The Tax Court held that the owner of a large investment management firm and his wife who conducted a sideline miniature donkey breeding business had a profit motive for the activity as required by Sec. 183 and therefore could deduct the losses from the activity for the years at issue.
Background
William Huff was the founder of the investment management firm W.R. Huff Asset Management Co. LLC (Huff Asset Management). Using a research-driven investment philosophy implemented by Huff, the company was highly successful, at one point having approximately $25 billion in assets under its management. This made Huff an extremely wealthy man, with Forbes magazine reporting his 2005 net worth at $750 million.
Huff had one child, a daughter named Jennifer. At her request, Huff started a dog grooming business for her. Huff, besides providing funding, was active in the startup, picking the location of the business, negotiating the lease for its premises, and paying the cost to construct the necessary facilities. He and some of his Huff Asset Management employees also advised her on marketing and bookkeeping. While Jennifer apparently was able after some years to keep the doors open without her father's financial support, the business showed a net operating loss on its tax returns from 2008 to 2019.
In 1987, Huff bought a 31.35-acre tract of farmland in New Jersey. Later, he bought a 7.5-acre tract adjoining that property on which Jennifer and her husband lived. In 2004, Huff formed Ecotone, a partnership he owned with his wife, which according to its operating agreement was organized for agricultural, equestrian, and equine purposes.
In 2010, Huff began looking for a use for his farmland. To this end, he talked to Arthur Papetti, a fellow businessman. Papetti was primarily in the egg business, but he also had extensive experience in the field of miniature donkeys and their breeding. Papetti beguiled Huff with talk of the considerable profits to be made by breeding high-quality miniature donkeys.
Huff took an interest in the idea and had his research team at Huff Asset Management look into the practicalities involved in miniature donkey breeding. The team did extensive research on miniature donkey nutrition and husbandry. As part of this research, Huff Asset Management employees talked to various veterinary and other specialists. Huff's research also made him aware of how a breeding venture could qualify as a commercial farm in New Jersey, which would entitle it to valuable protections under state law.
After completing extensive preliminary research, Huff decided to give breeding miniature donkeys a try. Although he had been a city boy who grew up in the Hell's Kitchen neighborhood of Manhattan, Huff thought himself well positioned for success, given his unused farmland, his deep research into husbandry, and the expertise of Papetti, who had agreed to help him with his venture. The breeding operation was to be conducted through Ecotone.
However, according to the Tax Court, Huff's main objective for going into the miniature donkey breeding business was not his own profit. Instead, it was for Jennifer, who, although independent from her parents, had only modest earnings. Although Jennifer had at that time no real experience with miniature donkey breeding, Huff believed that once he had the breeding operation properly established, he could turn it over to her and it would provide her a stream of income in future years.
The Huffs dedicated 25% of their farmland to Ecotone for the miniature donkey breeding operation. The land used, the location of buildings and fencing, and the materials used for the buildings and fencing were all carefully chosen by Huff, based on Huff Asset Management employees' previous research, Papetti's personal experience, research conducted personally by Huff, and the advice of other experts.
Ecotone bought five miniature donkeys between May and August 2010 and bought another 20 over the next eight years. The miniature donkeys that Ecotone purchased were largely chosen on Papetti's advice, which Huff did not always take. Ecotone also sold 20 miniature donkeys during that time. Throughout the years, one thing remained constant: Ecotone paid substantially more to acquire miniature donkeys than it sold them for, paying $92,985 for the ones it purchased and receiving only $23,500 for the ones it sold.
Initially, Huff relied on Papetti's advice almost exclusively for breeding his miniature donkeys. The original plan was to breed each female donkey as often as possible, which was generally once a year. After experiencing problems early on with stillborn and genetically defective foals, Huff changed the breeding strategy, limiting Ecotone's female donkeys to breeding once every two years. He believed that this would overall increase Ecotone's returns over the breeding life of its female miniature donkeys by producing fewer but superior quality foals.
In response to the deaths in the early years of a number of donkeys from cold winter temperatures, Huff made changes to their sheds, changed their feeding schedules (in hopes of raising their metabolism to keep them warmer), and quit making them wear jackets (because the jackets may have made them less resistant to the cold). To prevent disease, he began rotating the animals' paddocks and, believing that their feed might be causing problems, he experimented with supplemental feeds.
During the years at issue, Ecotone maintained books and records detailing donkey purchases and sales, veterinarian visits, and costs such as equipment, supplies, maintenance, and services. It had its own bank account and credit card, and it maintained business filings as a separate entity. Ecotone also maintained a registry of miniature donkeys and registered each one with the Miniature Donkey Registry.
On its returns for the years 2010 through 2017, Ecotone reported a net loss each year ($21,594 for 2010; $69,272 for 2011; $65,304 for 2012; $87,236 for 2013; $47,039 for 2014; $48,926 for 2015; $24,058 for 2016; and $35,656 for 2017). These losses passed through to Huff and his wife.
The IRS audited Huff's returns for 2013 and 2014. It disallowed the losses from Ecotone, claiming that Ecotone was not carrying on a trade or business and was an activity not engaged in for profit. Huff challenged the IRS's determination in Tax Court.
The Tax Court's decision
The Tax Court held that the Huffs' losses from Ecotone's donkey-breeding activity were allowable because they engaged in the activity with an actual and honest objective of making a profit. The court found that while the approach Huff used through Ecotone may have been misguided and its operation may have never achieved profitability, it did not mean Huff did not have an honest profit motive for the breeding activity. The Tax Court employed an analysis of the nine factors set out in Regs. Sec. 1.183-2(b).
As the court explained, under the hobby-loss rules of Sec. 183, a taxpayer may not deduct expenses associated with an activity not engaged in for profit. To escape this rule, a taxpayer must engage in an activity primarily with the hope and intent of making a profit. The expectation of a profit does not have to be reasonable, but it must be genuine. The determination of whether the requisite profit motive exists is based on all the facts and circumstances, and evidence from outside the particular tax years at issue may be considered.
Regs. Sec. 1.183-2(b): This regulation provides nine objective factors that should be considered in deciding if a taxpayer has a profit motive for an activity: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his or her advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that 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 with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. Neither a single factor nor the existence of even a majority of the factors is controlling but rather an evaluation of all the facts and circumstances is necessary.
Manner of carrying on the activity: A taxpayer must carry on the activity in a businesslike manner. The court found that this factor favored the Huffs because Huff had a business plan for Ecotone, albeit unwritten, and when confronted with problems with its breeding operations, made changes that were intended to improve the activity's profitability.
Expertise of Huff and his advisers: Preparation for an activity by extensive study or consultation with experts also may indicate a profit motive when the taxpayer carries on the activity as advised. The court found this factor favored the Huffs, as Huff had conducted extensive research into miniature donkey breeding and enlisted the aid of Papetti, who had expertise in the field.
Time and effort expended: The Tax Court stated that devoting personal time to an activity indicated a profit motive, but only devoting a limited amount of personal time did not indicate the contrary if a taxpayer employed competent and qualified people to work in the activity. Here, although Huff only had a small amount of time to devote to the activity, he employed Papetti to give operational advice and had another person who maintained the farm and the donkeys, so the court found that this factor favored the Huffs.
Expectation that assets may appreciate in value: The court determined that this factor favored the IRS. While Huff asserted that he expected his miniature donkeys and his farmland to appreciate in value, he offered no evidence to show either would appreciate, and the way he had conducted the operations indicated that an increase in value of his miniature donkeys was unlikely.
Success in other activities: Regs. Sec. 1.183-2(b)(5) states that "[t]he fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable." The Tax Court found that the miniature donkey activity was simply a smaller-scale version of the activities that Huff did at Huff Asset Management, researching the operations of a company and its respective industry, analyzing that information, and using it to "decide how to best pursue a profit." The court observed that in his past business history with Huff Asset Management, Huff had seen situations where "initial losses gave way to strong returns," and thus it was not unreasonable for Huff to believe that the miniature donkey activity would likewise one day turn a profit. Thus, the court found this factor favored the Huffs.
History of income or losses for the activity: Despite the fact that the miniature donkey activity had seen nothing but losses, the court concluded that this factor also favored the Huffs. While consistent losses indicate a lack of profit motive, losses in the initial or startup phase of an activity do not. In the court's view, Huff was still in the startup phase of the activity in 2013 and 2014, so the losses he had incurred in those years did not show a lack of profit motive.
Occasional profits from the activity: As the Huffs had not made any profit, occasional or otherwise, from the miniature donkey activity, the Tax Court found this factor favored the IRS.
Financial status of the Huffs: The regulations state if a taxpayer has substantial income from sources other than the activity in question, this may indicate there is not a profit motive for the activity, particularly if the activity has a recreational or personal element. Although Huff and his wife were rich, the court still found that this factor favored the Huffs. It first noted that although the Huffs had substantial assets, the miniature donkey activity was eventually to be turned over to their daughter as a source of income, and Huff had credibly testified that he would not give her a business that was losing money. Thus, it was reasonable to believe that they were sensitive as to whether the business made a profit.
In addition, the court found that based on what Huff knew when he started the activity, he could reasonably have believed that he could turn a profit on it. Furthermore, the court was persuaded that during the years at issue, 2013 and 2014, Huff believed he was close to turning the corner. Thus, while the Huffs' considerable fortune allowed them to plow ahead, it did not alter their end goal of making a profit on the activity.
Elements of personal pleasure or recreation: While many people may consider miniature donkeys cute and adorable creatures, Huff was the person doing the work in the activity, and, based on his testimony to the court, he derived no satisfaction from owning the donkeys and considered them to be nothing more than livestock. Taking Huff at his word, the Tax Court found that the activity did not provide the Huffs with personal pleasure or recreation.
Having done its analysis, the Tax Court found that the nine factors of Regs. Sec. 1.183-2(b) confirmed its conclusion that the Huffs had an actual and honest profit motive with respect to Ecotone's donkey-breeding activity in 2013 and 2014. The court believed, based mainly on Huff's testimony, that the Huffs thought that the activity, once properly established, would be consistently profitable and provide income to their daughter. The court further found that Huff had used an approach similar to what he used successfully for many other investments. Thus, despite Ecotone's lack of success, the Huffs pursued the breeding activity through Ecotone with the required profit motive under Sec. 183.
Reflections
Arguably, the most important factor to the Tax Court in showing that Huff had a profit motive for the donkey-breeding activity was the fifth factor in Regs. Sec. 1.183-2(b)(5), success in similar and dissimilar activities, which the court terms as success in other activities. As Regs. Sec. 1.183-2(b)(5) puts it, for this purpose success means success in turning an unprofitable business into a profitable one.
While a past history of success in turning around a business may show that a taxpayer has a higher probability of actually making a profit in his or her respective activity, it would seem to shed little light on whether the taxpayer has an actual profit motive. Business novices who have no experience with turning business losses into profits plausibly could have just as much of a profit motive when pushing ahead with a money-losing business as business pros. They may simply not have enough experience to know how difficult it may be to turn things around.
Huff, T.C. Memo. 2021-140
