February 2012

Horse Breeding: Expenses Not Deductible

The U.S. Tax Court ruled that the petitioner was not entitled to deduct various expenses incurred in connection
with horse breeding activities even though he acted in good faith, took reasonable efforts to assess his proper tax liability and relied upon his tax advisor. Accordingly, he was not liable under Code Section 6662(a) for penalties. Van Wickler v. C.I.R., T.C. Memo. 2011-196, T.C.M. (RIA) P 2011-196 (2011).

Background
Van Wickler, having earned a fortune in stock options, sought income-generating opportunities. He was introduced to Classic Star, a company that marketed horse-breeding activities to high-net-worth individuals. Classic Star told Van Wickler of its history of producing profitable horses and the belief that the government encouraged this type of investment because it generated revenue for the government. Van Wickler engaged a CPA to review the Classic Star materials and information and in addition spoke to another CPA recommended by the company. Van Wickler believed he could make a profit by investing in a mare lease program with Classic Star. Over a period of three years, Van Wickler invested large sums of money in mare lease programs after being advised by the firm that they believed the program, although high-risk, could produce high returns and, if not, deductions for losses could withstand IRS scrutiny.

Van Wickler created Bent Rock Farms LLC to invest in Classic Star. While Van Wickler believed the Classic Star horses were thoroughbreds, in fact most were not. As a result, he incurred very high losses that he deducted on his federal income tax returns over a two-year period. He then received a notice of deficiency that disallowed all horse breeding activity expenses. Van Wickler appealed to the U.S. Tax Court.

No Expenses Deductible
The IRS contended that Van Wickler was not entitled to deduct the horse breeding expense because he was not in the business and the amounts were unreasonable. Additionally the IRS had determined that Van Wickler was liable for accuracy-related penalties based on negligence or a substantial understatement of income tax. Negligence includes any failure to make a reasonable attempt to comply with the law or maintain adequate books and records. Although Van Wickler substantially understated his income tax, §6664(c)(1) provides no penalty shall be imposed if there was reasonable cause for the underpayment and the taxpayer acted in good faith.

Reliance on professional advice qualifies as reasonable cause if the reliance was reasonable and the taxpayer acted in good faith. Here, Van Wickler recognized his unfamiliarity with tax law and aspects of the mare lease program. He reviewed the materials given him by Classic Star, including tax opinions, and spoke with a tax professional about the program and the tax returns at issue. He lacked knowledge of tax law and sought advice from a party who was duped by Classic Star’s materials and representatives. The court concluded that Van Wickler acted in good faith and took reasonable efforts to assess his proper tax liability and reasonably relied upon the expertise of another. Accordingly, he was not liable for §6662(a), accuracy-related penalties.

This article was written by Robert Klein, CPA, and originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Winter 2012). Copyright 2012 BDO USA, LLP. All rights reserved. www.bdo.com. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.