                              T.C. Memo. 2013-294



                         UNITED STATES TAX COURT



    TRAVIS A. MATHIS AND BETTINA C. JARY-MATHIS, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 21704-10, 24596-11.            Filed December 30, 2013.



      James Frederick Martens, Kelli H. Todd, and Jeffrey S. Taylor, for

petitioners.

      Roberta L. Shumway and Bryan J. Dotson, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      GOEKE, Judge: Petitioners owned a cutting horse farm in Florence, Texas.

They continued to operate the farm despite sustaining significant losses for each of

the 13 years of its existence. Respondent audited petitioners’ Forms 1040, U.S.
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[*2] Individual Income Tax Return, for the years 2006 to 2008. Respondent

determined petitioners were not operating the farm for profit. Consequently, they

issued a notice of deficiency denying the related deductions and determining a

deficiency for each of those years. Respondent also imposed accuracy-related

penalties associated with the resulting deficiencies. The issues for decision are:

      (1) whether petitioners engaged in their cutting horse activity from 2006 to

2008 for profit within the meaning of section 183(a).1 We hold that they did not;

and

      (2) whether petitioners are liable for accuracy-related penalties under

section 6662(a) for 2006, 2007, and 2008. We hold that they are not.

                               FINDINGS OF FACT

I. Petitioners

      Petitioners resided in Texas when they filed the petition.

      Bettina Jary-Mathis grew up in south Texas and spent much of her youth

assisting her uncle on a cattle ranch. As a teenager she developed a passion for

cutting horses. Cutting is an equestrian event in which judges score a horse and

rider on their ability to isolate a cow or calf from a herd. When Mrs. Jary-Mathis

      1
      Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
                                         -3-

[*3] was in high school, her father, who was an architect, designed a house on a

cutting horse farm for one of his clients. While her father worked on the house,

Mrs. Jary-Mathis hovered around the barn and learned all she could about cutting

horses.

      In 1992 Mrs. Jary-Mathis married Travis Mathis. Mr. Mathis comes from a

wealthy family--his grandfather co-founded Brown & Root, a lucrative

engineering and construction company. Petitioners earn millions of dollars in

investment income every year.

II. La Brisa Farm

      In 1995 petitioners purchased property in Florence, Texas, and started La

Brisa Farm to train cutting horses. From 1995 until 2000 Mrs. Jary-Mathis

managed the farm primarily as a training operation. She bred her mares to high-

quality stallions to produce horses capable of competing in the premier cutting

events. She employed accomplished onsite trainers to develop her young horses’

talent, but the prize money she earned did not cover the expenses she incurred.

She also found retaining qualified trainers difficult, because the best trainers

wanted to demonstrate their skills on horses from many different farms.

      After sustaining losses in each of the first five years and losing her onsite

trainers, Mrs. Jary-Mathis decided to shift the farm’s focus to breeding rather than
                                        -4-

[*4] training. She created a written business plan, which stated the operation’s

new objective: breeding cutting horses with “proven and desirable bloodlines” for

which “customers will be willing to pay a premium”.

      A young cutting horse’s value depends largely on its bloodlines. Purchasers

evaluate a young horse’s potential on the success of its parents. Horses born to

parents that have won significant cutting competitions or have produced other

winners sell for more than those with less accomplished parents. To build La

Brisa Farm’s reputation, Mrs. Jary-Mathis sought to develop a premier band of

broodmares. She purchased broodmares with strong bloodlines and kept only

those that produced successful foals. She often sold young horses to top-level

trainers cheaply, because she knew those trainers could win competitions with

them. Those horses’ success would increase the value of future foals. By the end

of 2007 La Brisa Farm possessed an exceptional broodmare collection.

III. Mrs. Jary-Mathis’ Role on the Farm

      Petitioners hired an onsite breeding manager to perform day-to-day

activities, but Mrs. Jary-Mathis oversaw all aspects of the farm’s operations and

made all important decisions. She typically worked 40 hours per week on farm

activities. She spent most of that time researching performance records and

identifying stallions to breed with her mares. Her work volume increased to 60
                                         -5-

[*5] hours per week during the premier cutting competitions. During cutting

events she and her daughter, Maria, showed La Brisa Farm’s horses.

      Mrs. Jary-Mathis frequently attended cutting horse seminars and attended

one on ranching for profit. She continually consulted with cutting horse trainers

and other owners to improve her breeding operation. Mrs. Jary-Mathis also chose

the farm’s marketing methods. She periodically advertised in print and online

publications, but the farm did not have a Web site. She identified buyers for her

horses primarily by talking with owners and trainers at cutting events.

      Although Mrs. Jary-Mathis generally visited La Brisa Farm no more than

once a week, she regularly interacted with her horses. Mrs. Jary-Mathis often kept

young foals on her personal farm until they were weaned, so she could watch them

play and monitor their growth.

IV. Financial Reporting

      Petitioners hired Deborah Gorman to keep the farm’s books and track their

personal finances. She used a computer program to generate financial reports,

which Mrs. Jary-Mathis reviewed at least monthly. The financial statements

included petitioners’ personal items, but the farm items were clearly identifiable.

Petitioners provided complete and accurate financial reports to a certified public

accountant, who prepared their annual returns. Petitioners have used the same
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[*6] accounting firm throughout the farm’s history, and the same individual has

prepared their returns for each year since 1999.

V. La Brisa Farm Financial Performance

      La Brisa Farm has never earned a profit. From 1996 to 2011 petitioners

reported cumulative losses on their Schedules F, Profit or Loss From Farming, of

$9,152,718. Petitioners’ largest losses occurred in the three years at issue here.

Since 2008, petitioners’ Schedule F losses have decreased substantially as a result

of lower reported expenses; petitioners’ reported farming income has not

increased. Petitioners reported the following Schedule F net losses for the years at

issue and beyond:

                              Year               Loss
                              2006             $868,818
                              2007             1,102,816
                              2008             1,360,184
                              2009              372,174
                              2010              180,946
                              2011              255,936

      On December 31, 2008, La Brisa Farm owned 64 cutting horses, which

petitioners’ appraiser valued at $1,252,500. Petitioners have never sold a horse

for more than $65,000 and typically received much less.
                                         -7-

[*7]                                 OPINION

I. Burden of Proof

       The taxpayer generally bears the burden of proving the Commissioner’s

determinations are erroneous. Rule 142(a). The burden of proof may shift to the

Commissioner if the taxpayer satisfies certain conditions. Sec. 7491(a). However,

we decide the section 183 issue on the preponderance of the evidence and,

therefore, the burden of proof is not relevant. See Estate of Bongard v.

Commissioner, 124 T.C. 95, 111 (2005).

II. Section 183 For-Profit Requirement

       Section 183 limits the section 162 trade or business expense deductions a

taxpayer may claim for expenses attributable to an activity not engaged in for

profit. Taxpayers may not deduct such expenses to the extent they exceed income

generated by the activity less deductions attributable to the activity allowable

without regard to whether the taxpayer engaged in the activity for profit. Sec.

183(b).

       Taxpayers engage in an activity for profit when they entertain an actual and

honest profit objective in engaging in the activity. Dreicer v. Commissioner, 78

T.C. 642, 645 (1982), aff’d without opinion, 702 F.2d 1205 (D.C. Cir. 1983); sec.

1.183-2(a), Income Tax Regs. Whether the requisite profit objective exists is
                                          -8-

[*8] determined by looking at all the surrounding facts and circumstances.

Keanini v. Commissioner, 94 T.C. 41, 46 (1990); sec. 1.183-2(b), Income Tax

Regs. We give greater weight to objective facts than to a taxpayer’s mere

statement of intent. Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), aff’d,

792 F.2d 1256 (4th Cir. 1986); sec. 1.183-2(a), Income Tax Regs. Evidence from

years after the years in issue is relevant to the extent it creates inferences regarding

the taxpayer’s requisite profit objective in earlier years. E.g., Foster v.

Commissioner, T.C. Memo. 2012-207; Bronson v. Commissioner, T.C. Memo.

2012-17.

      Section 1.183-2(b), Income Tax Regs., provides a list of factors to consider

in evaluating a taxpayer’s profit objective: (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 expended 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 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 are involved. No single factor

controls. Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff’d without
                                         -9-

[*9] published opinion, 647 F.2d 170 (9th Cir. 1981). After careful consideration

of these factors, we find that petitioners did not engage in their cutting horse

activity with a profit motive. We present our analysis below.

      A. Manner in Which the Taxpayer Carries on the Activity

      The fact that the taxpayer carries on an activity in a businesslike manner and

maintains complete and accurate books and records may indicate a profit motive.

Sec. 1.183-2(b)(1), Income Tax Regs. Characteristics of a businesslike operation

include the preparation of a business plan and, in the case of horse breeding and

sales, a consistent and concentrated advertising program. Bronson v.

Commissioner, T.C. Memo. 2012-17. The regulations further provide that a

taxpayer’s change in operating methods or adoption of new techniques to improve

profitability may indicate an overall profit motive. Sec. 1.183-2(b)(1), Income

Tax Regs.

      Petitioners maintained complete and accurate books for their cutting horse

activity. Their bookkeeper prepared financial reports, and Mrs. Jary-Mathis

reviewed them monthly. The reports provided Mrs. Jary-Mathis an accurate

account of the farm’s financial performance.

      Petitioners did not create a business plan when they started La Brisa Farm in

1995, but they did when the farm’s focus shifted to breeding in 2000. The
                                        -10-

[*10] business plan indicates that petitioners planned to promote their horses “so

effectively that customers will be willing to pay a premium”. Petitioners have

maintained a consistent advertising program. The farm frequently displays its

horses at shows and has advertised in print publications and online. Mrs. Jary-

Mathis also marketed her horses by talking with industry insiders.

      Petitioners argue that the farm’s shift in focus from training to breeding

represents a change in operating method that indicates a profit motive. We find

that petitioners changed their focus not to improve profitability but because they

could not keep top-level trainers. The best cutting horse trainers want to

demonstrate their skills by training and riding horses from a variety of farms.

Because they could not keep good trainers at La Brisa Farm, petitioners decided to

focus on breeding instead.

      On balance, this factor favors petitioners. They maintained complete and

accurate records, created a business plan, marketed their horses, and generally ran

the farm in a professional manner.

      B. The Expertise of the Taxpayer or Her Advisers

      The taxpayer’s expertise, research, and extensive study of an activity, as

well as his or her consultation with experts, may indicate a profit motive. See sec.

1.183-2(b)(2), Income Tax Regs. Mrs. Jary-Mathis grew up around ranching and
                                         -11-

[*11] learned about cutting horses when she was in high school. When she began

her own cutting horse operation, she had help from experienced trainers. Since

she started La Brisa Farm, Mrs. Jary-Mathis has frequently discussed training and

breeding strategies with prominent figures in the cutting horse industry. She

continually performs online research to identify the best horses in the country, and

she has attended seminars to learn more about the cutting horse business.

      Mrs. Jary-Mathis has developed expertise in breeding quality cutting horses,

but she lacks business expertise. Mrs. Jary-Mathis attended a seminar on ranching

for profit, but that does not make her an expert. Moreover, she attended the

seminar long after she started the activity. Petitioners’ failure at the outset to

consult experts on the financial aspects of running a cutting horse farm indicates

that they lacked a profit motive. See Burger v. Commissioner, 809 F.2d 355, 359

(7th Cir. 1987), aff’g T.C. Memo. 1985-523; Smith v. Commissioner, T.C. Memo.

1997-503, aff’d without published opinion, 182 F.3d 927 (9th Cir. 1999).

      C. The Time and Effort Expended by the Taxpayer in Carrying On the
         Activity

      The taxpayer’s devotion of much of his or her personal time and effort to

carrying on an activity may indicate a profit motive, particularly if the activity
                                         -12-

[*12] does not involve substantial personal or recreational aspects. Sec. 1.183-

2(b)(3), Income Tax Regs.

      Mrs. Jary-Mathis devotes considerable time and effort to La Brisa Farm.

She typically spends 40 hours a week on the cutting horse activity and 60 hours a

week during the top cutting events. Although Mrs. Jary-Mathis works hard, her

work involves substantial personal and recreational aspects. She works with

cutting horses, which have been her passion since she was young. She spends

time with her daughter at horse shows, and she derives a sense of personal pride

from owning high-quality cutting horses. On balance, this factor weighs in

petitioners’ favor, but the personal and recreational aspects of the activity limit its

effect on our overall analysis.

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

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

indicate a profit motive even if the taxpayer derives no profit from current

operations. Sec. 1.183-2(b)(4), Income Tax Regs. However, we may infer a profit

objective from such expected appreciation only when the appreciation exceeds

operating expenses and would be sufficient to recoup the accumulated losses of
                                         -13-

[*13] prior years. Foster v. Commissioner, T.C. Memo. 2012-207; see Golanty v.

Commissioner, 72 T.C. at 427-428.

      Mrs. Jary-Mathis testified that she expects her horses to appreciate in value

as her broodmares produce successful foals. However, petitioners have failed to

present evidence that the appreciation will recoup the accumulated losses.

Petitioners have reported over $9 million in losses, and the highest price they have

ever received for a horse is $65,000. Petitioners’ expert appraised La Brisa Farm’s

entire horse inventory at $1,252,500 as of December 31, 2008. Any appreciation

on petitioners’ horses only minimally offsets the very large losses petitioners have

sustained since beginning their cutting horse activity.

      Petitioners also provided some evidence that the La Brisa Farm property has

increased in value, but this does not indicate that they had a profit motive for their

cutting horse activity. Petitioners did not purchase the property for investment;

they purchased it to breed and train cutting horses. We must evaluate any profit

motive petitioners had in operating the farm separately from any profit motive they

had in purchasing the land. See sec. 1.183-1(d)(1), Income Tax Regs. (providing

that the farming and holding of land will ordinarily be considered a single activity

only when the taxpayer engages in the farming activity to offset the carrying costs

of the land). Although the land’s appreciation would be relevant to petitioners’
                                         -14-

[*14] motive in holding the land, it is not relevant to their motive in operating the

cutting horse farm. Even if the land’s appreciation were relevant to petitioners’

profit motive in operating the cutting horse farm, they have not presented

sufficient evidence that the appreciation offsets the farm’s substantial losses. The

evidence in the record concerning appreciation in the farm’s assets fails to

persuade us that future profits motivated petitioners to continue the cutting horse

activity.

       E. The Success of the Taxpayer in Other Similar Activities

       Section 1.183-2(b)(5), Income Tax Regs., provides: “The fact that the

taxpayer has engaged in similar activities in the past and converted them from

unprofitable to profitable enterprises may indicate that he is engaged in the present

activity for profit, even though the activity is presently unprofitable.” None of

petitioners’ past activities provides evidence of a profit motive here.

       F. Taxpayer’s History of Income or Losses

       A history of continued losses with respect to an activity may indicate that

the taxpayer lacked a profit motive. See sec. 1.183-2(b)(6), Income Tax Regs.

Although a series of losses during the initial or startup stage of an activity may not

necessarily indicate a lack of profit motive, a record of large losses over many
                                        -15-

[*15] years is persuasive evidence that the taxpayer did not have such a motive.

Golanty v. Commissioner, 72 T.C. at 426; Foster v. Commissioner, T.C. Memo.

2012-207.

      Petitioners realized no profits from La Brisa Farm in 13 years. Petitioners

claim that they engaged in two separate activities during that period: (1) training

from 1995 to 2000 and (2) breeding from 2000 to present. They argue that the

breeding operation remained in its startup phase during the years at issue, so the

losses during those years do not indicate the absence of a profit motive. We find

that the 2000 change was not significant enough to constitute the start of a new

activity. Petitioners have bred and trained horses on their farm throughout the

entire period. They focused more on breeding after 2000 and moved the training

operation offsite, but these changes do not amount to a change in activity.

Accordingly, we decline to “reset the clock” as of 2000 simply because petitioners

shifted their focus. The startup period for petitioners’ cutting horse activity passed

before respondent conducted his audit, and the history of losses strongly indicates

petitioners lacked a profit motive.

      Petitioners reported smaller Schedule F losses for the years following those

respondent audited. They cite the diminishing losses as a sign that the farm is

nearing profitability. However, the smaller net losses did not result from increased
                                           -16-

[*16] sales, only from lower reported expenses. Petitioners reported lower

expenses only after they received notice of the audit, which indicates that the

audit, not a desire to earn profits, may have triggered the reductions. Accordingly,

we give little weight to the decline in expenses petitioners reported in determining

whether they had a profit motive.

      The current and expected losses of an activity should not be of such a

magnitude that an overall profit going forward would not be possible. Bessenyey

v. Commissioner, 45 T.C. 261, 274 (1965), aff’d, 379 F.2d 252 (2d Cir. 1967).

Petitioners have accumulated over $9 million in losses from their cutting horse

activity. It is unrealistic to expect that petitioners would not continue to

accumulate significant losses. They have presented no convincing evidence that

future profits could possibly offset these losses. Accordingly, this factor weighs

heavily against finding a profit motive.

      G. Amount of Occasional Profits

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

provide evidence of the taxpayer’s intent. Sec. 1.183-2(b)(7), Income Tax Regs.

Petitioners have never earned a profit from the cutting horse activity, yet they

continue to operate the farm. This indicates that they are running the farm for

personal rather than business reasons.
                                         -17-

[*17] H. Taxpayer’s Financial Status

      Substantial income from sources other than the activity may indicate that the

activity is not engaged in for profit. Sec. 1.183-2(b)(8), Income Tax Regs. A

taxpayer with substantial income unrelated to the activity can more readily afford

a hobby. Foster v. Commissioner, T.C. Memo. 2012-207. This is particularly true

if the losses from the activity might generate substantial tax benefits. Golanty v.

Commissioner, 72 T.C. at 429. Petitioners’ substantial investment income has

allowed them to continue the cutting horse operation despite 17 consecutive years

of substantial losses. Petitioners’ cutting horse activity also generated tax savings

in the form of net losses that offset petitioners’ investment income. This factor

weighs against finding a profit objective.

      I. Elements of Personal Pleasure or Recreation

      The presence of personal motives and 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. Mrs. Jary-Mathis enjoys working with horses and

derives substantial personal satisfaction from her cutting horse operation. She

enjoys watching the young horses and often brings them to her personal farm to

watch them grow. However, running a large-scale breeding operation takes many
                                         -18-

[*18] hours of hard work, and Mrs. Jary-Mathis has sacrificed family and personal

time to promote her horses. This factor weighs slightly against a profit motive.

      J. Conclusion

      After weighing all the facts and circumstances in light of the relevant

factors, we conclude that petitioners did not engage in their cutting horse activity

with the requisite profit objective. Mrs. Jary-Mathis is determined to be a

successful horsewoman. She wants to build a reputation as a producer of top-level

cutting horses. However, she has pursued this goal independently of any desire to

earn profits. She has continued training and breeding cutting horses for 17 years

without ever approaching profitability, yet she has never seriously considered

discontinuing operations. Accordingly, we sustain respondent’s determination

that petitioners did not engage in the cutting horse activity for profit.

III. Accuracy-Related Penalties

      Respondent determined that petitioners were liable for an accuracy-related

penalty pursuant to section 6662(a) for each of the tax years at issue. Section

6662(a) and (b)(1) and (2) imposes a penalty of 20% on any underpayment

attributable to, among other things, (1) negligence or disregard of rules or

regulations; or (2) any substantial understatement of income tax. An

understatement is substantial if it exceeds the greater of $5,000 or 10% of the
                                        -19-

[*19] income tax required to be shown on the return for the taxable year. Sec.

6662(d)(1)(A).

      The Commissioner bears the burden of production with respect to this

penalty. Sec. 7491©. The Commissioner satisfies the burden by presenting

sufficient evidence supporting the relevant penalty. Higbee v. Commissioner, 116

T.C. 438, 446 (2001). Respondent determined that petitioners underpaid their

income tax by $320,927, $376,318, and $491,571 for the years 2006, 2007, and

2008, respectively. These amounts exceed the “substantial understatement”

threshold for each year in question. Thus, respondent has carried his burden of

demonstrating that petitioners substantially understated their income tax.

      Pursuant to section 6664(c)(1), the accuracy-related penalty under section

6662 does not apply to any portion of an underpayment for which a taxpayer

establishes that he or she: (1) had reasonable cause, and (2) acted in good faith. A

taxpayer’s failure to comply with section 183 does not preclude a reasonable cause

and good faith defense. See, e.g., Rodriguez v. Commissioner, T.C. Memo. 2013-

221, at *57. Whether a taxpayer has acted with reasonable cause and in good faith

depends on the facts and circumstances of the case. Relevant factors include the

taxpayer’s efforts to assess the proper tax liability, the taxpayer’s knowledge and
                                        -20-

[*20] experience, and the extent to which the taxpayer relied on the advice of a tax

professional. Sec. 1.6664-4(b)(1), Income Tax Regs.

      Petitioners hired a certified public accountant to prepare their returns.

Because the return preparer had signed all of their returns since 1999, she knew

the farm’s financial history. Petitioners submitted complete and accurate books

and records to their accountant and relied on her to properly prepare their returns.

Although we find that petitioners lacked a profit motive, we acknowledge that

they operated the farm in a professional manner and took their activity seriously.

We are persuaded that petitioners had reasonable cause and acted in good faith.

Accordingly, we find they are not liable for accuracy-related penalties.

      To reflect the foregoing,


                                               Decisions will be entered for

                                       respondent as to the deficiencies and for

                                       petitioners as to the accuracy-related

                                       penalties under section 6662(a).
