                        T.C. Memo. 1997-128



                      UNITED STATES TAX COURT



   EUGENE J. PHILLIPS AND BARBARA A. PHILLIPS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8990-95.                 Filed March 11, 1997.



     Thomas J. Hall, for petitioners.

     John C. McDougal, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION

     WELLS, Judge:   Respondent determined deficiencies in

petitioners' Federal income taxes and penalties as follows:

                                               Penalty
       Year           Deficiency              Sec. 6662(a)

       1991            $14,997                  $2,999
       1992             18,847                   3,769
       1993             17,898                   3,580
                                - 2 -

     Unless otherwise indicated, 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.

     The issues to be decided are as follows:

     1.    Whether petitioners engaged in a horse breeding activity

with an actual and honest profit objective; and

     2.    whether petitioners are liable for penalties on income

tax pursuant to section 6662.

                          FINDINGS OF FACT

     Some of the facts have been stipulated for trial pursuant to

Rule 91.    The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

     At the time they filed their petition in the instant case,

petitioners Eugene J. Phillips (Mr. Phillips) and Barbara A.

Phillips (Mrs. Phillips) resided in Stuart, Virginia, at their

farm, known as Green Pines Farm.    Petitioners filed joint U.S.

Individual Income Tax Returns (Forms 1040) for each of the years

in issue.

     During the years in issue, Mr. Phillips was employed as a

nurse anesthetist, and Mrs. Phillips was engaged in the rearing

and breeding of Arabian horses (Arabians) and quarter horses

(hereinafter horse activity) on petitioners' farm.    Besides her

involvement with the horse activity, Mrs. Phillips was not

employed during the years in issue.
                                 - 3 -

     During 1965, Mr. Phillips purchased a quarter horse for Mrs.

Phillips as a Mother's Day gift.    Every year or every 2 years

thereafter, petitioners purchased another quarter horse.    During

1972, petitioners moved to Louisiana.    By the early 1980's, in

addition to breeding quarter horses, petitioners had a cattle

operation.   During 1982 or 1983, petitioners began filing a

Schedule F with their income tax returns, claiming that their

horse activity was a business.

     During 1985, petitioners decided to change the focus of

their horse activity from quarter horses to Arabians when they

purchased Bella Joya, an Arabian filly, along with 11 other

Arabians.    Petitioners financed the total purchase price for the

horses of $17,350 with a mortgage on the horses (purchase money

mortgage).   At the time of the purchase, petitioners owned

another Arabian horse, which they had saved from going to

slaughter.   By 1987, petitioners sold all of their cattle.

     During 1986, Bella Joya won several races at Delaware Park,

including the Delaware Arabian Stakes.    During 1987, Bella Joya

was named the Filly of the Year by Arabian Horse World, the

Racehorse of the Year by Arabian Horse Express, and the

International Arabian Three-Year-Old Horse of the Year by the

International Arabian Horse Association.    Additionally, during

1987, Bella Joya won a Darley Award for excellence in Arabian

racing.
                               - 4 -

     During 1986 and 1987, the 2 years that she raced, Bella Joya

won a total of $42,000 in purses.   The total cost of training and

boarding Bella Joya during those years was $40,000.   Petitioners

used the $2,000 in net winnings from Bella Joya to breed another

mare.

     During 1987, Mrs. Phillips developed an angina condition,

which was treated by cardiac catheterization and from which her

recuperation took approximately 6 months and caused her to reduce

her level of activities.   During 1988, Mrs. Phillips developed

acute cholecystitis, which was treated by surgery to remove her

gall bladder and from which her recuperation lasted approximately

4 months and caused her to reduce her level of activities.

     During 1988, Mr. Phillips lost his job in Louisiana.    He

obtained a position in Virginia and moved there at the end of

1988.   Subsequently, petitioners moved their horse activity from

Louisiana to Virginia during 1988 and 1989.   Petitioners chose

their current location in Stuart, Virginia, because they believed

that they could retire there with their horse farm.

     On October 3, 1988, petitioners filed for bankruptcy under

chapter 13 of the U.S. Bankruptcy Code in the U.S. Bankruptcy

Court for the Western District of Louisiana in order to protect

and to maintain their investment in their horse activity.

Pursuant to bankruptcy court order, petitioners made monthly

payments of $2,000 for 43 months and, then, monthly payments of

$1,600 for 17 months.   Petitioners' bankruptcy plan included the
                                - 5 -

purchase money mortgage on their Arabian horses.   Petitioners

were discharged of their debt pursuant to their bankruptcy plan

on December 29, 1993.

     During January 1990, petitioners hired a contractor to build

a horse barn on their farm in Virginia.   The barn was designed to

be 80 feet by 250 feet, with 32 stalls, an indoor riding arena, a

tack room, and a feed room.   Petitioners planned to use the barn

to board horses, train horses, teach horse classes in connection

with Farrier College, and contain a tack shop to sell riding

equipment.   The contractor, however, went bankrupt and did not

build the barn.   Consequently, petitioners built smaller barns to

serve as stalls for some of their horses.   At the time of trial,

petitioners still planned on building the original, larger barn.

     During 1990, Mrs. Phillips was involved in an automobile

accident in which she fractured her back, a clavicle, and some

ribs, as well as suffering a contused lung.   These injuries were

initially treated with a back brace and bed rest, and her

recuperation lasted approximately 18 months and caused her to

reduce her level of activities.   During 1991, Mrs. Phillips

developed spinal cord compression, with nerve deficit, and

paralysis.   This condition was treated with surgery to fuse and

to support several vertebrae.   Her recuperation from the surgery

lasted approximately 12 months and caused her to reduce her level

of activities.
                               - 6 -

     During 1990, Bella Joya produced a foal, after having been

bred to Wiking, a prize-winning stallion.   The foal, however, cut

its leg off in an accident and had to be put to sleep.   During

1995, Bella Joya produced another foal, which petitioners intend

to race.

     During the years in issue, when she was healthy, Mrs.

Phillips spent approximately 35 to 40 hours a week on

petitioners' horse activity.   During the years in issue, Mr.

Phillips spent approximately 10 to 15 hours a week feeding and

caring for the horses.

     During 1992 and 1993, Mrs. Phillips served on the Racing

Committee of the Virginia Arabian Horse Association, attending

monthly meetings in Richmond, Virginia.   During those years, Mrs.

Phillips also served as a District Director for the Virginia

Arabian Horse Association, presiding and speaking at monthly

district meetings.   In these positions, she met agriculture

teachers, college professors, and 4-H people, with whom she

discussed issues related to breeding horses.   Mrs. Phillips

served in these positions in order to advertise petitioners'

horse activity and to meet potential buyers.

     During 1992 and 1993, Mrs. Phillips was also active in the

American Horse Association, the Virginia Quarter Horse

Association, the Virginia Horse Council, the Roanoke Valley

Horsemen Association, the International Arabian Horse

Association, the Arabian Registry, and the Virginia Horse
                                - 7 -

Association.    She was not active in these organizations during

1991 because of her health problems.

     Mrs. Phillips conducted racing seminars at various

conventions and wrote a column on horse issues in The Virginia

Horse Trader.    Additionally, petitioners annually attended

Arabian horse conventions, where they rented a booth, showed a

tape of Bella Joya, distributed business cards, answered

questions about racing, discussed breeding, and consulted with

experts at marketing and management seminars.    Petitioners had a

portrait painted of their stakes winner, Bella Joya, which they

displayed at conventions.    Petitioners also have stationery with

the name of their farm, Green Pines.

     For each year in issue, petitioners maintained their

financial information in a Farm Record Book (farm book), which

was published by the Farm Credit Service.    In each farm book,

petitioners classified expenses under various categories, e.g.,

"Labor Hired", "Feed Purchased", "Breeding Fees and Veterinary

Costs", and "Other Expenses", and calculated an annual, and

sometimes quarterly, total for each category.    Petitioners

maintained records on each of their horses indicating the

pedigree and physical condition of the horses.    Additionally,

petitioners prepared an action plan projecting when a mare was to

come in season and to be bred and to which stallion she was to be

bred.
                                - 8 -

     Petitioners registered many of their Arabian horses with the

International Arabian Horse Association.    Registering a horse

entails hiring a veterinarian; paying for a representative of the

International Arabian Horse Association to be present; having a

blood test performed on the horse; freeze branding the horse on

the neck and, if it is racing, in the lip; and preparing

registration papers.    Each registration costs several hundred

dollars.

     During the years 1988 to the present, petitioners owned 32

horses, excluding 5 foals that they sold.    During those same

years, 9 of petitioners' 32 horses have been bred.    Finally,

during those years, 5 horses have been sold, for a total of

approximately $2,600.    During the years 1988 to the present, none

of petitioners' horses has raced or competed in shows, except on

a very minor basis.    No show activity was conducted for income.

After moving to Virginia, petitioners received several offers to

purchase various horses, but petitioners accepted none of them,

deeming them too low.    Petitioners did not place any of their

horses for sale at auctions.

     Petitioners used their geldings for teaching or show

purposes, trail riding, and carriages.    Additionally, petitioners

used one gelding for Special Olympics children and showed him.

Other geldings are used for bridleless/saddleless teams.

Finally, petitioners used geldings for children of potential

buyers to ride when visiting petitioners' farm.
                                   - 9 -

       Petitioners' Virginia farm and land, purchased in 1988 for

$90,000, were appraised during 1995 at a fair market value of

$155,000.     Petitioners' 8 registered quarter horses were

appraised during 1995 at a total fair market value of $10,000.

Petitioners' 22 registered Arabian horses were appraised during

1995 at a total fair market value of between $86,000 and $96,000.

Petitioners own 6 horses which were not appraised because they

are half Arabian/half quarter horse, and petitioners thought that

they were not worth insuring.



       During the years in issue, petitioners incurred losses on

their horse activity as follows:

            Income     Depreciation        Other Expenses   Income/(Loss)

1991         $114      ( $6,274)            ( $56,874)       ( $63,034)
1992           -       ( 7,756)             ( 61,235)        ( 68,991)
1993           -       ( 7,697)             ( 54,513)        ( 62,210)

             $114      ($21,727)            ($172,622)       ($194,235)

During the years in issue, petitioners received income from Mr.

Phillips' military retirement pay and other sources, as follows:

            Wages     Retirement Pay       Interest & Dividends   Total

1991        $74,246     $25,464                   $21             $99,731
1992         87,432      26,384                   125             113,941
1993         89,271      27,180                   129             116,580

Losses sustained by petitioners were out-of-pocket economic

losses with the exception of amounts deducted for depreciation.

       Since 1988, Mr. Phillips inherited approximately $25,000 to

$30,000, all of which petitioners invested in their horse
                              - 10 -

activity.   Similarly, since 1988, Mrs. Phillips inherited some

funds, all of which petitioners invested in their horse activity.

     At the time of trial, Mr. Phillips had not ridden a horse

for approximately 10 years, and Mrs. Phillips was unable to ride

because of her heart problems and back problems.    Prior to her

health problems, Mrs. Phillips rode some horses only to prepare

them for racing, sale, or show.   Both petitioners pursue other

recreational activities.

     At the time of trial, Mr. Phillips was receiving a military

retirement pension, which, if he predeceases her, Mrs. Phillips

would lose, leaving her with only Social Security payments and

the income from the horse activity to live on.   Petitioners

intend to develop a horse business that will support them when

Mr. Phillips retires from his employment as a nurse anesthetist,

provide a source of income to Mrs. Phillips if Mr. Phillips

should predecease her, and leave a business to their children.

                              OPINION

     Respondent contends that petitioners did not conduct their

horse activity with an actual and honest profit objective and

that, therefore, losses for the years in issue are nondeductible,

except to the extent of income from the activity.   Petitioners

contend that they engaged in their horse activity with the

requisite profit objective and that they are, therefore, entitled
                               - 11 -

to deduct activity expenses in excess of activity income.

Petitioners bear the burden of proof.   Rule 142(a).

     Section 183(a) provides the general rule which disallows all

deductions attributable to activities "not engaged in for

profit."   Section 183(b)(1), however, qualifies the general rule

by allowing those deductions otherwise allowable regardless of

profit objective, e.g., State and local taxes.   Further, 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 a section 183 activity 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 under sections

162 or 212(1) or (2) require the "actual and honest objective of

making a profit."   Dreicer v. Commissioner, 78 T.C. 642, 645

(1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983).     A

taxpayer's expectation of profit, however, need not be

"reasonable."   Dreicer v. Commissioner, supra at 644-645; sec.

1.183-2(a), Income Tax Regs.

     Whether a taxpayer has an actual and honest profit objective

is decided on the basis of all surrounding circumstances.
                              - 12 -

Dreicer v. Commissioner, supra at 645; sec. 1.183-2(b), Income

Tax Regs.   We give greater weight to objective facts than to a

taxpayer's statement of intent.   Dreicer v. Commissioner, supra

at 645; sec. 1.183-2(a), Income Tax Regs.

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

nonexclusive list of objective factors to be considered in

deciding whether an activity is engaged in for profit.    Allen v.

Commissioner, 72 T.C. 28, 33 (1979).   The factors are:   (1) The

manner in which the taxpayer carries on the activity; (2) the

expertise of the taxpayer or the taxpayer's advisers; (3) the

time and effort expended by the taxpayer in carrying on the

activity; (4) the expectation that assets used in the activity

may appreciate in value; (5) the success of the taxpayer in

carrying on other similar activities; (6) the taxpayer's history

of income or loss with respect to the activity; (7) the amount of

occasional profits, if any, which are earned; (8) the financial

status of the taxpayer; and (9) whether elements of personal

pleasure or recreation are involved.

     No single factor is determinative; all facts and

circumstances, including those not listed, should be considered.

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

2(b), Income Tax Regs.   Moreover, we do not resolve the issue of

profit objective by simply comparing the number of factors
                                 - 13 -

indicating profit objective with those indicating the lack of

such objective.   Sec. 1.183-2(b), Income Tax Regs.

     If gross income derived from a horse training or breeding

activity for 2 or more taxable years in a period of 7 consecutive

taxable years exceeds the deductions attributable to such

activity, then the activity is presumed to be an activity engaged

in for profit.    Sec. 183(d).    In the instant case, as gross

income from the activity did not exceed deductions from the

activity during any of the years in issue, petitioners are not

entitled to the presumption that their horse activity was engaged

in for profit.    Consequently, we address the aforementioned

factors to decide whether petitioners engaged in their horse

activity with an actual and honest profit objective during the

years in issue.

     The manner in which petitioners carried on their horse

activity indicates that they engaged in the activity with the

requisite profit objective.      The regulations provide that

"The fact that the taxpayer carries on the activity in a

businesslike manner and maintains complete and accurate books and

records may indicate that the activity is engaged in for profit."

Sec. 1.183-2(b)(1), Income Tax Regs.      As to whether petitioners

carried on their horse activity in a businesslike manner,

respondent concedes that petitioners engaged in the following
                              - 14 -

"business practices":   Using business stationery, advertising

their farm at horse conventions and seminars (including

displaying their portrait of Bella Joya and showing a video of

Bella Joya's races), and participating in various horse

associations.   Respondent, however, argues that such practices do

not counter "the unbusinesslike way in which petitioners have

made the major decisions about the conduct of their activity."

     Respondent argues that petitioners had no financial plan or

written budget for the horse activity and that petitioners never

attempted to calculate the income that was required to produce a

profit for any year, or the projected income that would be

required in future years to produce a profit.    Additionally,

respondent contends that petitioners never calculated the cost of

each component of their horse activity, or the cost of their

horse activity on a per horse basis, in order to determine

possible cost-cutting measures.   Finally, respondent argues that

petitioners, after they began to incur losses, made no effort to

consult experts on how to change their operations to cut costs

and increase profits.

     In the instant case, we conclude that petitioners carried on

their horse activity in a businesslike manner.    Petitioners

engaged in the business practices discussed above.    Additionally,

although they produced no financial plan or written budget,
                              - 15 -

petitioners maintained a business plan, which was to expand their

horse activity so that it could, among other things, support Mrs.

Phillips in the event that Mr. Phillips predeceased her.    The

business plan was evidenced by their actions:   Petitioners

contracted to build a barn and a tack shop for their horse

activity, bred Bella Joya to produce foals, and registered many

of their Arabians with the International Arabian Horse

Association.

     During the years in issue, however, numerous circumstances

beyond their control prevented petitioners from proceeding with

their business expansion plan.   Mrs. Phillips encountered several

health problems that prevented her from pursuing petitioners'

horse activity to the fullest.   Bella Joya's first foal, which

would likely have garnered a significant amount of income, had to

be put to sleep.   The barn was not completed before Mrs.

Phillips' automobile accident, so petitioners had to delay

construction of the barn and tack shop.   Consequently,

petitioners continued to sustain boarding expenses and lost

potential boarding income.   We consider also the fact that

petitioners were making payments under chapter 13 bankruptcy.     We

believe that, during the years in issue, petitioners did all that

they could to sustain their horse activity until Mrs. Phillips

recovered.
                                - 16 -

     As to the calculation of income that would be required in

future years to produce a profit, Mrs. Phillips testified that

she hoped that the horse activity would be profitable within 6 to

8 years after petitioners began focusing on Arabians.

Petitioners calculated the cost of each component of their horse

activity, categorizing their expenses in their farm books under,

inter alia, "Labor Hired", "Feed Purchased", and "Breeding Fees

and Veterinary Costs".   Additionally, Mrs. Phillips testified

that she calculated the cost of their horse activity on a per

horse basis.   Accordingly, petitioners knew the amount of income

that would be required in future years.      Finally, Mrs. Phillips

testified that she attended seminars on management and marketing

at Arabian horse conventions.    Accordingly, we conclude that

petitioners carried on their horse activity in a businesslike

manner.

     As to whether petitioners maintained complete and accurate

books and records, respondent contends that petitioners'

financial records are "nothing more than gross chronological

lists of expenditures which do not permit a detailed analysis of

the various parts of the activity".      Additionally, respondent

argues that the records contain many expenditures that are not

farm related, e.g., AARP dues, lottery tickets, and air

conditioning for the residence.    As to petitioners' records on
                              - 17 -

their horses, respondent argues that they consist of only a

registration application, which shows the bloodline and physical

description of each horse.   Citing Golanty v. Commissioner, 72

T.C. 411, 431 (1979), affd. without published opinion 647 F.2d

170 (9th Cir. 1981), respondent contends that such records are

the bare minimum needed to identify horses and are as consistent

with a hobby as with a business.

     Petitioners contend that they included in the farm books

expenses that they thought might be deductible for tax purposes.

Petitioners argue that they completed the farm books and sent

them to their accountant, who decided what expenses were

deductible.   Petitioners argue that, as to the records on their

horses, petitioners registered many of their Arabians with the

International Arabian Horse Association, which included blood

testing and freeze branding the horses.

     In the instant case, we conclude that petitioners maintained

complete and accurate books and records.   During each year in

issue, petitioners kept a farm book, which was published by the

Farm Credit Service.   In each farm book, petitioners classified

expenses under various categories, e.g., "Labor Hired", "Feed

Purchased", "Breeding Fees and Veterinary Costs", and "Other

Expenses", and calculated an annual, and sometimes quarterly,

total for each category.   Contrary to respondent's assertion,
                              - 18 -

petitioners performed a detailed analysis of each part of their

horse activity.

     Additionally, we disagree with respondent that petitioners'

records contain "many expenditures" that are not farm related.

All expenses that were not categorized under a heading such as

"Labor Hired" or "Feed Purchased" were placed by petitioners

under "Other Expenses".   The expenses cited by respondent as not

being related to the farm were all categorized as "Other

Expenses".   We are persuaded by Mrs. Phillips' testimony that

petitioners' procedure was to include in their farm books

expenses which might be deductible, leaving the determination of

deductibility to their accountant.     Although some expenses listed

in the farm books were ultimately determined not to be farm

related, petitioners nevertheless categorized all of their

expenses and periodically calculated the category totals.    As to

their records on their horses, petitioners maintained records

indicating the horses' pedigree and physical condition,

registered many of their Arabian horses with the International

Arabian Horse Association, and kept an action plan for each

breeding mare, projecting when she was to come in season and to

be bred and to which stallion she was to be bred.    Based on our

review of the record, we conclude that petitioners maintained
                              - 19 -

complete and accurate records and books within the meaning of

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

     The regulations also provide that "A change of operating

methods, adoption of new techniques or abandonment of

unprofitable methods in a manner consistent with an intent to

improve profitability may also indicate a profit motive."    Sec.

1.183-2(b)(1), Income Tax Regs.   Respondent contends that

petitioners continued their activity in essentially the same

manner they had in previous years, despite suffering growing

losses year after year.   Respondent argues that petitioners could

have increased profitability by selling some or all of the

unproductive animals.   Additionally, respondent argues that

petitioners' lack of effort to reduce costs and to increase

profitability is evidence of the lack of a genuine profit

objective.   Specifically, respondent contends that petitioners

lacked a profit motive because they increased the costs of

maintaining their herd during the years 1989 through 1993 by:

(1) Failing to sell any horse after 1989, (2) acquiring two

horses at a cost of $1,300, and (3) spending $6,500 in stud fees

to produce three half Arabians.   Additionally, respondent

challenges the efficacy of petitioners' advertising efforts at

Arabian horse conventions when, by petitioners' own testimony,

they were unable to sell horses or to increase breeding activity
                               - 20 -

because of their bankruptcy.   Respondent also questions

petitioners' intention to build the barn, arguing that, as

petitioners had enough funds to spend on horse purchases and stud

fees to produce half Arabians, petitioners were financially able

to build the barn.

     As to respondent's argument that petitioners did not attempt

to make changes in their operating methods and to reduce costs in

order to improve the profitability of their horse activity, we

disagree.   Petitioners planned to begin horse boarding, horse

training, teaching classes in connection with Farrier College,

and operating a tack shop to sell equipment.   Petitioners hired a

contractor to build a 32-stall horse barn on their farm, which

would have served both as a stable for the horses and as a

location for the tack shop.    When the contractor went bankrupt,

petitioners built smaller barns to reduce the cost of boarding

some of their horses.   Finally, during the years in issue,

petitioners attempted to sell horses but received offers that

they considered too low.

     As to whether petitioners could have increased the

profitability of their horse activity by selling some or all of

their unproductive animals, we cannot conclude on this record

that any of the animals were "unproductive".   Mrs. Phillips, for

example, testified that one gelding was used for Special Olympics
                               - 21 -

children and that other geldings were used for

bridleless/saddleless teams.   Additionally, geldings were helpful

in entertaining children of potential buyers.

     We disagree with respondent's contention that petitioners

increased the costs of maintaining their herd.     Mrs. Phillips

testified that they attempted to sell some horses but that they

received unacceptably low offers.   As to the purchase of two

horses for $1,300 and the outlay of $6,500 in stud fees,

respondent essentially argues that petitioners exercised bad

business judgment as to those transactions.     We do not conclude

that the expenses were either inconsistent with a profit motive

or unnecessary and extravagant.

     Furthermore, we disagree with respondent's contention that

petitioners' advertising efforts at horse conventions were

ineffectual.   As we have stated above, we believe that, during

the years in issue, petitioners were merely sustaining their

horse activity until Mrs. Phillips could proceed with the

expansion plans once she recovered.     Although petitioners were

unable to increase substantially the level of horse breeding

during the bankruptcy period, we view their attendance at horse

conventions as efforts to sustain both their name and their

farm's name in the Arabian horse industry.     Accordingly, we
                              - 22 -

believe that petitioners' attendance at horse conventions was

helpful to their horse activity.

     As to the barn and tack shop, we are persuaded by Mrs.

Phillips' testimony that the barn was not built because she was

involved in an automobile accident.    At trial, petitioners

testified that they still planned on building the barn.    In fact,

petitioners later built smaller barns in order to save on

boarding costs.   Accordingly, we conclude that both petitioners'

planned, unconstructed barn and the smaller, constructed barns

constitute adaptations in their operating methods, and that such

adaptations, along with the other actions taken by petitioners,

discussed supra, are consistent with an intent to improve the

profitability of their horse activity.

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

     Preparation for the activity by extensive study of its
     accepted business, economic, and scientific practices,
     or consultation with those who are expert therein, may
     indicate that the taxpayer has a profit motive where
     the taxpayer carries on the activity in accordance with
     such practices. * * *

Respondent argues that petitioners did not establish that they

"focused their efforts on the business or economic aspects of the

activity."   Respondent contends that the fact that the

information recorded by petitioners "did not lend itself to

analyses along cost or profitability lines is strong evidence
                              - 23 -

that such matters were of relative indifference to them when

compared to the management and care of the horses themselves."

Alternatively, respondent argues that petitioners did not

establish that they consulted experts one-on-one regarding the

business aspects of raising horses.

     Petitioners argue that they knew the business and economic

aspects of their horse activity.   Petitioners contend that they

have spent a considerable amount of time and effort to learn

about the Arabian horse and quarter horse industries by attending

seminars at conventions and colleges.   Additionally, petitioners

made a budget, estimated when the horse activity would be

profitable, and determined the costs per horse per month.

     Petitioners also contend that Mrs. Phillips herself is an

expert in horse breeding.   Additionally, in the positions that

she held, Mrs. Phillips met agriculture teachers, college

professors, and 4-H people, with whom she discussed horse

breeding issues.   Finally, petitioners argue that they consulted

with experts at horse conventions, where there were marketing and

management seminars.

     The regulations provide that consulting with experts

regarding an activity's accepted practices may indicate that the

taxpayer has a profit motive where the taxpayer carries on the

activity in accordance with such practices.   Sec. 1.183-2(b)(2),
                               - 24 -

Income Tax Regs.   Mrs. Phillips has served as a District Director

and as the Chairman of the Racing Committee for the Virginia

Arabian Horse Association.   Additionally, Mrs. Phillips has

conducted racing seminars at various conventions and written a

column answering questions in The Virginia Horse Trader.

Moreover, petitioners consulted with experts at horse convention

seminars.   Accordingly, Mrs. Phillips' expertise in the horse

activity and petitioners' consultation with experts are facts in

petitioners' favor.

     Section 1.183-2(b)(3), Income Tax Regs., provides that

     The fact that the taxpayer devotes much of his personal
     time and effort to carrying on an activity,
     particularly if the activity does not have substantial
     personal or recreational aspects, may indicate an
     intention to derive a profit. * * *

Respondent concedes that this factor "superficially favors

petitioners" but argues that there are "substantial pleasure or

recreational aspects" to their horse activity.

     Mr. Phillips is employed full time as a nurse anesthetist.

Generally, however, he works 10 to 15 hours per week in

petitioners' horse activity, primarily taking care of the horses.

He also attends seminars and conventions dealing with

petitioners' horse activity.

     Mrs. Phillips works full time in the horse activity,

generally spending 35 to 40 hours per week.   In addition to being
                             - 25 -

responsible for the day-to-day aspects of the activity, during

the years in issue, she was active in various organizations

associated with the horse industry, including the American Horse

Association, the Virginia Quarter Horse Association, the Virginia

Horse Council, the Roanoke Valley Horsemen Association, the

International Arabian Horse Association, the Arabian Registry,

and the Virginia Horse Association.    Additionally, Mrs. Phillips

served as a District Director and as the Chairman of the Racing

Committee for the Virginia Arabian Horse Association.     She

conducted racing seminars at various conventions and answered

questions as a columnist in The Virginia Horse Trader.

Accordingly, we conclude that the fact that petitioners devote

much of their personal time and effort to carrying on their horse

activity indicates an intention to derive a profit.

     Section 1.183-2(b)(4), Income Tax Regs., provides that "The

term 'profit' encompasses appreciation in the value of assets,

such as land, used in the activity."   Accordingly, the

regulations state that

     the taxpayer may intend to derive a profit from the
     operation of the activity, and may also intend that,
     even if no profit from current operations is derived,
     an overall profit will result when appreciation in the
     value of land used in the activity is realized since
     income from the activity together with the appreciation
     of land will exceed expenses of operation. * * *
     [Id.]
                               - 26 -

Section 1.183-1(d)(1), Income Tax Regs., however, provides:

     If the taxpayer engages in two or more separate
     activities, deductions and income from each separate
     activity are not aggregated either in determining
     whether a particular activity is engaged in for profit
     or in applying section 183.

In other words, two activities will be considered separate

activities with respect to ascertaining a profit objective when

there is no net income from one activity to reduce the cost of

the second activity.   See sec. 1.183-1(d)(1), Income Tax Regs.

     Petitioners argue that they have invested in two assets:

(1) The horses and (2) the horse farm and the land on which it is

located.    Respondent argues that the horse farm and the land are

not relevant to the instant case because petitioners' horse

activity never produced income in excess of expenses.

     We conclude that petitioners' horse farm and land are not to

be considered as a single activity along with petitioners' horse

activity.   During the years in issue, the horse activity did not

reduce the net cost of carrying the horse farm and land for their

appreciation in value.   Sec. 1.183-1(d)(1), Income Tax Regs.

Accordingly, we consider the horse activity and the horse farm

and land as separate activities in deciding whether a profit

objective existed.

     Based on our review of the record, we conclude that

petitioners intended that an overall profit would result from the
                               - 27 -

operation of their horse activity and from the appreciation in

the value of the horses once it was realized.      Petitioners had a

world champion Arabian, Bella Joya, which earned them a

substantial amount of money.   Petitioners bred Bella Joya to

Wiking, another champion horse, to produce a foal that they could

race.   The foal, however, had to be put to sleep.     Bella Joya has

produced another foal, which petitioners intend to race.

Additionally, petitioners' horses were appraised in 1995 at a

value of between $96,000 and $106,000.

     During the years in issue, however, petitioners were

hampered by their bankruptcy payments and by Mrs. Phillips'

numerous medical problems.   Once they are no longer hindered by

such considerations, petitioners will be able to invest more time

and money on their horse activity.      Accordingly, based on the

record, we conclude that petitioners intended that an overall

profit would result from the operation of their horse activity

and from the appreciation in the value of the horses once it was

realized.

     Section 1.183-2(b)(6), Income Tax Regs., provides that "A

series of losses during the initial or start-up stage of an

activity may not necessarily be an indication that the activity

is not engaged in for profit."   The regulations continue:
                               - 28 -

       If losses are sustained because of unforeseen or
       fortuitous circumstances which are beyond the control
       of the taxpayer, * * * such losses would not be an
       indication that the activity is not engaged in for
       profit. * * * [Sec. 1.183-2(b)(6), Income Tax Regs.]

Additionally, section 1.183-2(b)(7), Income Tax Regs., provides

that

       The amount of profits in relation to the amount of
       losses incurred, and in relation to the amount of the
       taxpayer's investment and the value of the assets used
       in the activity, may provide useful criteria in
       determining the taxpayer's intent. * * *

       Petitioners argue that they sustained losses because of

unforeseen circumstances beyond their control, viz, Mr. Phillips'

loss of his job, Mrs. Phillips' health problems, and their

chapter 13 bankruptcy.    Petitioners argue that the period of time

it has taken them to develop their horse activity is not out of

line with the period seen in other cases, citing Pirnia v.

Commissioner, T.C. Memo. 1989-627.      Additionally, petitioners

argue that the fact that they have not realized gross income in

their horse activity during each of the years in issue is not by

itself evidence that they lack the requisite profit objective.

       Respondent argues that petitioners' consistent history of

losses during the period 1987 through 1993 is persuasive evidence

that petitioners did not expect to make a profit, citing Golanty

v. Commissioner, 72 T.C. at 427.    Respondent, conceding that

petitioners encountered unforeseen circumstances, nonetheless
                              - 29 -

argues that "it is petitioners' reactions to these factors which

reveal the most about their motivations in running the activity."

Respondent argues that petitioners continued their activity "as

usual", buying additional horses and breeding more unshowable,

unraceable, and relatively unsalable half Arabians.

Additionally, respondent argues that petitioners could have

avoided bankruptcy altogether by selling Bella Joya for an amount

approximating their total debt.

     Respondent argues that petitioners lacked a profit objective

because they only bred Bella Joya twice in 6 years.    Respondent

argues that petitioners' decision to place their horse activity

on hold for several years, during which they accumulated another

$280,000 of losses in order to keep Bella Joya, clearly

demonstrates that their actions are motivated by something other

than profits.   Additionally, respondent contends that petitioners

could have sold their less productive animals in order to cut

down on expenses.   Respondent argues that the fact that they did

not suggests that the real reason for the magnitude of their

losses was their desire to keep all of their horses.

     Additionally, respondent argues that the absence of a profit

as far back as 1988 (the first year for which records are

available) indicates the lack of a profit motive.   Respondent

argues that Arabian breeding is not a highly speculative venture
                               - 30 -

with high stakes.   Respondent argues that, even if petitioners

had sold Bella Joya for the $180,000 asking price, there was no

prospect of recouping the cumulative losses for the activity, as

distinguished from Eisenman v. Commissioner, T.C. Memo. 1988-467.

     We conclude that petitioners began their horse activity

during 1985 when they decided to change the focus of their horse

activity from quarter horses to Arabians upon purchasing Bella

Joya, along with 11 other Arabians.     We have previously noted

that the startup phase of an American saddle-bred breeding

operation is 5 to 10 years.    Engdahl v. Commissioner, 72 T.C.

659, 669 (1979).    Similarly, we conclude in the instant case that

a period of 5 to 10 years for the startup phase of an Arabian

breeding operation is not unreasonable and hold that the years in

issue encompassed a startup period.

     The losses sustained by petitioners during the startup

period were the result of unforeseen circumstances beyond the

control of petitioners, viz, Mr. Phillips' loss of his job, Mrs.

Phillips' health problems, and their chapter 13 bankruptcy.     Sec.

1.183-2(b)(6), Income Tax Regs.   We have addressed, supra, the

changes that petitioners either made or attempted to make in

order to minimize their losses.   As petitioners' series of losses

were sustained because of unforeseen circumstances beyond their
                               - 31 -

control, we conclude that such losses are not an indication that

the activity is not engaged in for profit.

     Section 1.183-2(b)(8), Income Tax Regs., provides that

     The fact that the taxpayer does not have substantial
     income or capital from sources other than the activity
     may indicate that an activity is engaged in for profit.
     Substantial income from sources other than the activity
     (particularly if the losses from the activity generate
     substantial tax benefits) may indicate that the
     activity is not engaged in for profit especially if
     there are personal or recreational elements involved.

     Petitioners argue that the fact that they spent a

substantial amount of their gross income and all of their

inheritance moneys on the horse activity is strong evidence that

they are engaged in it for profit.      Petitioners argue that they

"are sacrificing a higher living standard today for the

expectation of enjoying substantial profits in the future."

     Respondent argues that petitioners' substantial income from

other sources "has allowed them to continue funding their horse

operation despite the heavy losses".     Respondent argues that

petitioners' activity "is sustainable, even on a current basis,

only through outside funds."

     In the instant case, petitioners have invested in their

horse activity, since 1988, all of the inheritances that they

received, and, during each of the years in issue, a large

percentage of their gross income, which indicates, in the
                               - 32 -

circumstances of the instant case, that the activity was not a

mere "hobby."   Additionally, petitioners' losses during the years

in issue were out-of-pocket economic losses.    As we have

discussed, supra, we conclude that petitioners, during the years

in issue, were attempting to sustain their horse activity until

Mrs. Phillips recovered and that petitioners intended for their

horse activity, among other things, to support Mrs. Phillips in

the event that Mr. Phillips predeceased her.    Accordingly, we

believe that petitioners' use of Mr. Phillips' income to aid in

sustaining the horse activity during the years in issue was

warranted, given the circumstances in which petitioners found

themselves, and does not indicate the lack of a profit objective.

     Section 1.183-2(b)(9), Income Tax Regs., provides that

"The presence of personal motives in carrying on of an activity

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

especially where there are recreational or personal elements

involved."   The regulations provide that

     the fact that the taxpayer derives personal pleasure
     from engaging in the activity is not sufficient to
     cause the activity to be classified as not engaged in
     for profit if the activity is in fact engaged in for
     profit as evidenced by other factors whether or not
     listed in this paragraph. [Sec. 1.183-2(b)(9), Income
     Tax Regs.]

     Petitioners do not use the horses for personal riding

pleasure.    At the time of trial, Mr. Phillips had not ridden a
                              - 33 -

horse for approximately 10 years, and Mrs. Phillips was unable to

ride because of her heart problems and back problems.   Before her

health problems, Mrs. Phillips rode some horses only in order to

prepare them for racing, sale, or show.   Consequently, we

conclude that petitioners did not engage in their horse activity

for its recreational or personal aspects.

     We have considered respondent's remaining arguments and find

them to be without merit.   After considering the record as a

whole, and particularly Mrs. Phillips' health problems during the

years in issue, petitioners' bankruptcy, and the startup nature

of petitioners' activity, we find that petitioners engaged in

their horse activity for profit.   We therefore hold that section

183 does not apply to petitioners' horse activity and that

petitioners are entitled to deduct activity expenses in excess of

activity income for the years in issue.

     As we have held that petitioners are entitled to deduct

activity expenses in excess of activity income for the years in

issue, petitioners are not liable for the penalties for

substantial understatement of income tax pursuant to section

6662.

     To reflect the foregoing,


                                    Decision will be entered
- 34 -

for petitioners.
