                       T.C. Memo. 2000-288



                     UNITED STATES TAX COURT



RICHARD J. AND MELODIE D. MCKEEVER, Petitioners v. COMMISSIONER
                OF INTERNAL REVENUE, Respondent



     Docket No. 4130-97.                 Filed September 14, 2000.


     B. Paul Husband, for petitioners.

     Jordan S. Musen and Michael H. Salama, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     MARVEL, Judge: Respondent determined the following

deficiencies and accuracy-related penalties with respect to

petitioners’ Federal income taxes:
                                 - 2 -



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

     1991            $16,902                     $3,380
     1992             21,165                      4,233
     1993             29,073                      5,815

     After concessions,1 the issues remaining for decision are

whether petitioners’ horse activity during the years at issue was

an activity not engaged in for profit within the meaning of

section 183(a),2 and whether petitioners are liable for accuracy-

related penalties on account of negligence under section 6662(a)

for the years at issue.

                          FINDINGS OF FACT

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

The first and second stipulations of facts are incorporated in

this opinion by this reference.

The Petitioners

     Richard J. and Melodie D. McKeever (petitioners) resided in

Norco, California, on the date they filed their petition in this

case.



     1
      Petitioners conceded that they received $28,000 of
unreported taxable commission income in 1993 and that
respondent’s determinations for 1991 and 1992 are not time barred
by the statute of limitations.
     2
      All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts are
rounded to the nearest dollar.
                               - 3 -

     At all relevant times, Richard J. McKeever was the sole

shareholder, chief executive officer, and general sales manager

of Aero Industrial Alloy, Inc., a metals distributing business.

Mr. McKeever does not hold a college degree.

     Since at least 1986 and continuing through the date of

trial, Melodie D. McKeever has been employed full time as a

medical technologist by Kaiser Permanente.    Mrs. McKeever

received a bachelor of science degree in microbiology, with an

emphasis in premed for veterinarians, from Long Beach State

University in 1972.

     Mrs. McKeever has been involved with horses her entire life.

As a child, Mrs. McKeever spent time with horses on her

grandfather’s and uncle’s ranches.     When her father was stationed

in Barstow, California, Mrs. McKeever cleaned stalls and did

other volunteer work at the U.S. Marine Corps stables in exchange

for lessons in riding and horsemanship.    From 1975 until 1983,

Mrs. McKeever was a member of Equestrian Trails, Inc., an

organization devoted to maintaining trails throughout California.

Mrs. McKeever served as the secretary of her local chapter for 2

years.   Prior to 1988, Mrs. McKeever owned two horses:   A grade

gelding and a quarter horse mare.

Commencement of the Horse Activity

     In 1987, petitioners began their horse activity.

Petitioners did not have any prior employment history or business
                              - 4 -

experience in breeding, showing, or selling horses.    By the time

they began their horse activity, petitioners had acquired only

general experience in owning, caring for, and riding horses.

Petitioners have never taken any classes or attended any programs

regarding the financial or business aspects of horse breeding and

showing.

     Petitioners chose the paso fino breed for their horse

activity for a variety of reasons.    Petitioners admired paso

finos for their beauty and smooth-gaited ride.    Petitioners also

decided that, because of their smooth ride, paso finos are good

for people, like Mr. McKeever, who have back problems.    Prior to

starting their horse activity, petitioners did not research the

marketability of the paso fino breed or determine how they were

most likely to make money with paso fino horses.    Petitioners did

not seek business advice prior to purchasing their first paso

fino horses.

     In August 1987, petitioners purchased their first two paso

fino horses, Chispa Nuac and Sol Rey de Pito, from Dorothy

Sarnecky for a total of $15,000.   During 1988, petitioners had

discussions with Ms. Sarnecky and Charles Minter which confirmed

petitioners’ perception that paso finos have an excellent

disposition and that they are marketable.
                                - 5 -

Petitioners’ Advisers

     In 1988, petitioners used Mr. Minter as a breeding and sales

consultant and horse trainer.    Petitioners did not pay Mr. Minter

for his advice.   Petitioners initially approached Mr. Minter for

advice on breeding and showing Chispa Nuac, the mare they had

purchased from Ms. Sarnecky.    Mr. Minter has served on the board

of directors and several committees, including the ethics

committee, of the Paso Fino Horse Association.      His ranch, Rancho

Paso Bravo, has approximately 125 paso finos.

     From 1988 through 1992, petitioners purchased at least 10

horses from or through Mr. Minter.      All the horses were mares,

except for one gelding included in a six-horse dispersal sale.

Several of the horses purchased in that sale were untrained.

Other horses purchased from or through Mr. Minter during the

years 1988-92 had health problems which made them unsuitable for

riding or showing.3

     At some point during 1991, petitioners began consulting with

other paso fino breeding and training experts.      They did so after

talking with successful owners and trainers at horse shows.      As a




     3
      For example, in June 1988, petitioners purchased Adelita
LaCe. Adelita LaCe had a “hitching” gait condition in her rear
left leg. Mrs. McKeever had the mare examined by a veterinarian,
who stated that she had severe osteoarthritis due to an injury.
However, Mrs. McKeever expected that Adelita LaCe would still be
adequate for breeding purposes.
                                - 6 -

result of these conversations, petitioners began to question

their reliance on Mr. Minter’s advice.

     In March 1992, petitioners purchased six horses from Richard

Howe in a package deal for $15,000.     Mr. Minter brokered the

deal.    The package consisted of five mares and a gelding.    One of

the mares was trained, one was partly trained, and the rest were

untrained.

     Petitioners placed Bonita Bravo, a brood mare and show horse

purchased as part of the package deal, in training under Mr.

Minter and Favio Arias at Mr. Minter’s ranch.     During 1992 and

while at Mr. Minter’s ranch, Bonita Bravo suffered a cut to her

tongue.4   As a result of the injury, Bonita Bravo was never

shown.

     The injury to Bonita Bravo led petitioners to end their

business relationship with Mr. Minter.     Petitioners were unhappy

with many of the horses they had purchased from Mr. Minter.

Although Mr. Minter had a trade-in policy that allowed

dissatisfied customers to trade in unsatisfactory animals, the

time limit on the policy effectively limited its application to

animals purchased for riding, as opposed to breeding stock.

Moreover, although Mr. Minter arranged prepurchase veterinary

examinations of animals he purchased for Rancho Paso Bravo, he


     4
      A trainer may cut a horse’s tongue by being overly harsh
during training. Horses with cut tongues cannot hold a bit in
their mouths.
                               - 7 -

advised petitioners not to obtain veterinary examinations of any

horses purchased from him or through him.   Petitioners did not

have a veterinarian examine any of the horses purchased from Mr.

Minter either prior to or immediately after their purchase.

     During 1991, Mrs. McKeever hired Diego Palacio as a trainer

for petitioners’ horses.   Mr. Palacio introduced petitioners to

Carlos Cortelezzi, D.V.M., who became petitioners’ mentor and

principal adviser concerning their horse activity.    Dr.

Cortelezzi first saw petitioners’ horses in 1993, and since then,

he has given petitioners general advice on improving the quality

of their herd.5   He also advised them to purchase several mares

in 1994 from a third party.   Several younger horses, including El

Niño Cisco de Norco, were purchased with the mares.    The total

purchase price of the horses purchased in 1994 was $25,000.

Breeding Activities

     Since the acquisition of their first mare in 1987,

petitioners have attempted to expand their herd through breeding,

with mixed results.   A number of setbacks have hampered

petitioners’ attempts to breed their horses.




     5
      Petitioners generally have followed Dr. Cortelezzi’s
advice. However, when Dr. Cortelezzi was out of the country for
3 years, petitioners made their own decisions regarding which
animals to use for breeding. Petitioners have negotiated with
Dr. Cortelezzi regarding purchases of breedings from his
stallion, and Dr. Cortelezzi co-owns at least one of petitioners’
horses.
                              - 8 -

     In 1989, petitioners purchased three breedings from Mr.

Minter’s stallion, Bochica Tres, for a total of $8,000.   Bochica

Tres has been a “top-ten stallion” many times.   However, the

foals produced as a result of these breedings were all

unsatisfactory and eventually sold at or below the cost of

Bochica Tres’ stud fee.

     In 1994, petitioners began using one of their home-foaled

horses, Sindicato de Norco, as a breeding stallion.   Although he

sired two foals, neither foal met petitioners’ quality standards,

and Sindicato de Norco was gelded in 1997.6

     The breeding history with respect to petitioners’ brood

mares through and including the years at issue is summarized in

the following chart:




     6
      Since 1996, petitioners have used El Niño Cisco de Norco as
their herd sire. In 1997, petitioners began using transported
semen from well-known paso fino stallions to inseminate some of
their mares.
                                             - 9 -

YEAR       MARE                  BREEDING HISTORY                  BREEDING RESULTS

1989       Chispa Nuac1          Bred to Bochica Tres              Dominador Bravo
           Adelita LaCe          Bred to Rey La Joya               Cassandra del Rey
           Dulcinea del Rey      Bred to Reyzuelo Bravo            Did not take

1990       Adelita LaCe          Bred   to   Dios del Mar Bravo    Did not take
           Bernardita LaCe2      Bred   to   Bochica Tres          Filly died at birth
           Dulcinea del Rey      Bred   to   Dios del Mar Bravo    Preciosa de Dios
           Bonita Bravo          Bred   to   Flamenco del Moro     Sindicato de Norco
           Flint Oak Aura3       Bred   to   Festival Dos          Did not take

1991       Chispa Nuac           Bred   to   Bochica Tres          Did not take
           Adelita LaCe          Bred   to   Dios del Mar Bravo    El Capital de Norco
           Bernardita LaCe       Bred   to   Bochica Tres          Did not take
           Bonita Bravo          Bred   to   Paco Bravo            Antoinetta de Norco
           Flint Oak Aura        Bred   to   Bochica Tres          Did not take

1992       Chispa Nuac           Bred   to   Bochica Tres          Did not take
           Adelita LaCe          Bred   to   Bochica Tres          Miranda de Norco
           Bernardita LaCe       Bred   to   Bochica Tres          Did not take
           Dulcinea del Rey      Bred   to   Santo Humo            La Duquesa de Norco
           Flint Oak Aura        Bred   to   Impetuoso del Ocho    La Tempestad de Norco
           Vanescita de          Bred   to   Bochica Tres          La Briesa de Norco
             Caroline
           Bernardita LaCe       Bred to Bochica Tres              Did not take
           Lobo Lucinda de Oro   Bred to Impetuoso Del Ocho        Did not take

1993       None

      1
        This mare was found to have an immune deficiency, resulting in constant
infections. She was successfully bred only once (1989). Further attempts to
breed her were unsuccessful despite extensive medical treatment.
       2
        As a result of a difficult delivery, this mare developed a large hematoma
and bladder tumors. Further attempts to breed her were unsuccessful.
      3
        Eventually, petitioners discovered that Flint Oak Aura needed to receive
medication in order to carry a foal.

Marketing Petitioners’ Horses

       Petitioners sponsored various California horse shows where

they showed their horses.               In 1990, petitioners commissioned an

oil painting and a portrait of Chispa Nuac.                       Petitioners also

rode their horses in parades.                 Paso finos are known as dancing

horses because of their unique footfalls and are popular parade

horses.           In 1993, petitioners obtained printed business cards for

their horse activity and began handing out the cards in response

to inquiries at parades.
                                     - 10 -

     Petitioners showed their horses and rode in parades during

the years at issue.    In 1991 and 1992, respectively, petitioners

paid the Paso Fino Horse Association $853 and $1,703 for

advertising, sponsorship, registration, and other show-related

expenses.   The record does not reflect the amount spent on those

activities in 1993.    Petitioners kept videotapes of their horses

competing in various shows.         Petitioners’ horse show videos,

through and including the years at issue, are of the following

competitions:
     Year                Show                        Horse(s) Shown

     1988       West Coast Championships             Chispa Nuac

                Los Angeles Equestrian Center        Flint Oak Aura

                Santa Barbara                        Chispa Nuac


     1989       Paso Fino National                   Flint Oak Aura

                Ventura All Breed                    Adelita LaCe

                Scottsdale All Breed                 Dulcinea del Rey
                                                     Chispa Nuac

                Santa Barbara                        Dulcinea del Rey
                                                     Bernardita LaCe

                West Coast Championship              Dulcinea del Rey

     1990       National Championship                Flint Oak Aura

     1991       Springbreed Classic                  Flint Oak Aura

                West Coast Championship              Flint Oak Aura
                                                     Dulcinea del Rey

     1992       Indio Show                           Flint Oak Aura

                Lancaster Show                       Flint Oak Aura

                West Coast Championship              Flint Oak Aura

     1993       Del Mar National                     Preciosa de Dios
                                                     Anna Maria Bravo
                              - 11 -


     Paso fino horses are shown in three categories:   Pleasure,

performance, and classic fino.   The categories are based on the

horses’ ability to perform the gaits required of each class.

Classic fino is the quickest, most difficult gait to perform, and

horses able to perform classic fino are the most sought after

within the paso fino breed.   Classic fino horses that win at the

national level are worth at least $50,000, and a champion mare is

valued at $250,000 or more.   Petitioners hoped to acquire horses

that could compete and be sold in the classic fino market.

     The market for paso finos, especially classic fino horses,

is concentrated in Florida; some sales of high-priced horses,

however, have occurred in California.   During the years in issue,

petitioners marketed their horses by advertising in regional

publications, such as the California Horsetrader, and by posting

flyers at their local feed stores.

     Petitioners claimed advertising expenses on their Federal

income tax returns of $380 for 1992 and zero for 1991 and 1993.

In contrast, petitioners’ expense journals show advertising

expenses of $372 in 1991 and $486 in 1993.   The expense journals

do not indicate petitioners’ total advertising expenditures for

1992.

     Petitioners have held open houses and fun shows at their

ranch, where potential customers may test ride the horses.

Petitioners’ E-mail address is Pasolove@aol.com.   Petitioners did
                                - 12 -

not list Rancho Paso de Norco in the phone book or with directory

assistance.

Petitioners’ Horse Sales

      From 1987 through the years at issue, petitioners did not

sell any horses.7   Since 1991, when petitioners were advised by

Diego Palacio to cull their herd of animals unlikely to produce

classic fino horses, petitioners have been attempting to sell

horses.   They sold their first horse in 1994.   All of their sales

occurred in California.    The sales of petitioners’ horses are

shown on the following table:




     7
      In 1988, petitioners traded Sol Rey de Pito in partial
payment for Adelita LaCe.
                                         - 13 -
  Date              Horse                 Original Purchase Price       Sales Price
                                                                        1
02/04/94       Lozano Bravo                     $3,646                   $3,000
02/05/94       Cassandra del Rey                 Home-foaled              4,000
                                                                            1
03/31/95       Molly Dakota                       1,500                     2,000
06/16/95       El Dominador Bravo                 Home-foaled               3,000
10/17/95       Vanescita de Caroline              1,000                     1,078
10/25/95       El Capitan de Norco                Home-foaled               2,000

03/29/96       Anna Maria Bravo                   1,500                     5,385
05/05/96       La Briesa de Norco                 Home-foaled               2,000
05/20/96       El Principe de Angelita            Home-foaled               1,000
06/01/96       San Miguel de Norco                  850                     3,770
06/21/96       Miranda de Norco                   Home-foaled               2,000

01/20/97       La Duquesa de Norco                Home-foaled                4,000
03/17/97       Mystique Bravo                     1,000                      3,500
                                                                            2
06/11/97       El Hechicero de Norco                500                      4,000
08/09/97       Valentino de Norco                 Home-foaled                  750
08/17/97       Monarquillo de Intocable             500                      4,500
12/17/97       Misterio de Resorte                Home-foaled                3,500
                                                                            3
03/ /98        Molly Dakota                       1,500                      3,000
06/06/98       Esperanza de Norco                 unknown                    4,000
                                                                            1
unspecified    Sindicato de Norco                 unknown                    3,000
         1
          Returned by purchaser.
         2
          The evidence is conflicting as to whether the sales price is $4,000 of
$4,500.
         3
        The purchaser paid an additional $1,000 for a breeding to El Niño Cisco
de Norco.

All of the above sales were culling sales.                  The record does not

reflect the amount of feed, training, or veterinary expense

incurred per horse.         Because petitioners did not allocate feed,

training, or other expenses such as stud fees                   among their

horses, the record does not reflect the economic profit, if any,

earned on each sale.

Value of Petitioners’ Herd

         As of July 1998, petitioners’ herd consisted of 26 horses

with a total value of approximately $307,000.                   The majority of

the animals owned as of that date were foaled by petitioners’
                               - 14 -

brood mares.    The purchase price of a new brood mare, Sopresa de

Capuchino, is not in the record.    The fair market values and

original purchase prices of the remaining purchased horses

totaled $103,500 and $87,838, respectively.

        During the years at issue and through the date of trial,

petitioners did not maintain equine mortality insurance because

they felt the insurance was too expensive.     Although petitioners

maintained fire and liability insurance on their ranch, the

record does not reflect whether that insurance covered any horse-

related losses.

Petitioners’ Time and Effort

        Petitioners managed and operated their horse activity

themselves.    Since 1988, petitioners have been members of the

Paso Fino Horse Association and the California Paso Fino Horse

Association.    During 1992, 1993, 1994, and 1995, petitioners were

members of the American Horse Show Association.       During 1996 and

1997, Mrs. McKeever was a member of the Norco Paso Fino Drill

Team.

        During the years in issue, petitioners fed their horses

twice daily; cleaned, clipped, and groomed their horses daily;

and exercised, conditioned, and trained their horses 4 days each

week.8    Petitioners bred and foaled their horses.    Petitioners


     8
      Starting in 1991, most horses were kept at petitioners’
Norco ranch. Previously, petitioners had boarded the majority of
                                                   (continued...)
                               - 15 -

also took blood samples from, wormed, and inoculated their

horses.   In addition, Mr. McKeever handled and halter trained

weanling paso finos until they reached the age of 2-1/2 years.

Petitioners hired someone to clean the Norco ranch stables.

      Petitioners love their horses and enjoy the work associated

with the horse activity.

Purchase of the Norco Facility

      Petitioners resided in Anaheim, California, when they began

their horse activity.    They sold their residence during 1987 and

moved to Yorba Linda, California.    The Yorba Linda residence had

a four-stall barn.    In 1991, petitioners sold the Yorba Linda

residence and purchased a 3.6-acre ranch in Norco, California,

for approximately $316,000 (the ranch).    City zoning allowed

petitioners to keep approximately 39 horses on the ranch.    By

1998, the ranch had in excess of 20 horse stalls and pasture

space capable of accommodating an additional 10 horses.

      After they moved to the ranch, petitioners improved it in

several respects.    Beginning in 1991, petitioners expanded the

then-existing barn and constructed an additional barn, an arena,

and a round pen.    They graded and installed an irrigation and

drainage system, and they installed pipe corrals and fencing.      By

the end of 1994, petitioners substantially had completed


     8
      (...continued)
their herd at Mr. Minter’s Rancho Paso de Bravo and visited the
animals on weekends.
                                - 16 -

construction of the barns and the round pen, gradation and

installation of irrigation lines, and installation of the pipe

corrals and fencing.    Petitioners also installed benches with a

view of the arena and a fino board, which is used to hear the

sound of the paso fino’s four-beat gait.     Petitioners spent

$6,546 on corrals and arenas, but the record does not reflect

clearly the total cost for all horse-related improvements.

     The ranch is modest and functional.     It does not have a

swimming pool or a tennis court.    There is a sign for the ranch

near the street, making it identifiable to passersby and to

people looking for the ranch.

     During the years at issue and through trial, petitioners

resided at the ranch.   In 1993, Mr. McKeever applied for a loan;

on his loan application, he listed the ranch as his residence,

not as an income-producing property.     In 1998, petitioners had

the ranch appraised.    The appraisal valued the ranch at $409,000.

Petitioners’ Books and Records

     The ranch has an office with a separate entrance where

petitioners keep a library of videos and the books and records

for their horse activity.    From 1987 through the years at issue,

Mrs. McKeever provided bookkeeping services for the horse

activity.   Petitioners used one of their then-existing checking

accounts (709 account) to pay expenses associated with their

horse activity.   The records kept consisted of copies of
                              - 17 -

invoices, receipts, and other documents, which Mrs. McKeever

placed in a manila envelope each month.   At the end of each

taxable year, Mrs. McKeever compiled annual expense journals from

the stored documents.

      Petitioners also kept pedigrees and show records for their

horses.   Starting in about 1993, Mr. McKeever began studying

bloodlines and pedigrees.   Petitioners did not keep heat and

health records for their horses, except for copies of veterinary

bills and notations made on a small calendar kept in their barn.

      Petitioners did not prepare written profit and loss

projections for the taxable years 1991, 1992, and 1993 concerning

their horse activity, or any of their other activities, nor have

they prepared any such projections for taxable years commencing

after 1993 through the trial in this case.9




     9
      In 1998, after the petition in this case had been filed,
petitioners consulted an accountant with experience in the horse
industry, Patrick J. Hurley. At Mr. Hurley’s suggestion,
petitioners began using a computerized record keeping system.
Mr. Hurley provided petitioners with a sample “Summary of
Operations” for a horse business and advised them to prepare a
similar document. Petitioners prepared a summary of operations
for their horse activity for the years 1988 through 1998, which
they refer to as a business plan. The document summarizes
various facts related to the horse activity and indicates in very
general terms how petitioners plan to improve the profitability
of the activity. The document does not indicate what level of
income would be required to achieve profitability or to what
extent expenses might be reduced. Although petitioners
maintained detailed expense records, the summary of operations
does not analyze any of the past expenses to determine whether
any adjustments to those expenses could improve profitability.
                                - 18 -

     Petitioners’ books and records for the years at issue were

adequate to substantiate all expenses claimed on their Federal

income tax returns with respect to their horse activity in those

years.

Petitioners’ Other Activities

     Petitioners owned and operated two other alleged

businesses:   A dog breeding business and an antiques business.

These ventures generally were not profitable.   Petitioners

discontinued the dog breeding operation because they purportedly

believed that the horse activity would be more profitable and

because the owner of a quality stud dog moved out of State.    The

antiques operation was discontinued because the shopping mall in

which petitioners had been renting space was leveled for a

freeway and because Mr. McKeever, who refinished some of the

items himself, was beginning to suffer adverse health effects

because of exposure to the refinishing chemicals.

Income Tax Returns

     Petitioners timely filed a Form 1040, U.S. Individual

Income Tax Return, for each of the years at issue.   Petitioners

reported income and expenses from their horse activity on either

Schedule C, Profit or Loss from Business, or Schedule F, Profit

or Loss From Farming, for the years 1987 through 1997, inclusive.

Losses from the horse activity over the years 1987 through 1997

totaled $542,751.
                             - 19 -



     During the years at issue, petitioners’ returns were

prepared by the office of Maurice Joffe, C.P.A.   When the returns

were filed, Mr. Joffe believed them to be correct, based on his

understanding of the facts and the then-applicable law.

     Petitioners reported gross receipts, including income from

sales of horses reported on Form 4797, Sales of Business

Property, and Form 6252, Installment Sale Income, from their

horse activity as follows:

           Year                    Gross Receipts

           1987                           -0-
           1988                          $520
           1989                           -0-
           1990                           -0-
           1991                           -0-
           1992                           -0-
           1993                           818
           1994                         7,400
           1995                         7,223
           1996                        15,843
           1997                        24,206
             Total                    $56,010

     Petitioners reported wage income, Schedule C or Schedule F

business income (loss), and adjusted gross income from 1987, when

petitioners began their horse activity, through 1997, as shown in

the following table:
                                        - 20 -



                                                                             Adjusted
        Wages and      Horse activity    Dog activity    Antiques activity    gross
Year   other income1   income (loss)     income (loss)     income (loss)      income


1987       $76,516       ($12,918)         ($1,099)          ($11,359)       $57,090
1988        78,008        (21,675)            (816)             1,945         58,882
1989        92,893        (28,223)             236              9,209         57,430
1990       124,663        (53,037)            (316)            (7,491)        66,208
1991       141,724        (55,843)            N/A              (7,126)        81,205
1992       148,169        (70,598)            N/A              (5,886)        73,434
1993       171,379        (64,886)            N/A                N/A          81,076
1994       205,580        (66,880)            N/A                N/A         140,806
1995       159,117        (51,175)            N/A                N/A         109,309
1996       139,049        (56,853)            N/A                N/A          92,794
1997       165,083        (60,663)            N/A                N/A         115,982

       1
       Includes income from all other sources except the horse activity and the
dog breeding and antiques ventures.


Notice of Deficiency

       Following an examination of petitioners’ Federal income tax

returns for 1991, 1992, and 1993, respondent issued a notice of

deficiency in which he determined that (1) petitioners’ horse

activity in those years was an activity not engaged in for profit

under section 183 and expenses claimed with respect to the horse

activity were disallowed, except as allowed by section 183(b), (2)

petitioners had failed to report commission income of $28,000,

(3) computational adjustments to petitioners’ itemized deductions

were required because of the preceding adjustments, and (4)

petitioners were liable for the negligence prong of the accuracy-

related penalty under section 6662(a).
                              - 21 -

                              OPINION

I.   Whether Petitioners Operated Their Horse Activity for a
Profit

     A.   In General

     The principal issue before us is whether petitioners’ horse

activity constituted “an activity not engaged in for profit”

within the meaning of section 183 during 1991, 1992, and 1993.

     Section 183(a) provides that if an activity is not engaged

in for profit, no deduction attributable to the activity shall be

allowed except as provided in section 183(b).    Section 183(b)(1)

allows those deductions which otherwise are allowable regardless

of profit objective.   Section 183(b)(2) allows those deductions

which would be allowable if the activity were engaged in for

profit, but only to the extent that gross income attributable to

the activity exceeds the deductions permitted by section

183(b)(1).   Section 183(c) defines “activity not engaged in for

profit” as “any activity other than one with respect to which

deductions are allowable for the taxable year under section 162

or under paragraph (1) or (2) of section 212.”

     Deductions are allowable under section 162 for the expenses

of carrying on an activity which constitutes a trade or business

of the taxpayer.   See sec. 162; sec. 1.183-2(a), Income Tax Regs.

To be engaged in a trade or business with respect to which

deductions are allowable under section 162, “the taxpayer must be

involved in the activity with continuity and regularity,” and
                               - 22 -

“the taxpayer’s primary purpose for engaging in the activity must

be income or profit”.   Commissioner v. Groetzinger, 480 U.S. 23,

35 (1987); see also Warden v. Commissioner, T.C. Memo. 1995-176,

affd. without published opinion 111 F.3d 139 (9th Cir. 1997).

     This case is appealable to the Court of Appeals for the

Ninth Circuit, which applies a primary purpose standard to test

whether an alleged business activity has the requisite profit

motive under sections 162 and 183.      That standard is “whether the

activity was entered into with the dominant hope and intent of

realizing a profit.”    Vorsheck v. Commissioner, 933 F.2d 757, 758

(9th Cir. 1991), affg. in part and revg. in part T.C. Memo. 1994-

281; see also Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir.

1993) (“Profit must be the predominant, primary or principal

objective), affg. T.C. Memo. 1991-212; Machado v. Commissioner,

T.C. Memo. 1995-526, affd. without published opinion 111 F.3d 139

(9th Cir. 1997); Warden v. Commissioner, supra.      We apply that

standard here.

     Whether the requisite profit objective exists is to be

resolved on the basis of all the surrounding facts and

circumstances of the case.   See Golanty v. Commissioner, 72 T.C.

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

(9th Cir. 1981); sec. 1.183-2(b), Income Tax Regs.     The

taxpayer’s expectation of profit need not be reasonable, but it

must be bona fide.   See Golanty v. Commissioner, supra at 426.
                              - 23 -

Although our analysis focuses on the subjective intention of the

taxpayer, greater weight is given to objective facts than to a

taxpayer’s mere statement of intent.   See Independent Elec.

Supply Inc. v. Commissioner, 781 F.2d 724 (9th Cir. 1986), affg.

Lahr v. Commissioner, T.C. Memo. 1984-472; Dreicer v.

Commissioner, 78 T.C. 642, 645 (1982), affd. without opinion 702

F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs.

For purposes of section 183, the term “profit” means economic

profit, independent of tax savings.    Drobny v. Commissioner, 86

T.C. 1326, 1341 (1986), affd. 113 F.3d 670 (7th Cir. 1997).

Petitioners bear the burden of proving that they had the

requisite profit objective.   See Rule 142(a); Golanty v.

Commissioner, supra at 426.

     Section 1.183-2(b), Income Tax Regs., sets forth a

nonexclusive list of factors that normally should be taken into

account in determining whether the requisite profit intent has

been shown.   The factors are: (1) The manner in which the

taxpayer carries on the activity; (2) the expertise of the

taxpayer or his advisers; (3) the time and effort expended by the

taxpayer in carrying on the activity; (4) expectation that assets

used in the activity may appreciate in value; (5) the success of

the taxpayer in carrying on other similar or dissimilar

activities; (6) the taxpayer’s history of income or loss with

respect to the activity; (7) the amount of occasional profits, if
                              - 24 -

any, which are earned; (8) the financial status of the taxpayer;

and (9) elements of personal pleasure or recreation.   No single

factor is determinative, see sec. 1.183-2(b), Income Tax Regs.,

and not all factors are applicable in every case; see Allen v.

Commissioner, 72 T.C. 28, 34 (1979).

     Petitioners assert that breeding and raising horses for

sale has long been recognized as a trade or business meeting the

profit requirements for deductibility, that a history of losses

during the startup phase of their enterprise does not vitiate

their profit motive, and that the objective facts demonstrate

that they had the requisite profit objective.   Conversely,

respondent argues that the evidence demonstrates a lack of profit

motive and that petitioners’ horse activity was not engaged in

primarily for profit.

     B.   Applying the Factors

          1.   Manner in Which Activity Conducted

     In deciding whether a taxpayer has conducted the activity

in a businesslike manner, we consider whether complete and

accurate books and records were maintained, whether the activity

was conducted in a manner substantially similar to other

activities that were profitable, and whether changes in operating

methods, adoption of new techniques, or abandonment of

unprofitable methods were made in a manner consistent with an
                               - 25 -



intent to improve profitability.    See Engdahl v. Commissioner, 72

T.C. 659, 666-667 (1979); sec. 1.183-2(b)(1), Income Tax Regs.

     Petitioners contend that they operated their horse activity

in a businesslike manner because they maintained accurate books

and records, persevered in their sales and marketing efforts,

culled their herd and focused on the highly marketable registered

paso fino breed, and changed operating methods.

     Respondent asserts that the books and records served no

part in controlling costs and increasing profitability, that

anemic and ineffective sales and marketing efforts do not support

a profit motive, that petitioners continued to breed horses from

the bloodline allegedly culled, and that the changes in operating

methods were insufficient to materially affect the activity’s

profitability.    Respondent also asserts that petitioners used

poor business practices in carrying on the activity.

             a.    Petitioners’ Record Keeping

     Petitioners maintained copies of invoices and checks which

documented horse-activity expenses and which were used to prepare

an expense journal at the close of each taxable year.    The

maintenance of these limited records, however, represents nothing

more than petitioners’ substantiation of the expenses claimed on

their returns.    As we have stated previously:

     The purpose of maintaining books and records is more
     than to memorialize for tax purposes the existence of
                                - 26 -

     the subject transactions; it is to facilitate a means
     of periodically determining profitability and
     analyzing expenses such that proper cost saving
     measures might be implemented in a timely and
     efficient manner. [Burger v. Commissioner, T.C. Memo.
     1985-523 (citing Golanty v. Commissioner, 72 T.C.
     411, 430 (1979)), affd. 809 F.2d 355 (7th Cir.
     1987).]

The 1992 and 1993 expense journals admitted into evidence were

merely summaries of the expenses reflected on the checks and

receipts; they were not used to improve the performance of

petitioners’ losing venture.    See Steele v. Commissioner, T.C.

Memo. 1983-63 (checks served as adequate substantiation for

claimed expenses but were not businesslike records).

     While a taxpayer need not maintain a sophisticated cost

accounting system, the taxpayer should keep records that enable

the taxpayer to make informed business decisions.    See Burger v.

Commissioner, 809 F.2d 355, 359 (7th Cir. 1987), affg. T.C. Memo.

1985-523.   For a taxpayer’s books and records to indicate a

profit motive, the books and records should enable a taxpayer to

cut expenses, increase profits, or evaluate the overall

performance of the operation.    See Abbene v. Commissioner, T.C.

Memo. 1998-330.

     Petitioners presented no evidence that their records were

used to implement cost-saving measures or to improve

profitability.    Petitioners urge us to consider their tax

returns, which contain depreciation schedules, expense summaries,

and other information from which business decisions could be made
                                - 27 -

and the considerable volume of documentation that served to

substantiate the claimed expenses, as well as the pedigrees that

were kept for their horses.   Finally, petitioners refer us to the

testimony of their current accountant, Mr. Hurley, to demonstrate

that their records during the years at issue were adequate and

consistent with a profit motive.

     Although petitioners’ records were voluminous, the record

demonstrates that petitioners’ record keeping was nothing more

than a conscious attention to detail.    See Golanty v.

Commissioner, 72 T.C. at 430.    The records were not used to

review and reduce expenses or to enhance the possibility of

generating income.   For example, Mrs. McKeever testified that

there were no written records that provided per-horse information

regarding the cost to maintain the horse but that such

information existed in her mind such that she could approximate

the cost to maintain a horse.    She failed to demonstrate,

however, that she actually possessed such information, or that

she used it in an effort to achieve an economic profit from the

horse activity.   See, e.g., Steele v. Commissioner, supra

(failure to keep track of expenses on a per-animal basis implies

lack of profit motive).   Because petitioners failed to use the

existing books and records to minimize their expenses or

otherwise foster profitability, the fact that they maintained

records does not indicate that the activity was carried on with a
                               - 28 -

profit motive.    See Sullivan v. Commissioner, T.C. Memo. 1998-367

(generally no profit motive where lack of evidence that taxpayer

used records to improve losing venture), affd. without published

opinion 202 F.3d 264 (5th Cir. 1999).

     Petitioners also failed to prepare any financial

statements, profit and loss projections, budgets, breakeven

analyses, or marketing surveys, all of which can be significant

financial tools to aid in “cutting expenses, increasing profits,

and evaluating the overall performance of the operation.”

Golanty v. Commissioner, supra at 430.    We conclude that

petitioners’ maintenance of books and records was simply to

memorialize for tax purposes the various expenses associated with

the activity.    That petitioners were able to substantiate their

claimed expenses simply does not prove that their books and

records were kept or used in a businesslike manner.

             b. Petitioners’ Involvement in Other Profitable
     Enterprises

         There is no evidence in the record that shows how

petitioners operated or participated in other profitable

enterprises, such as Mr. McKeever’s employer, Aero Industrial

Alloy.    Thus, we are unable to consider whether the horse

activity was operated in a similar manner.    See sec. 1.183-2(b),

Income Tax Regs.
                              - 29 -

              c.   Changes Made To Foster Profitability

      Petitioners claim that several changes in operating methods

support their claim of businesslike operation.   First, in 1991,

petitioners purchased the Norco ranch, where they could board

their herd.   Second, they changed advisers from Mr. Minter to Dr.

Cortelezzi.   Third, petitioners changed their breeding program to

focus on different bloodlines10 in reliance on Dr. Cortelezzi’s

advice.   Although we agree that these could be material changes,

see Engdahl v. Commissioner, 72 T.C. at 667-668, petitioners have

not convinced us that the changes had or will have a material

impact on their horse activity’s profitability; see Golanty v.

Commissioner, supra at 428 (Changes must be sufficient to change

materially the prospect of profitability).   Petitioners have

failed to show that the changes they made were sufficient to

reduce their operating losses materially and to enhance

materially their prospects of making a profit.   See id.

      Petitioners’ plan with respect to the activity was to breed

horses and sell the foals at a profit.   See Phillips v.

Commissioner, T.C. Memo. 1997-128 (written financial plan not

required where business plan evidenced by action).   Although, for

each year at issue except 1993, petitioners attempted to breed



     10
      Respondent argues that petitioners’ continued breeding of
Mi Palabra belies the claim of changed bloodlines. The evidence,
however, supports petitioners’ claim that they switched to
Colombian bloodlines.
                              - 30 -

their mares and sometimes used top-ranked stallions, their

efforts to market their horses were unfocused and anemic prior to

and during the years at issue.   Petitioners did not sell any

horses during the years at issue, and the only sales that have

occurred through June 1998 have been culling sales.    None of the

changes made during the years at issue, including petitioners’

reliance on Dr. Cortelezzi, had any material impact on

profitability.

     Petitioners’ marketing and sales efforts have changed

little since the inception of the enterprise.    Relatively little

has been spent on advertising.   Cf. Burrow v. Commissioner, T.C.

Memo. 1990-621.   Petitioners advertised their operation and the

availability of their horses in trade magazines, journals, and

via local horse show sponsorships and parades.    Petitioners also

showed, on average, two or three of their horses each year at

regional events on the West Coast.     However, petitioners had no

marketing plan; they did not even have business cards until 1993.

Considering the importance of horse sales to their business plan,

petitioners’ failure to attempt to reach a larger customer base

is not consistent with the behavior of a profit-minded taxpayer.

See Dodge v. Commissioner, T.C. Memo. 1998-89, affd. without

published opinion 188 F.3d 507 (6th Cir. 1999).
                               - 31 -

     Finally, we note that none of the changes made by

petitioners, ostensibly to reduce losses, control costs, and

foster profitability, had any material effect.    The amount of

petitioners’ losses did not decline following the move to the

ranch, despite petitioners’ claims that the move enabled them to

perform ranch work and otherwise minimize expenses.    The emphasis

on new bloodlines did not result in any significant reduction in

net losses.

     Under the facts and circumstances of this case, “the

trappings of a business” that exist are insufficient to

demonstrate that petitioners’ horse activity was carried on in a

businesslike manner for profit.    See Golanty v. Commissioner, 72

T.C. at 430.   On balance, we conclude that petitioners did not

operate their horse activity in a businesslike manner.

     This factor favors respondent’s position.

          2.   The Expertise of Petitioners or Their Advisers

     Preparation for an activity by extensive study of its

accepted business, economic, and scientific practices, or

consultation with industry experts, may indicate a profit motive

where the taxpayer carries on the activity in accordance with

such practices.   See sec. 1.183-2(b)(2), Income Tax Regs.

Petitioners argue that Mrs. McKeever’s background as a lifelong

horsewoman provided sufficient expertise to indicate a profit

motive.   We disagree.   We do not intend to denigrate Mrs.
                               - 32 -

McKeever’s horse background, petitioners’ conversations with

trainers, or Mr. McKeever’s study of bloodlines, but the record

does not reflect that petitioners had any background in the

business or economic aspects of horse breeding, showing, and

selling, or that they sought advice prior to beginning the

activity from those who did.

     Petitioners purchased their first paso finos in 1987.

There is no evidence that petitioners chose paso finos for their

horse activity after consultation with expert advisers.

Petitioners did not seek advice from Ms. Sarnecky or Mr. Minter

until the following year.   Although petitioners referred to Mr.

Minter as a breeding and sales consultant, Mr. Minter was not

paid for his advice.   Both Mr. Minter’s testimony and

petitioners’ testimony concerning the advice Mr. Minter gave to

petitioners were vague.   At best, it appears that the advice was

general advice regarding showing and promoting horses, not

business advice.   While Mr. Minter’s credentials are impressive,

petitioners presented very little evidence that they sought

advice from Mr. Minter on how to run a profitable horse business.

On the record before us, we conclude petitioners did not

investigate the economic viability of their proposed horse

activity prior to its inception in 1987, nor did they consult

with knowledgeable experts concerning the economic and business

aspects of their horse activity.
                                - 33 -

     Petitioners did not engage Dr. Cortelezzi until 1993, well

after the start of their horse activity.        As in Daley v.

Commissioner, T.C. Memo. 1996-259, petitioners decided to

commence their activity with little concept of the expenses

involved or of the steps required to achieve cost efficiency and

an eventual profit.

     Petitioners did not prepare for the economic aspects of the

activity by study or consultation with experts, and they have not

shown that, prior to inception of the activity, they had any

concept of what their ultimate costs might be, how they might

achieve any degree of cost efficiency, the amount of revenue they

could expect, or what risks might impair the production of such

revenues.    Accordingly, they were unprepared for the economic

realities of the horse business.     See Rinehart v. Commissioner,

T.C. Memo. 1998-205.

     This factor favors respondent’s position.

            3.   Petitioners’ Time and Effort

     The fact that a taxpayer devotes personal time and effort

to carry on an activity may indicate an intention to derive a

profit, particularly where there are no substantial personal or

recreational elements associated with the activity.       See Daley v.

Commissioner, supra; sec. 1.183-2(b)(3), Income Tax Regs.

     While working full time, petitioners also managed and

operated their paso fino activity during the years at issue.
                                - 34 -

Although someone was hired to clean stalls, petitioners fed their

horses twice daily, washed, clipped, or groomed their horses

daily, and exercised, conditioned, and trained their horses 4

days a week.   Mrs. McKeever also kept the books and paid bills

associated with the activity.

     Subsequent to their move to the ranch in mid-1991,

petitioners spent substantially all their free time on their

horse activity.   Although respondent argues that petitioners

failed to establish the number of hours per week engaged in the

horse activity, the stipulated facts confirm that petitioners

must have spent considerable time and effort on mundane tasks

pertaining to their horse activity.

     The time and effort expended by petitioners on their horse

activity supports their contention of profit motivation.

Although petitioners love their horses and enjoy the work

associated with the activity, many duties performed in connection

with the activity do not have recreational aspects, such as

feeding, washing, and worming the animals.   Although some tasks,

such as showing horses and riding in parades, have recreational

aspects, on balance we conclude that petitioners’ time and effort

favor their contention that the activity was engaged in for

profit.   See sec. 1.183-2(b)(3), Income Tax Regs.

     This factor favors petitioners’ position.
                              - 35 -

         4. Expectation That Assets Used in the Activity Would
     Appreciate in Value

     “The term ‘profit’ encompasses appreciation in the value of

assets, such as land, used in the activity.”   Sec. 1.183-2(b)(4),

Income Tax Regs.   Petitioners argue that their expectation that

their ranch and their horses would appreciate in value indicates

a profit motive.   Respondent disagrees for several reasons.

First, respondent argues that petitioners engaged in two separate

activities: petitioners bred and raised horses, and they owned a

ranch.   Second, respondent argues that petitioners have produced

no evidence showing that appreciation in their horses would cover

their past losses.   Petitioners argue that their ranch is a

business asset and that their assets (the ranch and the herd)

have increased in value by approximately $500,000, thus

demonstrating that their expectation of asset appreciation is

reasonable.

     Petitioners purchased the land primarily for reasons

related to their horse activity; profit from the property’s

increase in value was a secondary consideration.   Petitioners’

ownership of the ranch and their horse-related activities are

considered a single activity for purposes of determining expected

asset appreciation under section 1.183-2(b)(4), Income Tax Regs.

See Engdahl v. Commissioner, 72 T.C. at 668 n.4.

     Petitioners were in the fifth year of their horse operation

when they purchased the ranch in 1991 for approximately $316,000.
                              - 36 -

Petitioners spent $6,546 on corrals and arenas to improve the

ranch for use in their horse activity.   The record does not

reflect clearly the total cost for all the improvements.    As of

July 14, 1998, the fair market value of the ranch, based on its

use as a horse ranch and residence, was $409,000.

      As of July 1998, petitioners’ horses had a fair market

value of $307,000.   Respondent’s expert, Deborah McMahon-King,

valued the herd at $289,500, while petitioners’ expert, Dr.

Cortelezzi, valued the herd at $496,500.   Both reports were

conclusory.   Ms. McMahon-King’s report offered at least some

explanation for her valuation of specific horses, however, and we

found her report more reliable than Dr. Cortelezzi’s report.    See

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441

(1980); Estate of Hinz v. Commissioner, T.C. Memo. 2000-6 (slip

op. at 27 n.15) (citing 15 Mertens, Law of Federal Income

Taxation, sec. 59.08 at 22 (1999)).

      Ms. McMahon-King did not value three horses in the herd, La

Sensacion de Norco, Presumida de Besilu, and Adelita LaCe.     Dr.

Cortelezzi valued these horses at $6,000, $15,000, and $3,500,

respectively.   We find that the horses had values of $6,000,

$10,000, and $1,500, respectively, for a net addition of $17,500

to Ms. McMahon-King’s figure of $289,500.11


     11
      Our findings with respect to Sensacion de Norco and
Presumida de Besilu are based upon Ms. McMahon-King’s valuation
                                                   (continued...)
                               - 37 -

      As of the time of trial, the majority of petitioners’ herd

consisted of home-foaled horses.   The horses acquired by purchase

had a total fair market value of $103,500.   Petitioners’ tax

returns reflect that the cost of the purchased horses was

$87,838.    Thus, the purchased horses have increased in value by

approximately 18 percent.

      Petitioners argue that the appreciation shown by the assets

used in the activity is powerful corroboration of their claimed

profit motivation.   Respondent argues that to prevail regarding

this factor, petitioners’ objective must be to realize a profit

on the entire operation.    See Bessenyey v. Commissioner, 45 T.C.

261, 274 (1965), affd. 379 F.2d 252 (2d Cir. 1967).

      We agree with petitioners that the question to be addressed

here is not the ultimate issue in this case, i.e., petitioners’

profit motivation, but whether the assets used in the activity

were expected to appreciate in value.   See sec. 1.183-2(b)(4),

Income Tax Regs.   We find petitioners had a bona fide expectation

that at least some of the business assets would increase in

value.    That those assets actually increased in value weighs in




     11
      (...continued)
of horses with similar bloodlines. With respect to Adelita LaCe,
we do not believe that Dr. Cortelezzi’s estimation of $3,500 was
realistic, considering that the mare’s health problems preclude
her use as a brood mare or riding horse. Our determination of
value is based on our review of the record.
                               - 38 -

their favor, but it is not conclusive.    Cf. Engdahl v.

Commissioner, supra at 668-669.

     This factor favors petitioners’ position.

          5.   Petitioners’ Past Successes in Other Activities

     That a taxpayer has engaged in similar activities in the

past and converted them from unprofitable to profitable

enterprises may indicate that the taxpayer is engaged in the

present activity for a profit, even though the activity is

presently unprofitable.   See sec. 1.183-2(b)(5), Income Tax Regs.

     Petitioners engaged in a dog breeding activity, which

operated at a net loss in 3 of 4 years for which petitioners’ tax

returns reflect the operating results for that activity.

Similarly, petitioners’ antiques activity also reported operating

losses in 5 of the 6 years for which its results are part of the

record.   From the annual compensation that Mr. McKeever received

from Aero Industrial Alloy, Inc., we infer that Aero Industrial

Alloy, Inc., was successful.

     Petitioners argue that they are entrepreneurial in nature,

and their history of ending unprofitable businesses supports

their contention of profit motivation.    We disagree.   Mrs.

McKeever testified that the dog activity was closed because the

owner of a quality stud dog moved away.    Mrs. McKeever also

testified that she switched to the horse activity because she

thought horses would be more profitable than dogs.    The antiques
                               - 39 -

operation was closed because the shopping mall in which the

operation was located was displaced by a new freeway and because

Mr. McKeever began suffering health impacts from the refinishing

chemicals.    The record as a whole does not support petitioners’

contention that these ventures were closed because of their poor

operating results.

     In making our decision regarding petitioners’ intent, we

must give greater weight to the objective facts than to any mere

statement of intent.    See sec. 1.183-2(a), Income Tax Regs.   The

objective facts gleaned from petitioners’ mixed results in their

entrepreneurial ventures do not indicate a profit motive.

     This factor, on balance, favors respondent’s position.

         6.     Petitioners’ History of Income or Loss

     A taxpayer’s history of income, losses, and occasional

profits with respect to any activity may indicate the presence or

absence of a profit objective.    See Golanty v. Commissioner, 72

T.C. at 426; sec. 1.183-2(b)(6), Income Tax Regs.    A horse racing

and breeding activity may be engaged in for profit despite

consistent losses during the initial startup phase.      See Golanty

v. Commissioner, supra at 427.    We previously have found that the

startup phase for an activity involving horses may be between 5

and 10 years.    See Engdahl v. Commissioner, 72 T.C. at 669;

Phillips v. Commissioner, T.C. Memo. 1997-128.    Losses sustained

beyond the period normally required to generate profits may
                               - 40 -

indicate the lack of profit motive unless such losses occurred

because of unforeseen or unfortuitous circumstances.

      Petitioners began their horse activity in 1987.   From 1987

to 1997, petitioners reported losses in 11 consecutive years

totaling $542,751.12   During that same period, petitioners

reported gross receipts of $56,010, all earned after the years at

issue.    The magnitude of the activity’s losses in comparison with

its revenues is an indication that petitioners did not have a

profit motive.   See Dodge v. Commissioner, T.C. Memo. 1998-89

(citing Burger v. Commissioner, 809 F.2d 355, 359 (7th Cir.

1987)), affd. without published opinion 188 F.3d 507 (6th Cir.

1999).

      Petitioners first argue that their losses were incurred

during the startup phase of the activity.    We agree that the

years at issue, 1991-93, are startup years for the enterprise.

As in Dodge v. Commissioner, supra, however, the massive losses

are attributable more to petitioners’ inability to generate

significant sales of foals than to startup expenditures.

Petitioners did not sell a horse until 1994, even though

petitioners had several horses that they knew would not win in

the show ring or produce marketable foals.    Although petitioners’


     12
      If gross income from a horse activity exceeds the
deductions attributable to the activity during 2 out of 7 taxable
years, a presumption arises that the activity is engaged in for
profit. See sec. 183(d). Because petitioners’ activity has
never shown a profit, the statutory presumption does not apply.
                                - 41 -

horse activity generated some gross income during 1994 through

1997 as a result of culling the herd, the level of petitioners’

operating losses remained relatively steady.

     Dr. Cortelezzi testified that the market for paso finos

became depressed in 1992.   Petitioners maintain that a depressed

horse market hampered their ability to sell horses.     The

depressed market, however, does not explain the absence of sales

in earlier years.   Similarly, petitioners’ claim of higher than

average veterinary expense fails to explain their losses.     While

petitioners suffered some breeding setbacks and lost horses due

to medical problems, the veterinary expenses were a small

fraction of overall expenses.

     Petitioners’ reliance on Mr. Minter also does not explain

their history of losses.    We need not decide whether petitioners

received good advice from Mr. Minter.     Even if we assume that

petitioners relied on Mr. Minter to their detriment, it is far

from clear that petitioners would have sold horses at a profit if

they had not relied upon his advice.     Petitioners ended their

association with Mr. Minter in 1992.     As of the date of trial,

petitioners had not made any sales other than the culling sales.

In sum, we do not find any of petitioners’ explanations for their

history of losses adequate to explain the magnitude and duration

of those losses.

     This factor favors respondent’s position.
                               - 42 -

           7.   Amount of Occasional Profits

       The amount of profits earned in relation to the amount of

losses incurred, the amount of the investment, and the value of

the assets in use may indicate a profit objective.     See sec.

1.183-2(b)(7), Income Tax Regs.    The opportunity to earn

substantial profits in a highly speculative venture may be

sufficient to indicate that the activity is engaged in for profit

even though only losses are produced.    See id.    In determining

whether the taxpayer entered into the activity for profit, a

small chance of making a large profit may indicate the requisite

profit objective.    See id.

       In 11 years of operation, petitioners’ horse activity has

never turned a profit.    Classic fino horses that win at the

national level can sell for prices in excess of $250,000.

Petitioners claim to be focusing on that market and hope that one

day their herd will produce such a horse.      Petitioners’ professed

belief that a champion horse could generate a substantial amount

of revenue and correspondingly large profits may be indicative of

profit motivation.    See Dawson v. Commissioner, T.C. Memo. 1996-

417.

       Under the circumstances of this case, however, we agree

with respondent that the possibility of a speculative profit is

insufficient to outweigh the complete absence of profits over a

period of 11 years.    During the years at issue, none of
                              - 43 -

petitioners’ horses were of the quality to generate top prices in

the classic fino market.   Even as late as the time of trial,

petitioners had yet to show any of their horses at the national

paso fino horse shows.   During the years at issue, petitioners

advertised their horses for sale at local feed stores and in

classified ads in various horse publications.    Petitioners’ sales

and marketing efforts were extremely limited and directed

primarily, if not exclusively, toward the local and regional

market.   Petitioners’ conduct during the years at issue simply

does not support their assertion that a speculative profit in an

amount sufficient to offset their accumulated losses from prior

years was attainable by selling a national champion classic fino

horse from their herd.

     This factor favors respondent’s position.

          8.   Financial Status of Petitioners

     That the taxpayer does not have substantial income or

capital from sources other than the activity in question may

indicate that the activity is engaged in for profit.   See sec.

1.183-2(b)(8), Income Tax Regs.    Substantial income from sources

other than the activity may be indicative of a lack of profit

motivation, particularly where there are elements of personal

pleasure or recreation involved.   See id.

     Although petitioners were able to reduce their taxable

income by approximately $60,000 per year as a result of their
                                 - 44 -

horse activity, this tax benefit resulting from the activity does

not prove the absence of a profit motive.     See Engdahl v.

Commissioner, 72 T.C. at 670.     It is, however, a factor to be

considered.      See Golanty v. Commissioner, 72 T.C. at 429.

     The size of the horse-related expenditures in comparison to

petitioners’ adjusted gross income is substantial.     In 1991,

1992, and 1993, petitioners reported wage income of $141,724,

$148,169, and $171,379, respectively.     During those same years,

the horse activity lost $55,843, $70,598, and $64,886,

respectively.

     Petitioners argue that the level of expenses compared to

their gross income favors their position since the amount is more

than one normally would spend on a mere hobby.     Respondent

asserts that the substantial tax benefits, coupled with the

enjoyment petitioners derived from their horses, suggest the

activity was not engaged in for profit.     We think there is some

truth to both parties’ assertions, but we do not fully agree with

either party.

     This factor does not favor either party’s position in our

analysis.

            9.   Elements of Personal Pleasure or Recreation

     The existence of personal pleasure or recreation relating

to the activity may indicate the absence of a profit objective.

See sec. 1.183-2(b)(9), Income Tax Regs.
                               - 45 -

     Petitioners argue that the only pleasurable aspect

regarding their horse activity was riding in horse shows and

parades.   Petitioners also argue that Mrs. McKeever saw the horse

activity as a way to exit the field of hematology, from which she

fears contracting a blood-borne illness.    Finally, petitioners

argue that the size of their herd indicates that they are in the

horse business for profit, not pleasure.    Respondent asserts that

both petitioners enjoy riding horses and that the horses provide

a social outlet for them, noting petitioners’ involvement in

parades and horse shows.    Respondent points to the fact that paso

finos were chosen, in part, so that Mr. McKeever would be able to

ride despite his back problems.    Respondent also notes Mr.

Minter’s testimony regarding the purpose for which Flint Oak Aura

was purchased and cites petitioners’ E-mail address

(Pasolove@aol.com) as evidence of petitioners’ emotional

attachment to their horses.

     We agree with respondent that substantial elements of

personal pleasure and recreation are present in petitioners’

horse activity.   However, “We also note that 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.    ‘Success in business is largely obtained by

pleasurable interest therein.’”    Jackson v. Commissioner, 59 T.C.

312, 317 (1972) (quoting Wilson v. Eisner, 282 F. 38, 42 (2d Cir.
                               - 46 -

1922).    The elements of personal pleasure are only one factor to

be considered in determining whether the activity is engaged in

for profit.   See sec. 1.183-2(b)(9), Income Tax Regs.

     In this case, petitioners derived pleasure from their horse

activity and were attached to their horses.    That attachment may

explain why petitioners devoted so little effort to culling their

herd, improving the quality of their horses, and reducing their

operating expenses prior to 1994.

     This factor favors respondent’s position.

     C.    Conclusion

     On balance, we conclude that petitioners’ horse activity

during the years at issue was an activity not engaged in for

profit within the meaning of section 183(c).   In reaching our

decision, we have considered the factors listed in section 1.183-

2(b), Income Tax Regs., all contentions presented by the parties,

and the unique facts and circumstances of this case.

     Petitioners engaged in their horse activity for at least 11

years, losing more than $500,000 on a cumulative basis.

Petitioners did not generate a profit or even come close during

any of the years at issue.   Although petitioners were dedicated

to their horses, the totality of the objective facts and

circumstances does not support petitioners’ assertion that their

horse activity was engaged in for profit.   Petitioners did not

prepare for the economic realities of the business, and they did
                               - 47 -

not operate the activity in a businesslike manner.    While the

activity, in theory, could have turned a profit had petitioners

hit the lottery with a million-dollar horse, petitioners’

prospect for doing so with their existing horses was negligible.

The evidence simply is insufficient to convince us that

petitioners were motivated primarily by profit during the years

at issue.   The evidence is more consistent with the conclusion

that petitioners enjoyed breeding and showing their horses and,

therefore, were willing to sustain continuing losses despite the

improbability of profits.    Cf. Dreicer v. Commissioner, 78 T.C.

at 646.

      We hold that petitioners’ horse activity during the years

at issue in this case was not engaged in for profit within the

meaning of section 183(c).

II.   Whether Petitioners Are Liable for the Section 6662 Penalty

      The only remaining issue is the applicability of the

accuracy-related penalty for negligence during the years at

issue.    Section 6662 imposes an accuracy-related penalty in the

amount of 20 percent of any portion of an underpayment

attributable to negligence or disregard of rules and regulations.

See sec. 6662(a) and (b)(1).   “Negligence” is defined in section

6662(c) as “any failure to make a reasonable attempt to comply

with the provisions of this title”.     See also Freytag v.
                              - 48 -

Commissioner, 89 T.C. 849, 887 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991).

      Section 6664(c)(1) provides that the accuracy-related

penalty shall not be imposed with respect to any portion of an

underpayment if it is shown that a taxpayer acted in good faith

and that there was reasonable cause for the underpayment.     The

determination of whether a taxpayer acted with reasonable cause

and in good faith is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.   See sec. 1.6664-

4(b)(1), Income Tax Regs.   Petitioners bear the burden of proving

facts showing good faith and reasonable cause.   See Rule 142(a).

      In the notice of deficiency, respondent determined that

petitioners had omitted commission income of $28,000 from their

1993 return.   Petitioners conceded this adjustment prior to trial

but introduced no evidence at trial to explain the omission.13

As to the underpayment attributable to this adjustment,

therefore, petitioners have failed to prove that they acted with

reasonable cause and in good faith as required by section 6664.

The accuracy-related penalty as it relates to this adjustment is

sustained.


     13
      Although petitioners attempted to provide in their brief
an explanation for their failure to report the commission income,
they failed to introduce evidence to that effect at trial.
Petitioners’ failure to adduce evidence at trial on this issue
cannot be remedied on brief. See Rule 143(b); Evans v.
Commissioner, 48 T.C. 704, 709 (1967), affd. per curiam 413 F.2d
1047 (9th Cir. 1969).
                              - 49 -

     We reach a different conclusion, however, with respect to

the adjustments made pursuant to section 183.   As we view the

record in this case, petitioners made a reasonable attempt to

comply with the applicable revenue laws.   Our determination

regarding petitioners’ profit motivation was not easy.

Petitioners presented facts in support of their position that

their primary objective in conducting their horse activity was to

make a profit, and their arguments with respect to this highly

fact-intensive issue were reasonable and not frivolous.     See

Engdahl v. Commissioner, 72 T.C. 659 (1979); Johnston v.

Commissioner, T.C. Memo. 1997-475; Phillips v. Commissioner, T.C.

Memo. 1997-128.   Although we do not agree with petitioners’

arguments in the final analysis, petitioners have persuaded us

that their position regarding their horse activity was taken in

good faith and that they believed their return position was in

accordance with applicable law.   This conclusion is supported by

petitioners’ certified public accountant, who prepared the

returns for the years at issue.   He testified that petitioners’

returns were prepared and filed in good faith and in accordance

with his understanding of the then-applicable revenue laws.       We

hold that the accuracy-related penalty does not apply to

respondent’s section 183 adjustments.   We have carefully

considered the remaining arguments of both parties for results

contrary to those expressed herein, and to the extent not
                             - 50 -

discussed above, find those arguments to be irrelevant, moot, or

without merit.

     To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
