The goal, however, must be to realize a
                                          - 35 -

[*35] profit on the entire operation, which presupposes not only future net

earnings but also sufficient net earnings to recoup losses incurred in the

intervening years. See Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965),

aff’d, 379 F.2d 252 (2d Cir. 1967).

      As indicated, Marestelle Farm has not earned a profit since its inception in

1985. From its inception to 2012 it realized income totaling $33,691 and incurred

expenses totaling $1,008,303, resulting in cumulative losses of $974,612. In their

answering brief petitioners attempt to justify the continued losses, asserting that

Marestelle Farm was a startup business and that “it remained in the startup phase

in all 30 years of operations.” However, as we indicated supra p. 27, we have

previously found that the startup phase for a horse breeding activity is 5 to 10

years, not 30. Engdahl v. Commissioner, 72 T.C. at 669. In 2010, the first year at

issue, petitioners were already in their 25th year of their horse activity (all without

a profit) and well beyond the startup phase.

      Petitioners also argue that Marestelle Farm suffered losses due to the Great

Recession. While Marestelle Farm’s operations may have been harmed by the

recession, its history of losses long predates that recession and thus the recession

cannot entirely account for the losses.

      Accordingly, this factor weighs heavily in favor of respondent’s position.
                                         - 36 -

[*36] G.      Amount of Occasional Profits

        The amount of profits in relation to the amount of losses incurred may

provide a useful criterion in determining the taxpayer’s intent. Sec. 1.183-2(b)(7),

Income Tax Regs.; see also Giles v. Commissioner, T.C. Memo. 2006-15, slip op.

at 41. A taxpayer’s belief that he could one day earn a substantial profit from his

activity may indicate a profit objective if that belief is adequately supported. See

Giles v. Commissioner, slip op. at 41-42; see also sec. 1.183-2(b)(7), Income Tax

Regs.

        In their answering brief petitioners contend that thoroughbred horse

breeding and racing is a highly risky activity but that it has a potential for large

profits. However, from its inception in 1985 through its dissolution in 2014,

Marestelle Farm has never had a profitable year, let alone a substantial one. Thus,

petitioners’ alleged belief is not adequately supported.

        Accordingly, this factor weighs heavily in favor of respondent’s position.

        H.    Petitioners’ Financial Status

        A lack of 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.; see also Helmick v. Commissioner, T.C. Memo. 2009-220, slip op. at 32.

In contrast, the fact that a taxpayer derives substantial income from sources other
                                        - 37 -

[*37] than the activity (particularly if losses from the activity generate substantial

tax benefits) may indicate that the taxpayer is not engaged in the activity for profit,

especially if personal or recreational elements are involved. Sec. 1.183-2(b)(8),

Income Tax Regs.

      It is undisputed that petitioners received a total of over $100,000 in wage

and Social Security income in each of the years at issue ($102,376 in 2010,

$106,102 in 2011, and $111,374 in 2012). After applying their Schedule E

deductions attributable to Marestelle Farm ($52,554 in 2010, $69,719 in 2011, and

$61,028 in 2012) petitioners reported total tax due of $538 in 2010 and zero in

2011 and 2012.

      Section 183 does not apply just to wealthy individuals as even taxpayers

with modest tax liabilities can have a motive to shelter those liabilities. Helmick

v. Commissioner, slip op. at 33. In this instance petitioners’ claimed losses

allowed them to shield their other income from tax and significantly reduced the

after-tax cost of their horse activity. See Hillman v. Commissioner, T.C. Memo.

1999-255, slip op. at 24; Sullivan v. Commissioner, T.C. Memo. 1998-367, slip

op. at 35, aff’d without published opinion, 202 F.3d 264 (5th Cir. 1999).

      Accordingly, this factor weighs in favor of respondent’s position.
                                        - 38 -

[*38] I.     Elements of Personal Pleasure or Recreation

      The presence of personal motives or recreational elements in carrying on an

activity may indicate that the activity is not engaged in for profit. Sec. 1.183-

2(b)(9), Income Tax Regs. However, the fact that the taxpayer derives personal

pleasure from engaging in the activity does not show that the taxpayer lacks a

profit objective if other evidence shows the activity is conducted for profit. Id.

“[A] business will not be turned into a hobby merely because the owner finds it

pleasurable; suffering has never been made a prerequisite to deductibility.”

Jackson v. Commissioner, 59 T.C. 312, 317 (1972); see also Giles v.

Commissioner, slip op. at 33. But if the chance for profit is small relative to the

potential for gratification, the latter may emerge as the primary motivation for the

activity. See Annuzzi v. Commissioner, T.C. Memo. 2014-233, at *32 (citing

White v. Commissioner, 23 T.C. 90, 94 (1954), aff’d per curiam, 227 F.2d 779

(6th Cir. 1955)).

      Petitioners clearly enjoyed owning horses. They began their horse activity

when Mrs. Donoghue found her dream horse, Lilac Domino. As a child Mrs.

Donoghue fell in love with thoroughbred horses because of her grandfather, a

successful thoroughbred racing horse breeder. Indeed, Mrs. Donoghue’s

sentimental feelings toward horse breeding and racing played a role not just in
                                        - 39 -

[*39] petitioners’ decision to begin their horse activity but also in the manner in

which they conducted the activity. For example, the reason she secured a license

to race their horses in Florida was in homage to her grandfather, who had raced at

Gulfstream Park. Petitioners’ possibility of profit was small compared to the

possibility for gratification to them, Mrs. Donoghue in particular, from the

activity, and they left the most grueling aspects of caring for their horses to paid

professionals.

       Accordingly, this factor weighs in favor of respondent’s position.

       J.    Conclusion

       Of the nine factors listed in section 1.183-2(b), Income Tax Regs., eight

favor respondent and one is neutral. After weighing the factors and the facts and

circumstances of this case, we conclude that petitioners did not have an actual and

honest objective to operate Marestelle Farm for profit during the years at issue.

Accordingly, we sustain respondent’s disallowance of petitioners’ claimed loss

deductions attributable to Marestelle Farm for the years at issue on the ground that

they did not engage in their horse activity for profit within the meaning of section

183.
                                        - 40 -

[*40] III.   Section 6662(a) Accuracy-Related Penalties

      We now address whether petitioners are liable for accuracy-related penalties

under section 6662(a) for the years at issue.

      Various grounds for the imposition of these penalties are set forth in the

notice of deficiency although only one accuracy-related penalty for a given year

may be applied with respect to any given portion of an underpayment, even if that

portion is subject to the penalty on more than one ground. Sec. 1.6662-2(c),

Income Tax Regs. We need only address respondent’s claim that petitioners are

liable for accuracy-related penalties for the years at issue on the ground that

petitioners’ underpayments of tax for these years were attributable to substantial

understatements of income tax under section 6662(b)(2). For purposes of section

6662(b)(2), an understatement of tax generally means the excess of tax required to

be reported on the return over the amount shown on the return. Sec.

6662(d)(2)(A). An understatement of income tax is substantial in the case of an

individual if it exceeds the greater of 10% of the tax required to be shown on the

return for the taxable year or $5,000. Sec. 6662(d)(1). Petitioners’ income tax

was understated by $8,491, $9,316, and $10,353, respectively, for 2010, 2011, and

2012. As determined in the notice of deficiency petitioners’ understatements of

income tax for the years at issue were substantial.
                                        - 41 -

[*41] The Commissioner bears the burden of production with respect to accuracy-

related penalties. Sec. 7491(c). Once the Commissioner meets this burden, the

taxpayer must come forward with persuasive evidence that the Commissioner’s

determination is incorrect. See Rule 142(a); Welch v. Helvering, 290 U.S. at 115;

Higbee v. Commissioner, 116 T.C. 438, 447 (2001). Section 6751(b)(1) provides

that “[n]o penalty * * * shall be assessed unless the initial determination of such

assessment is personally approved (in writing) by the immediate supervisor of the

individual making such determination or such higher level official as the Secretary

may designate.” In Graev v. Commissioner (Graev III), 149 T.C. 485, 493 (2017),

supplementing and overruling in part Graev v. Commissioner (Graev II), 147 T.C.

460 (2016), we held that the Commissioner’s burden of production under section

7491(c) includes establishing compliance with the supervisory approval

requirement of section 6751(b). Further, we recently held that, for purposes of

section 6751(b), the IRS’ 30-day letter can be the “initial determination”. Clay v.

Commissioner, 152 T.C. ___, ___ (slip op. at 43-44) (Apr. 24, 2019).

      Trial of this case was held, and the record was closed, before we vacated in

part our decision in Graev II and issued Graev III (and issued Clay). In the light of

Graev III, we ordered respondent to file a response addressing the effect of section

6751(b) on this case and directing the Court to any evidence of section 6751(b)
                                        - 42 -

[*42] supervisory approval in the record and petitioners to respond. Respondent

was unable to direct the Court to any evidence in the record that satisfies his

burden of production with respect to section 6751(b)(1) and filed a motion to

reopen the record to offer into evidence in pertinent part (1) the declaration of Ms.

McCarthy, the IRS revenue agent who conducted the audit of petitioners’ joint

Forms 1040 for the years at issue and recommended imposing section 6662(b)(2)

accuracy-related penalties for substantial understatements of income tax for the

years at issue, and (2) the Civil Penalty Approval Form for the years at issue, dated

contemporaneously with the 30-day letter to petitioners and before the issuance of

the notice of deficiency and signed by Michael Edelstein, Ms. McCarthy’s

immediate supervisor.13 Respondent also separately filed a motion to withdraw his

objection to the admission of the pages of Exhibit 23-P which consist of the Civil


      13
         Additionally with this motion respondent offers into evidence (1) the
declaration of IRS Appeals Officer Camesia V. Anderson, who was assigned
petitioners’ case in the IRS Office of Appeals and recommended imposing sec.
6662(b)(1) accuracy-related penalties for negligence or disregard of rules or
regulations for the years at issue and (2) a copy of the notice of deficiency that set
forth the imposition of sec. 6662(b)(1) and (2) accuracy-related penalties (as well
as sec. 6662(b)(3) and (4) accuracy-related penalties) and that was signed by Mark
C. Pettigrew, Ms. Anderson’s immediate supervisor. The record contains a copy
of the notice of deficiency without the signature page. Since we need only address
respondent’s claim that petitioners are liable for sec. 6662(b)(2) accuracy-related
penalties, it is unnecessary for us to address the admissibility of this proffered
evidence.
                                         - 43 -

[*43] Penalty Approval Form. As we indicated supra note 11, Exhibit 23-P

includes, in addition to this form, the IRS’ 30-day letter, which was also signed by

Mr. Edelstein. Petitioners objected to the introduction of any additional evidence

with respect to the penalties and requested that the Court deny respondent’s

motions.

      Reopening the record for the submission of additional evidence lies within

the Court’s discretion. Zenith Radio Corp. v. Hazeltine Research, Inc., 401 U.S.

321, 331 (1971); Rivera-Flores v. P.R. Tel. Co., 64 F.3d 742, 746 (1st Cir. 1995);

Butler v. Commissioner, 114 T.C. 276, 286-287 (2000); see also Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359, 363 (9th Cir. 1974) (“[T]he Tax Court’s

ruling [denying a motion to reopen the record] is not subject to review except upon

a demonstration of extraordinary circumstances which reveal a clear abuse of

discretion.”), aff’g T.C. Memo. 1971-200. We will not grant a motion to reopen

the record unless, among other requirements, the evidence relied on is not merely

cumulative or impeaching, is material to the issues involved, and probably would

change some aspect of the outcome of the case. Butler v. Commissioner, 114 T.C.

at 287; see also SEC v. Rogers, 790 F.2d 1450, 1460 (9th Cir. 1986) (explaining

that the trial court “should take into account, in considering a motion to hold open

the trial record, the character of the additional * * * [evidence] and the effect of
                                        - 44 -

[*44] granting the motion”), overruled on other grounds by Pinter v. Dahl, 486

U.S. 622 (1988).

      In reviewing motions to reopen the record, courts have considered when the

moving party knew that a fact was disputed, whether the evidentiary issue was

foreseeable, and whether the moving party had reason for the failure to produce

the evidence earlier. See, e.g., George v. Commissioner, 844 F.2d 225, 229-230

(5th Cir. 1988) (and cases cited thereat) (holding that refusal to reopen the case

was not an abuse of discretion because the issue was foreseeable to the taxpayers

and the court could see no excuse for the taxpayers’ failure to produce evidence

earlier), aff’g Frink v. Commissioner, T.C. Memo. 1984-669. We also balance the

moving party’s diligence against the possible prejudice to the nonmoving party.

In particular we consider whether reopening the record after trial would prevent

the nonmoving party from examining and questioning the evidence as it would

have during the proceeding. See, e.g., Estate of Freedman v. Commissioner, T.C.

Memo. 2007-61; Megibow v. Commissioner, T.C. Memo. 2004-41.

      The evidence that is the subject of respondent’s motions would not be

cumulative of any evidence in the record and it would not be impeaching material.

Respondent bears the burden of production with respect to penalties and would

offer the evidence as proof that the requirements of section 6751(b)(1) have been
                                        - 45 -

[*45] met. The subject evidence is material to the issues involved in the case, and

we conclude that the outcome of the case will be changed if we grant respondent’s

motions.

      Petitioners seemingly suggest that (1) irregularities occurred not during the

audit of their Forms 1040 for the years at issue but during the audit of Marestelle

Farm’s Forms 1065 for these same years and (2) there are irregularities with

respect to the Civil Penalty Approval Form. As for their first suggestion, it is of

no moment (and unsupported in any event). See Riland v. Commissioner, 79 T.C.

185, 201 (1982) (and cases cited thereat). As for their second suggestion, we

agree with respondent that the Civil Penalty Approval Form is a record kept in the

ordinary course of a business activity and is authenticated by the declaration of

Ms. McCarthy. See Fed. R. Evid. 803(6), 902(11). We also agree with respondent

that the Civil Penalty Approval Form is material to the penalty issue in this case

and is not cumulative. Thus, we will admit the Civil Penalty Approval Form into

evidence and the declaration for purposes of authentication under rule 902(11) of

the Federal Rules of Evidence. See Clough v. Commissioner, 119 T.C. 183, 190-

191 (2002). Similarly, with the issuance of our Opinion in Clay, Exhibit 23-P,

which includes the 30-day letter, is material to the penalty issue in this case and is

not cumulative, and thus we will now admit this exhibit in its entirety into
                                        - 46 -

[*46] evidence. Respondent has met his burden of production for the accuracy-

related penalties for substantial understatements of income tax for the years at

issue.

         Since respondent has met his burden, petitioners must come forward with

persuasive evidence that the penalties are inappropriate because, for example, they

had reasonable cause and acted in good faith. See sec. 6664(c)(1); Higbee v.

Commissioner, 116 T.C. at 446-447; see also Rodriguez v. Commissioner, at *57

(finding a taxpayer’s failure to satisfy section 183 does not preclude a reasonable

cause and good faith defense). The determination whether the taxpayer had

reasonable cause and acted in good faith depends upon the pertinent facts and

circumstances of a particular case. Sec. 1.6664-4(b)(1), Income Tax Regs. We

consider, among other factors, the experience, education, and sophistication of the

taxpayer; however, the principal consideration is the extent of the taxpayer’s

efforts to assess the proper tax liability. Id.; see also Higbee v. Commissioner, 116

T.C. at 448. Taking into consideration the taxpayer’s experience, education, and

sophistication, an honest misunderstanding of fact or law may indicate reasonable

cause and good faith. Higbee v. Commissioner, 116 T.C. at 449 (citing Remy v.

Commissioner, T.C. Memo. 1997-72). In addition, reliance on professional advice

may indicate reasonable cause and good faith if, in the light of all the facts and
                                         - 47 -

[*47] circumstances, such reliance was reasonable and the taxpayer acted in good

faith. Id. at 448-449.

      Petitioners, however, have not presented evidence to show reasonable cause

or good faith for the loss deductions they claimed with respect to Marestelle Farm

for the years at issue. Petitioners admit that they did not receive any advice

regarding the deductibility of their horse activity losses for any of the years at

issue. Petitioners are both college educated, and Mr. Donoghue has a degree in

finance. Additionally, they both have experience in business; in the past Mr.

Donoghue managed a construction business and Mrs. Donoghue was a corporate

executive. Their professional backgrounds make it unreasonable for them to have

conducted their horse activity without soliciting advice as to the deductibility of

their horse activity losses for the years at issue. Simply employing tax return

preparers (for 2010 and 2011) does not permit them to avoid accuracy-related

penalties. See Neonatology Assocs., PA v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

      Petitioners suggest that they had reasonable cause and acted in good faith

because they had a prior audit for 2007 which resulted in respondent’s ultimately

conceding the asserted deficiency as reflected in a November 8, 2011, decision of

this Court. Their suggestion, however, lacks merit. As we stated in Transupport,
                                            - 48 -

[*48] Inc. v. Commissioner, T.C. Memo. 2016-216, at *41, supplementing T.C.

Memo. 2015-179, aff’d, 882 F.3d 274 (1st Cir. 2018):

             Petitioner again argues that the methodology was used
      consistently over years and was therefore correct. Petitioner
      apparently believes that repeating a fallacy over and over again and
      ignoring contrary evidence will succeed. It does not. A well-
      established principle is that what was condoned or agreed to for a
      previous year may be challenged for a subsequent year. Auto. Club
      of Mich. v. Commissioner, 353 U.S. 180 (1957); Rose v.
      Commissioner, 55 T.C. 28 (1970). Thus, the results of a prior audit
      do not constitute substantial authority. * * *

      Accordingly, we sustain respondent’s determination regarding the accuracy-

related penalties for the years at issue.

      We have considered all of the arguments made by the parties and, to the

extent they are not addressed herein, we find them to be moot, irrelevant, or

without merit.

      To reflect the foregoing,


                                                     Decision will be entered

                                            under Rule 155.
