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Keating v. Commissioner of Internal Revenue: TAX - no error finding horse breeding wasn't for profit, so losses not deductible

United States Court of Appeals
No. 07-3660
No. 08-1266
Nora E. Keating and *
Richard L. Shearer, *
Petitioners - Appellants, * Appeal from the
* United States Tax Court.
v. **
Commissioner of Internal Revenue, *
Respondent - Appellee. *
Submitted: September 24, 2008
Filed: October 14, 2008
Before MURPHY, ARNOLD, and BENTON, Circuit Judges.
MURPHY, Circuit Judge.
Nora E. Keating and Richard L. Shearer filed a petition in United States Tax
Court challenging the determination of the Commissioner of Internal Revenue
(Commissioner) that because Keating engaged in her horse breeding activity as a
hobby rather than for profit, losses from the activity were incorrectly deducted on their
1996 through 2002 tax returns, resulting in deficiencies in their federal income tax
1The Honorable Stephen J. Swift, Judge, United States Tax Court.
obligations. Following a trial the tax court1 concluded that Keating had not engaged
in the horse activity for profit and ordered Keating and Shearer liable for all
deficiencies assessed by the Commissioner. Keating and Shearer appeal, and we
In 1996 Keating moved to Williston, North Dakota, where she began work as
an emergency room physician and purchased a home on a 10 acre farm. She worked
approximately 60 hours per week, preferring two 24 hour shifts and one 12 hour shift
because she felt "burned out" from medical school and because it allowed her more
full days with her six children. Her average annual salary was 8,134. Her
husband at the time, Richard Shearer, worked as a firefighter medic. The two filed
joint federal income tax returns from 1996 through 2000 but divorced prior to the
filing of Keating's 2001 individual income tax return.
Also in 1996, Keating realized a lifelong dream of working with horses when
she purchased four Arabians, which she considers the "ballerinas of the horse world."
She had always loved horses and had experience owning, caring for, and riding them
dating back to high school when she worked in a veterinary clinic, belonged to several
riding clubs, and purchased and boarded her first horse at age 15.
When Keating purchased the Arabians in 1996 she spoke with an award
winning Arabian horse breeder, two horse trainers, and a veterinarian about training
methods, breeding, selection of stallions and mares, and veterinary issues including
factors that could result in early termination of pregnancy. She also spoke with people
who had been audited for their horse activities; they recommended that she keep good
expense records and all receipts. She consulted a certified public accountant (CPA)
regarding tracking receipts and maintaining records.
Although Keating had extensive experience caring for and riding horses, she
had no experience in the business of buying, selling, or showing horses, and she
presented no evidence at trial that she had consulted anyone regarding the economic
or business aspects of breeding, training, or showing horses. Between 1996 and 2002
Keating purchased 13 horses and bred 7, but she sold only 2 horses, each for half of
its purchase price.
Keating did not change her work schedule after purchasing the Arabians, but
on each day off she spent approximately 7 to 10 hours with the horses. She engaged
in their training and feeding, and she also rode them, cleaned their stalls, performed
basic veterinary work, and competed in shows. Before a showing she would hire a
professional trainer to finish training the horses. Keating and her daughter rode in
many shows which gave her great pride, and on four occasions her horses participated
in nationally competitive horse shows.
In 2000 Keating built a barn to shelter the horses during the breeding months.
In 2001 she began boarding other people's horses, leasing out her own horses, and
providing horse clinics, but she did not advertise the boarding and leasing services.
She advertised that her horses were for sale by word of mouth, by showing them, and
by advertising on three websites; she did not advertise in any written publication.
Between 1996 and 2001, Keating paid both personal and horse activity
expenses from the same two or three personal checking accounts. In 2002 she opened
a checking account in the name of Nora Ellen Keating Stony Creek Arabians (Stony
Creek Arabians) and two new personal checking accounts, but she continued to pay
personal and horse activity expenses from all three accounts. For example, she
deposited the proceeds from the 2002 sales of the two horses in one of her personal
accounts, not the Stony Creek Arabians account. She kept a ledger of total horse
activity expenses, retained receipts by month of transaction, and kept records of
training, ovulatory cycles, and vaccinations relating to each horse. She did not,
however, keep expense records for each individual horse. She had no written business
plan and no financial projections relating to her horse activity.
Keating and Shearer filed joint federal income tax returns for 1996 through
2000 and Keating filed individual federal income tax returns for 2001 and 2002, each
of which listed "horses" as the principal activity on Form 1040 Schedule F, "Profit or
Loss from Farming." The following gross income, expense, and net loss amounts
attributable to the horse activity were included on Schedule F:
Year Gross Income Expenses Net Loss
1996 $ 144 $ 22,227 $ (22,083)
1997 178 22,187 (22,009)
1998 335 48,289 (47,954)
1999 432 44,784 (44,352)
2000 750 50,550 (49,800)
2001 1,200 84,382 (83,182)
2002 1,418 102,550 (101,132)
These losses reduced reported taxable income dollar for dollar, resulting in
substantial tax savings. In 2005 the Commissioner audited these federal income tax
returns and concluded that the horse activity was not engaged in for profit. As a result
the Commissioner disallowed the horse activity losses on Schedule F for each year
examined and issued Notices of Deficiency asserting that Keating and Shearer owed
additional taxes equal to their entire claimed tax benefit from the horse activity:
Tax Year Tax Deficiency/Additional Tax Owed
1996 $ 7,784
1997 6,507
1998 18,181
1999 16,191
2000 20,219
2001 29,066
2002 35,815
Keating and Shearer filed a petition in United States Tax Court for a
redetermination of the deficiencies assessed by the Commissioner, and the matter was
tried in 2007. Based on its analysis of all of the facts and circumstances the tax court
concluded that a preponderance of the evidence supported the Commissioner's
determination that the horse activity was not engaged in for profit, and concluded that
Keating and Shearer were liable for all deficiencies assessed by the Commissioner.
Keating and Shearer appeal, claiming that the tax court erred in concluding that
Keating's horse breeding activity was not carried out with a profit motive. This is a
factual determination which we review for clear error and must affirm unless left with
a conviction that the tax court has committed a mistake. See Blodgett v. Comm'r, 394
F.3d 1030, 1034-35 (8th Cir. 2005). Keating argues that her horse activity was
engaged in for profit. As evidence she cites the facts that she kept good records, spent
most of her time outside of work with the horses, and invested her savings, earnings,
and retirement funds in the horses with the expectation that they would provide
income for her retirement. The Commissioner counters that these arguments were
made to the tax court and that it did not err in concluding that the activity was not
engaged in for profit.
The deductibility of taxpayer expenses related to an activity depends on
whether it is carried on for profit. See 26 U.S.C. 162, 212. Subject to two
exceptions in 26 U.S.C. 183(b) which do not apply here, a person may not deduct
a loss attributable to an activity unless that activity is engaged in for profit. 26 U.S.C.
183(a). For example, a taxpayer may not deduct losses related to an activity "carried
on primarily as a sport, hobby, or for recreation." Treas. Reg. 1.183-2(a).
An activity is engaged in for profit if the taxpayer has an actual, honest profit
objective, even if it is unreasonable or unrealistic. Treas. Reg. 1.183-2(a). Treasury
Regulation 1.183-2(b) includes a nonexhaustive list of nine factors to consider in
determining whether a business is engaged in for profit: (1) the manner in which the
taxpayer carries on the activity; (2) the expertise of the taxpayer or her advisors; (3)
the time and effort expended by the taxpayer in carrying on the activity; (4) the
expectation that assets used in the activity may appreciate in value; (5) the success of
the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's
history of income or losses in respect to the activity; (7) the amount of occasional
profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) any
elements of personal pleasure or recreation. No single factor or even a majority of the
factors is controlling, and all of the facts and circumstances must be evaluated, giving
greater weight to objective facts than to the taxpayer's statement of intent. See Evans
v. Comm'r, 908 F.2d 369, 373 (8th Cir. 1990).
The tax court thoroughly analyzed the facts and circumstances of Keating's
horse activity as they related to each of the nine factors in Treasury Regulation
1.183-2(b). It found that five of the factors favored the Commissioner's conclusion
that the horse activity was not carried on for profit, four factors were neutral, and none
favored Keating's argument that she engaged in the horse activity for profit.
The tax court concluded that the first factorwhether the activity is carried on
in a businesslike manner and whether complete and accurate books and records are
maintainedfavored the Commissioner's finding of liability. It found that she had not
carried on the horse breeding activity in a businesslike manner. She commingled her
personal and horse funds in her various bank accounts even after opening the Stony
Creek Arabians account, made meager efforts at advertising, made relatively small
improvements to the grounds and operations, and had no written business plan. It also
found that although her books and records were thorough in respect to each horse's
vaccinations and ovulatory cycles, her failure to keep track of expenses on a per horse
basis and to prepare any financial projections to assess the economics of the activity
indicated a lack of profit objective. See Filios v. Comm'r, 224 F.3d 16, 23 (1st Cir.
2000) (to indicate profit motive, records generally should assist in cutting expenses,
increasing profits, making financial projections, and evaluating overall performance
of business). It also found that the books and records were kept by Keating only to
"memorialize for tax purposes the existence of the subject transactions."
The tax court found that the second factorthe taxpayer's expertise and
preparation with regard to the economic aspects of the businessfavored the
Commissioner's determination. It said that although Keating consulted with breeders
and horse experts regarding breeding and training, she was not an expert and did not
seek expert advice regarding the economic aspects of the horse business. Burger v.
Comm'r, 809 F.2d 355, 359 (7th Cir. 1987) (mechanics and economics of activity are
separate areas of expertise, and failure to obtain expertise in economics of activity
may indicate lack of profit objective). It found that she discussed tracking receipts
with a CPA only for tax purposes.
The tax court found that the fourth factorthe expectation that assets used in
the activity may appreciate in valuefavored the Commissioner's determination
because Keating presented no evidence of the value of the horses, making it
impossible to determine their current or expected future value. The only two horses
Keating sold between 1996 and 2002 were sold for less than half of their purchase
price, suggesting that any expectation of appreciation may have been unreasonable.
The tax court concluded that the eighth factorthe financial status of the
taxpayerfavored the Commissioner's determination because Keating had a high
salary from her work as a physician and had 3,763 in claimed tax savings from the
horse activity over seven years. See Treas. Reg. 1.183-2(b)(8) (substantial income
from sources other than activity in question may indicate activity not carried on for
profit, especially where losses generate substantial tax benefits).
The tax court concluded that the ninth factorelements of personal pleasure
or recreationfavored the Commissioner's determination because the recreational
aspects of Keating's horse activity and the fact that her daughter rode recreationally
suggest an activity without a profit objective. See Montagne v. Comm'r, T.C. Memo.
2004-252, 2004 WL 2504388 at *3 (U.S. Tax Ct. 2004) (concession that family
enjoyed riding and competing with horses showed lack of profit objective), aff'd, 166
Fed. Appx. 265 (8th Cir. 2006).
With the exception of the eighth factortaxpayer's financial statuswhich she
did not discuss on appeal, Keating and Shearer argue that the tax court erred in its
factual determinations regarding each of the other factors. They argue that Keating
kept detailed records, advertised, consulted experts for business advice, believed that
the assets were increasing in value, and undertook many unpleasant chores related to
the horse activity. The tax court's factual findings involved credibility determinations,
however, which are virtually unreviewable on appeal. Blodgett, 394 F.3d at 1035.
The evidence in the record established that Keating did not have a written business
plan or financial projections for the horse activity, commingled horse related funds in
her personal and horse activity accounts, failed to develop economic expertise
regarding the horse breeding business, and derived great pride and enjoyment from
showing the horses. In light of these objective facts we cannot say that the tax court
erred in its factual determinations.
Keating also argues that the tax court erred because two of the four factors
which it found neutralfactors six and seven regarding the history of income or
losses and any occasional profitsfavored Keating's position that she engaged in the
horse activity for profit. The tax court concluded that these factors were neutral
because although Keating had consistent and increasing losses over the seven years
at issue, a horse business may have a five to ten year startup phase during which the
taxpayer may incur losses before turning a profit. See, e.g., Davis v. Comm'r, T.C.
Memo. 2000-101, 2000 WL 307276 at *10 (U.S. Tax Ct. 2000). Because Keating's
horse activity incurred consistent and increasing losses, however, it was not clear error
for the tax court to find these factors neutral rather than in favor of Keating's position.
The tax court did not err in concluding that based on all of the facts and
circumstances, including an analysis of the nine factors in Treasury Regulation
1.183-1(b)(2), a preponderance of the evidence supported the Commissioner's
determination that Keating's horse activity was not engaged in for profit.
Accordingly, the court did not err in concluding that Keating and Shearer were liable
for the tax deficiencies as assessed by the Commissioner.
Keating and Shearer also contend that a remand to the tax court would be in
order because it erred in failing to shift the burden of proof to the Commissioner to
disprove their entitlement to the loss deductions. We presume that the
Commissioner's determination regarding the existence of a tax deficiency is correct,
requiring the taxpayer to bear the burden of proving entitlement to a claimed
deduction by a preponderance of the evidence. Blodgett, 394 F.3d at 1035. This
burden shifts to the Commissioner to disprove the entitlement if the taxpayer
introduces "credible evidence" with respect to the tax liability. 26 U.S.C. 7491. We
review de novo the legal question of whether a taxpayer produced evidence sufficient
to shift the burden of proof to the IRS under 26 U.S.C. 7491, Blodgett, 394 F.3d at
1035, but must recognize that "a shift in the burden of preponderance has real
significance only in the rare event of an evidentiary tie," id. at 1039 (party supported
by weight of evidence will prevail regardless of who bore burden of proof). The tax
court stated that "[t]his case is decided on the preponderance of the evidence and is
unaffected by section 7491." Any error in assigning the burden of proof would have
been harmless under the circumstances, and there is no basis upon which to remand
this matter for further proceedings.
Accordingly, we affirm the judgment of the tax court.


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