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Situational Awareness: Accurate Financial Recordkeeping and Business Deductions

Posted on Aug. 1, 2022
[Editor's Note:

Kathrin Gardhouse
Kathrin Gardhouse
Benjamin Alarie
Benjamin Alarie

Benjamin Alarie is the Osler Chair in Business Law at the University of Toronto and the CEO of Blue J Legal Inc. Kathrin Gardhouse is a legal research associate at Blue J.

In this article, Alarie and Gardhouse explore the Tax Court decision in Skolnick, which emphasizes the importance of keeping accurate financial records for activities that may be subject to IRS scrutiny regarding their business nature.

Copyright 2022 Benjamin Alarie and Kathrin Gardhouse.
All rights reserved.


Losses are not allowable for an activity that is carried on primarily for sport, as a hobby, or for recreation.1 The logic behind this is that those activities are typically not engaged in for profit and will predictably generate losses. Allowing these losses to be deducted could then amount to a de facto tax subsidy of personal activities. Despite this sensible approach to truly personal recreational activities, seemingly similar kinds of activities with mixed business and personal elements do sometimes have a sufficient profit motive and genuine commercial reality to give rise to allowable losses (and, in most years, taxable profits). It is well established that if a recreational activity is primarily engaged in for profit, it can give rise to allowable losses under section 162(a).

This raises a difficult line-drawing exercise between activities for which losses are allowed and those for which they are not allowed. Given that sport, hobby, and recreational activities often have mixed motives, and their profit and loss experience can be highly variable, determining in any given set of facts and circumstances whether a hobby or recreational activity has been engaged in as a trade or business for section 162(a) purposes can be challenging.

This topic is frequently litigated. The Blue J Tax data set on whether an activity amounts to a trade or business for purposes of section 162(a) consists of 758 decisions addressing this question over the 35 years from 1987 to 2022. Three-quarters of these 758 decisions found that the activity in question should not be considered a trade or business; the other quarter found that it should be. But there is much more that we can learn from these cases than the relative rate of their outcomes. In addition to the powerful search tools in Blue J Tax that allow users to filter through these decisions by the discrete facts and circumstances of each, we can use enterprise-grade machine-learning techniques to mine these cases for powerful insight into the facts and circumstances that are linked to different outcomes.2

This month in Blue J Predicts, we investigate the importance of maintaining complete and accurate financial records to determine whether horse breeding and related activities will be characterized as being for profit for purposes of the deduction of expenses under section 162(a). To ground our analysis in a particular set of facts and circumstances, we examine the recent Tax Court decision in Skolnick.3

Analytical Context

The Tax Court held in Skolnick that horse breeding activities conducted by the taxpayers through Bluestone Farms LLC (which was treated as a partnership for federal income tax purposes) were not engaged in for profit. While several factors were indicative of a trade or business, including the keeping of “voluminous” financial records, the Tax Court found many faults with Bluestone’s financial recordkeeping and stewardship, including incomplete documentation of important transactions and the taxpayers’ personal use of Bluestone resources. Moreover, according to the Tax Court, “The manner in which Bluestone conducted its activities shows that it was largely insensitive to costs.”4

The decision is now being appealed to the Third Circuit. On appeal, the taxpayers assert that, contrary to the conclusion of the Tax Court, Bluestone kept accurate financial records, and their adequacy should weigh in the taxpayers’ favor. The taxpayers further assert that the court erred in finding that there were significant gaps in Bluestone’s financial records, as well as in finding that those records were not used to increase the profitability of what the taxpayers characterized as a business.

What does an analysis of all the prior case law suggest about the merits of the taxpayers’ appeal? The Blue J Tax algorithm, which develops machine-learning insights based on the Blue J Tax database, shows that, conditional on the Tax Court’s findings of fact, including those concerning the financial records of Bluestone, there is a high likelihood (81 percent) that the court’s decision that there was not a trade or business will be sustained on appeal.

But what if the Third Circuit accepts the taxpayers’ position regarding the maintenance of sound financial records? In this event, a different story emerges. Scenario testing reveals that there would be a highly significant improvement (from an 81 percent chance of the appeal failing to a 77 percent chance of its success) if the taxpayers prevail in their position that the financial records were adequately maintained. Indeed, our Blue J analysis of Skolnick shows that the adequacy of financial records is extremely important to the outcome. In fact, analysis shows that it is more important in Skolnick than in any other decision in our database.

Tax Law and Horse Losses

When a taxpayer engages in a trade or business, ordinary and necessary business expenses are deductible under section 162(a). Guidance for what constitutes a trade or business is provided by section 183(c) and reg. section 1.183-2. Under these provisions, an “activity not engaged in for profit” is any activity other than a trade or business for which deductions are allowable under section 162, or an investment activity for which deductions are allowable under section 212(1) or (2). This definition indicates that an activity not engaged in for profit cannot be a trade or business for which deductions are allowable under section 162.

Assessing a profit motive is based on a subjective standard, but the courts will look to objective evidence establishing a profit motive while at the same time refraining from judging whether the investment decision was wise or reasonable. Generally, the taxpayer must simply have honestly believed that the activity would be or become profitable.

It is accepted that breeding and racing horses can be an activity entered into for profit.5 However, the courts exercise caution with cases arising in this industry:

The stereotypical abusive scenario involving horse breeding is the wealthy businessman who runs a real business during the week . . . and owns a “gentleman’s farm” as a weekend retreat where he keeps horses for the recreation of himself and his family and friends. . . . He dabbles in breeding horses, with no expectation of ever making a profit, so that he can deduct the expenses of his horses and thereby have Uncle Sam subsidize the weekend farm.6

Hence, to decide whether the horse breeding activity is undertaken for profit, a court will make a holistic determination based on many factors. Reg. section 1.183-2(b) lists nine objective factors to be considered when making a profit motive determination. This is not an exhaustive list of factors, and none of them are determinative. Further, the courts explicitly say the factors can have varying weights, depending on the scenario under consideration.

Factors provided in reg. section 1.183-2(b):

  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. 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 regarding 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.

We do not analyze the influence of every one of these factors, although the Tax Court has provided its take on all of them. Rather, we select those that the Blue J Tax analysis considers to have had the greatest effect on the outcome of Skolnick, those that the appellants most strongly rely on in their appellate brief, and those in which the facts seem to be most reasonably disputed. For example, we will not address the element of personal pleasure, as the evidence against the taxpayers appears to be particularly strong on this point.

The Facts in Skolnick

In Skolnick, the taxpayers engaged in horse breeding and racing activities on a large scale with revenue in the millions. Mitchel Skolnick had been introduced to horse breeding and racing by his father. In 1998, after a few years of working on his father’s farm, Skolnick and Eric Freeman cofounded their own horse breeding business, Bluestone Farms, as a New Jersey limited liability company. Skolnick lived on the Bluestone property and worked in a managerial capacity full time. In 2004 they sold a 15 percent interest in the business to Frank Russo, an independent investor. In 2002 and 2007 the taxpayers expanded the horse breeding farm by purchasing two nearby properties for $850,000 and $4 million, respectively.

The taxpayers can point to the practice of keeping records on each horse that included the total cost of owning the animal in support of their claim that the horse breeding activity was conducted in a businesslike manner. Also, as a reaction to the 2008 financial crisis and regulatory changes in New Jersey that cut a subsidy to in-state horse breeders, along with other legislative changes in other states that increased the competitive pressure, Bluestone relocated some of its horses to other states to allow them to race on more profitable tracks and participate in competing for breeder awards elsewhere. Bluestone also entered a co-venture arrangement with Cane Run Farm in Kentucky in 2009 so that they would co-own horses rather than bid against each other at auctions. The co-owned horses were financially more successful than the horses Bluestone owned on its own.

Some of the less helpful facts for the appellants’ case are that Bluestone did not make a profit up until and during the tax years at issue — namely, 2010 to 2013. Further, starting in 2003, Skolnick received generous distributions from a trust set up by his parents totaling around $10 million. This allowed him to retire from other work and keep Bluestone afloat despite the seven-figure losses it generated. Skolnick contributed large amounts of money each year to Bluestone. For these and other reasons detailed below, the Tax Court found that the activity was not a business but was instead undertaken as a hobby.

Blue J’s Analysis

Based on the Tax Court’s factual findings, Blue J’s prediction module, “section 162 — trade or business,” agrees with the outcome finding no trade or business with a confidence level of 81 percent. Our analysis shows that if all the taxpayers had done differently was to keep meticulously accurate financial records, the data from the previously decided 758 decisions suggest that, all else being equal, the outcome of the case would have been in their favor, with a likelihood of 77 percent.

Four Important Factors in Skolnick


Factor 1: Was There a Change in Practice to Increase Profits?

Factor 2: Were the Financial Records Accurate?

Factor 3: Were Any Losses Caused by Unforeseen Circumstances?

Factor 4: Did Assets Used in the Course of the Business Appreciate in Value?

Predicted Likelihood of a Finding of a Trade or Business

1 (original prediction)




































Table 1 sets out the factors we focus on in this analysis. The single most significant factor concerns the question whether the taxpayers made changes to the way the activity was being conducted in order to increase profitability once a particular approach proved to be economically unsustainable. Skolnick argues on appeal that the partnership with Cane Run in 2009 was just that kind of business practice improvement — made in reaction to the losses generated during the financial crisis in order to generate profits.7 The increased financial success of the co-owned horses allegedly shows that this strategy was successful, even though, overall, Bluestone did not generate profits until 2016. If the Tax Court had agreed with Skolnick in this regard, Blue J’s predictor would have been 83 percent confident that the outcome of the case would have been in the taxpayers’ favor (see Hypothetical 2). However, the Tax Court found that the overall sales of yearlings decreased in 2013 compared with 2010 despite Skolnick’s testimony that the average price of yearlings increased after Bluestone entered the partnership with Cane Run.8

Overall, the Tax Court found that even though changes were made, their effect on the profitability of the business was not material. The court also observed that some unprofitable methods were not abandoned even though they seemed easily correctable, such as selling off additional farmland that was not used for horse breeding.9 On appeal, Skolnick counters that the offer Bluestone received for the farm properties was not favorable because it would not have received money for 10 years, and that’s why the decision was made to reject the offer.10

Importance of Financial Records

Question: Is a taxpayer’s financial recordkeeping contemporaneous, substantiated, and accurate in portraying the activity’s financial transactions?

The Modeled Effect of Changing Finding of Inadequate Financial Records to Adequate Financial Records on Likelihood of Trade or Business (n = 243)

The figure displays the magnitude of a factor’s effect throughout the entire set of decisions considered by Blue J’s section 162 trade or business predictor. The effect is measured when we use as a starting point a fact scenario in which the financial records are held to be inadequate, and then change that factor to adequate financial records, which makes it more likely that the court will find the activity to be undertaken as a business. It is the change in the confidence level of the outcome that is depicted in this figure. As we can see, for the majority of decisions, the adequacy of the financial records changes the algorithm’s confidence level of the outcome by 0 to 5 percent toward constituting a trade or business. In Skolnick, on the other hand, the effect of this factor is 58 percent. Among the 758 decisions this predictor is working with, financial records were held to be inadequate in 243. From those 243, Skolnick is the case in which this factor is the most significant.

In our experience, it is unusual for a single factor to swing a hobby loss case so strongly (that is, increasing the probability of the taxpayer winning from 19 percent to 77 percent) (see Hypothetical 3). Consequently, we also explore whether the inadequacy of financial records takes on this level of importance in other cases in our database. As an extension of the analysis of Skolnick, we investigate the frequency with which the adequacy of financial records is just as important. Interestingly, back-testing prior case law for sensitivity to this factor suggests that in no other case was it as significant as it is in Skolnick. The median effect of changing a finding that financial recordkeeping was inadequate to adequate was a +4.6 percent likelihood of finding in favor of a trade or business; the average effect across all cases was +12 percent. The +58 percent effect in Skolnick is unusual.

This analysis showcases how the mix of factors determining the outcome of a case influences their respective effects. The influence of a factor can vary dramatically based on the presence or absence of other facts and circumstances. This insight can be uniquely gathered from a machine-learning model that allows the user to scenario-test — that is, to change the presence and absence of various factors, getting a new outcome and a corresponding confidence level when a factor is changed. The interdependency of the factors can be explored with Blue J Tax, which allows the user — at the tax planning stage — to assess the risk of each consideration that factors into the analysis of whether an activity is undertaken as a business or a hobby. It is, of course, always a good idea to keep accurate financial records, but knowing that an audit or potentially imminent litigation may depend on it could motivate a tax professional to make an additional effort.

Financial Records in Skolnick

In Skolnick, the court conceded that the taxpayer had kept voluminous records.11 However, it highlighted that these records had “important inaccuracies and gaps, particularly as they relate to money.”12 Examples the court focused on were the absence of a written financial arrangement setting out the initial agreement between the partners regarding their respective contributions, records of any change in ownership interests over the years, and later contributions by the partners. The court also noted the lack of a distinction between capital contributions and loans from the partners to the business and the partners’ failure to capture some income items, such as income from breeders’ awards.13

In response to the taxpayers’ claim that detailed records were kept — and not only general financial records, but extensive records on each horse the business owned — the court responded that those records merely distinguish a serious hobbyist from a careless amateur, but as long as the records are not used to increase profits — that is, to form the basis of businesslike decision-making — even extensive records do not strongly weigh in favor of the activity constituting a business.

In Skolnick’s brief, he notes that accounting records were kept and that the records included accounts payable, job accounting, general ledgers, and financial reporting. Skolnick relies on his accountant’s testimony that the general ledger was detailed and appropriate.14 He disagrees with the Tax Court on the purported inaccuracies, pointing the Third Circuit to the evidence that sets out the financial arrangement between the partners, the ownership changes, and the nature of the contributions.15

Loss Caused by Unforeseen Events

A less significant factor in Skolnick is whether some of the losses the business generated were caused by unforeseen circumstances. The rationale here is that if a taxpayer engages in an activity with the intent to make a profit, then their failure to do so should not be punished with a finding that the activity is a mere hobby if that failure is caused by unforeseen circumstances rather than a lack of effort by the taxpayer. Skolnick points to the financial crisis in 2008 and 2009 as well as the legislative changes that negatively affected the horse breeding industry in New Jersey. The Tax Court rejected those arguments, noting that Bluestone’s losses from 2010 to 2013 were only slightly smaller than during the financial crisis.16 If the taxpayers can convince the Third Circuit that some of Bluestone’s losses were in fact caused by unforeseen circumstances and not a result of the lack of intention to generate profits, Blue J’s algorithm predicts a 20 percent increase in the likelihood of the taxpayers’ success in the case (from 19 percent to 39 percent) (see Hypothetical 4). However, overall, this factor alone will likely not flip the outcome, as the predictive module still predicts a likelihood of 39 percent that, all else being equal, the outcome would be not a trade or business.

Asset’s Appreciation in Value

When gauging the profitability of a taxpayer’s activity in determining whether it constitutes a business, the courts will also look to the potential of the assets used in the activity to appreciate in value. If that appreciation together with the income generated from the activity generates overall profits, the activity will overall be considered profitable. Important in this respect are reg. section 1.183-2(b)(4) (providing that profit encompasses appreciation of assets used in the activity) and reg. section 1.183-1(d), which requires that the holding of the asset and the activity in question stand in an organizational and economic interrelationship for the appreciation of the value of the asset to count toward the profitability of the activity.

The Tax Court found that that connection did not exist regarding the two additional properties purchased for $850,000 and $4 million, as these properties were not needed to host the 20-25 horses that remained in New Jersey after the partnership with Cane Run was established and many horses were boarded in other states to take advantage of the breeder award competitions and races taking place elsewhere. Skolnick, on the other hand, faults the court for focusing on the use of the properties made after the financial crisis. He argues that the properties were acquired with the intent to use them in the farming business. The land was developed accordingly, as farming infrastructure was built, including a paddock and watering system. Trees were cleared off the property, and hay was stored there to graze and feed the Bluestone horses. Indeed, both farms were used, as horses were rotated for good pasture management. Also, a natural hill located on one of the properties was used to develop the muscles of the horses. After the financial crisis, the use of the two additional properties decreased and Bluestone considered selling them, taking initial measures to put them on the market. However, an ensuing offer was rejected because of its unfavorable conditions. According to Skolnick, this business decision should not have been considered to the detriment of Bluestone, as the initial motivation to purchase the farm properties was consistent with the primary intent to profit from their appreciation in value.17

Skolnick does not address the Tax Court’s further finding that the farming activity did not reduce the net cost of carrying the land for its appreciation, as further required by reg. section 1.183-1(d) for the appreciation of the land’s value to be factored into the profitability of the farming activity. The chance of the taxpayers convincing the Third Circuit on this point is therefore uncertain. The Tax Court also addressed the potential appreciation of the herd but found that one major success — a horse called Always B Miki — would be an insufficient basis for the hope that the herd’s value as a whole would appreciate with time.18

The effect of this factor is still significant, with a 15 percent change in the confidence of the predictor’s finding that Bluestone will be considered a trade or business from 19 to 34 percent (see Hypothetical 5). As shown in hypothetical 6 in Figure 1, if the taxpayer was also successful on the previously discussed point (loss caused by unforeseen events), the outcome would be trade or business with a confidence level of 66 percent.


The Tax Court decision in Skolnick emphasizes the importance of keeping accurate financial records of activities that may be subject to IRS scrutiny regarding their business nature. Whether this is the case can be most easily determined with a machine-learning tool such as Blue J’s section 162 trade or business predictor. This tool also allows practitioners at the planning stage to play around with the factors, assess the risks of setting up an activity in one way or another, and then adjust their arrangements until the desired outcome can be achieved with a degree of confidence that the client is comfortable with. As takeaways from our analysis, consider that for financial records to be considered accurate and complete, (1) ownership interests should be clearly documented, as well as any changes thereto; (2) there should be documentation on the nature of capital contributions; and (3) taxpayers should document any efforts they are relying on to establish their use of records to make changes in their business practice to enhance profitability.


1 Reg. section 1.183-2(a).

2 Visit for more information.

3 Skolnick v. Commissioner, T.C. Memo. 2021-139.

4 Id. at 34.

5 Dennis v. Commissioner, T.C. Memo. 2010-216 (2010); Engdahl v. Commissioner, 72 T.C. 659 (1979); Commissioner v. Widener, 33 F.2d 833 (3d Cir. 1929); Den Besten v. Commissioner, T.C. Memo. 2019-154.

6 Helmick v. Commissioner, T.C. Memo. 2009-220.

7 Skolnick v. Commissioner, No. 22-1501 (3d Cir. 2022), appellant’s brief at 55.

8 Skolnick, T.C. Memo. 2021-139, at 40.

9 Id. at 41.

10 Appellant’s brief, supra note 7, at 40.

11 Skolnick, T.C. Memo. 2021-139, at 33.

12 Id. at 34.

13 Id. at 40.

14 Appellant’s brief, supra note 7, at 35.

15 Appellant’s brief, supra note 7, at 29.

16 Skolnick, T.C. Memo. 2021-139, at 54.

17 Appellant’s brief, supra note 7, at 44 to 50.

18 Skolnick, T.C. Memo. 2021-139, at 51.


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