NINTH CIRCUIT AFFIRMS TAX COURT'S DECISION THAT HORSE BREEDERS FAILED TO CLEAR HURDLES OF A FOR-PROFIT ACTIVITY.

APPEAL FROM THE DECISION OF THE TAX COURT OF THE UNITED STATES

Argued and Submitted April 4, 1988

Pasadena, California

MEMORANDUM*

Before: Tang, Fletcher, and Pregerson, Circuit Judges.

The United States Tax Court disallowed certain tax deductions attributable to the Rubens' horse ranching activities on the ground that the Rubens engaged in those activities without the objective of making a profit. The Rubens appeal the Tax Court's ultimate finding of fact, arguing that they did intend to make a profit. We affirm.

Section 183 of the Internal Revenue Code prohibits taxpayers from deducting net losses resulting from an "activity not engaged in for profit." 26 U.S.C. section 183 (1982). When a taxpayer engages in an activity without the objective of making a profit the taxpayer may deduct only:

(1) the deductions which would be allowable under this chapter for the taxable year without regard to whether or not such activity is engaged in for profit, and

(2) a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph (1).

Id. section 183(b). Thus, the taxpayer may first take deductions that do not require a profit motive -- for example, interest expense and taxes. Then, the taxpayer may take deductions that do require a profit motive -- for example, depreciation and most losses -- but those deductions may not exceed the gross amount of income from the activity. Section 183 was enacted as part of the Tax Reform Act of 1969 to curtail excessive deductions associated with "hobby losses." Pub. L. No. 91-172, section 213, 83 Stat. 487, 571-72; see S. Rep. No. 552, 91st Cong., 1st Sess., reprinted in 1969 U.S. Code Cong. & Admin. News 2027, 2133-35.

To determine whether an activity is carried on for profit, the facts and circumstances of each case are examined in light of objective standards. Independent Elec. Supply, Inc. v. Commissioner, 781 F.2d 724, 726-27 (9th Cir. 1986). A reasonable expectation of profit is not required, but the facts and circumstances must indicate that the taxpayer entered into or continued the activity with the objective of making a profit. 26 C.F.R. section 1.183-2(a) (1987).

The tax regulations list nine factors to be taken into account in determining whether a taxpayer acted with the requisite profit objective. 26 C.F.R. section 1.183-2(b) (1987). In most cases, the following will be relevant: (1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his 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 with respect to the activity; (7) the amount of occasional profit, if any, which is earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. Id. These factors are not exclusive, and no one factor or mathematical preponderance of factors is determinative. Id.

Since 1943, the Rubens have been involved -- in varying degrees -- with the practice of breeding, boarding, and racing harness horses. They have owned four different ranches, and they personally participated in ranching activities during the tax years at issue in this case. The Rubens assert that their horse ranching is an "activity" "engaged in for profit" within the meaning of 26 U.S.C. section 183. On their tax forms, the Rubens claimed deductions for losses resulting from their ranching activities.

The Commissioner and the Tax Court disagreed with the Rubens' characterization of their ranching activities. On the basis of 26 U.S.C. section 183 and 26 C.F.R. section 1.183, the Tax Court determined that the Rubens' horse ranching is an "activity NOT engaged in for profit." The Tax Court further found that the Rubens are liable for the following tax deficiencies because they claimed deductions prohibited by section 183: $34,785.23 for 1976; $43,511.01 for 1977; and $40,282.06 for 1978.

We review for clear error the Tax Court's factual finding of whether an activity is undertaken for profit. Polakof v. Commissioner, 820 F.2d 321, 323 (9th Cir. 1987), cert. denied, 108 S. Ct. 748 (1988). The taxpayer bears the burden of proving a profit motive. Id.

The Rubens highlight the following facts to support their contention that the circumstances of this case indicate a profit motive. The Rubens have been associated with the harness horse industry since the 1940's. They have been actively involved in harness horse racing and breeders associations. They have developed experience and knowledge in the field of breeding and racing horses. Rather than race horses purchased on the market, they have developed their own stock of horses. They operated their latest ranch on a cash basis and without incurring debt. Mr. Ruben monitored the cash position of the ranch. Both of the Rubens regularly spent long weekends at the ranch. They occasionally visited the ranch more frequently during breeding season and in emergencies. Mrs. Ruben selected horses for breeding, and Mr. Ruben participated in ranch management decisions.

The government notes that the following facts support the Tax Court's finding that the Rubens were not motivated by profit. The Rubens did not maintain a separate bank account for their ranch; rather, they mingled ranch finances with their own personal finances. From 1962 to 1979, the ranch suffered net losses of over one million dollars. Mr. Ruben apparently was not aware of the extent of the losses. There was little or no evidence that information contained in the books and records of the ranch was used systematically to cut costs or to improve profitability. The Rubens failed to present any forecasts of profitability for the ranch. During the three years in question, the ranch suffered net losses of over $150,000. Although the Rubens spent time at the ranch, they indicated that they derived personal pleasure out of their activities. Personal benefits mitigate the importance of time spent on an activity under 26 C.F.R. section 1.183-2(b)(9) (1987). Before taking into consideration the losses and property taxes of the ranch, the Rubens' adjusted gross income for 1976, 1977, and 1978, the years at issue, was $370,326, $315,544, and $370,962, respectively. Mr. Ruben was already engaged in a full-time profitable enterprise as a successful real estate businessman.

There is no doubt that the Rubens presented evidence that reasonably could be construed as indicating a profit motive. If the Rubens did not bear the burden of proof, these facts might lead us to find a profit motive. ¹ However, the evidence in this case is insufficient to overcome the two difficult hurdles the Rubens face on appeal. Not only did the Rubens bear the initial burden before the Tax Court of proving a profit motive, but they bear the added burden on appeal of showing that the Tax Court's finding was clearly erroneous. In light of the initial presumption in favor of the Commissioner, and the deference owed the Tax Court on appeal, we cannot say that these facts so obviously indicate a profit motive that they render the Tax Court's decision clearly erroneous.

In its opinion, the Tax Court stated that "[w]hen land/a ranch appreciates independently of the horse related activities, the gain on the sale of the land is not taken into account when evaluating petitioner's profits and losses from their ranching operations." The Rubens contend that this statement is legally erroneous. They further assert that their objective of making a profit would have appeared more obvious if the Tax Court had considered the substantial gains they received from the sale of one of their ranches when evaluating the profitability of their subsequent ranching activities.

The Ruben's argument that the Tax Court's statement is legally erroneous is based on their reading of two sections of the tax regulations. Section 1.183-2(b)(4) states that a profit motive may be indicated by the expectation that assets used in an activity will appreciate in value:

(4) EXPECTATION THAT ASSETS USED IN ACTIVITY MAY APPRECIATE IN VALUE. The term "profit" encompasses appreciation in the value of assets, such as land, used in the activity. Thus, 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. See, however, paragraph (d) of section 1.183-1 for definition of an activity in this connection.

26 C.F.R. section 1.183-2(b)(4) (1987).

Section 1.183-1(d) sets forth the criteria for deciding when assets are used in a particular activity. That section notes that activities can be separated or aggregated for tax purposes depending on the "degree of organizational and economic interrelationship of various undertakings." 26 C.F.R. section 1.183-l(d) (1987). It also notes that farming -- which is regarded as the functional equivalent of ranching -- and the holding of land for its appreciation value may be considered two separate activities, even when the farming takes place on the land that is appreciating. Id.

The Rubens argue that farming and the holding of land are a single activity for the purposes of section 1.183-2(b)(4) unless the land is purchased with the primary intent of benefiting from its appreciation in value. They base that contention on a portion of section 1.183-1(d), which states that "[w]here land is purchased or held primarily with the intent to profit from increase in its value, and the taxpayer also engages in farming on such land, the farming and the holding of the land will ordinarily be considered a single activity only if the farming activity reduces the net cost of carrying the land for its appreciation in value." Id.

The record indicates that the Rubens purchased their ranch property with the primary intent of using it as a ranch, rather than with the primary intent of speculating on the land. Accordingly, the Rubens claim that their ranching activities and their ownership of the land constitute a single activity under section 1.183-1(d), and that the increase in the value of the land must therefore be considered in evaluating the profitability of their ranching activities under section 1.183-2(b)(4).

The government interprets sections 1.183-1(d) and 1.183-2(b)(4) differently. It follows the view expressed by the Tax Court in LaMusga v. Commissioner, 51 T.C.M. (P-H) 3225 (1982) (T.C. Memo 1982- 742), and in the Rubens' case. In LaMusga, the Tax Court stated that "[w]e do not interpret section 1.183-2(b)(4), Income Tax Regs., to allow a taxpayer to avoid section 183 and deduct large losses simply by virtue of conducting an unprofitable activity on a piece of land that is appreciating independently of or in spite of the activity." Id. at 3229. The Tax Court repeated this view in the Rubens' case when it said that "[w]hen land/a ranch appreciates independently of the horse related activities, the gain on the sale of the land is not taken into account when evaluating petitioner's profits and losses from their ranching operations." In its interpretation, the government has essentially read an additional rule into the language of sections 1.183-1(d) and 1.183-2(b)(4): the appreciation of assets generally will not be considered in evaluating the profitability of an activity when the appreciation is completely unrelated to the activity. This implied rule is supported by the general language of section 1.183-1(d), which emphasizes the "economic interrelationship of various undertakings." 26 C.F.R. section 1.183-l(d) (1987).

Under the government's interpretation of the tax regulations, the Tax Court had legal authority to disregard the gains from the sale of the Rubens' previous ranch. The Rubens admit that the appreciation in value of that ranch resulted primarily from housing pressures in the area. In other words, the appreciation gains were not related to the Rubens' ranching activities. Therefore, the government argues that these gains unrelated to ranching should not be used to evaluate the profitability of the Rubens' ranching operations.

The government argues in the alternative that the Tax Court's finding that the Rubens lacked a profit objective is still supportable even if the gains from the sale of the ranch are factored into the overall picture of profitability. It correctly notes that the appreciation of assets involved in an activity is merely one out of nine factors listed in the tax regulations as relevant to determining whether a taxpayer engaged in an activity with a profit objective. See 26 C.F.R. section 1.183-2(b) (1987). Even if the Rubens' assets showed considerable appreciation, the fact remains that the Tax Court identified several other factors that weigh AGAINST finding that the Rubens engaged in their horse ranching activities with the objective of making a profit.

We agree with the government that the evidence of capital gains from the sale of the Rubens' previous ranch, even if considered as favorable evidence to the Rubens, does not ultimately invalidate the Tax Court's decision. As we noted earlier, the standard of review in this case is clearly erroneous, and no single factor can determine the presence or absence of a profit objective. On the basis of our overall view of the Rubens' horse ranching activities, we cannot say that the Tax Court's decision was clearly erroneous.

Because our decision would not be affected by the inclusion or exclusion of the capital gains as relevant evidence, we do not need to decide whether the Tax Court misapplied sections 1.183-1(d) and 1.183-2(b)(4) of the tax regulations. We do, however, note that both the interpretation proferred by the Rubens and the interpretation expressed by the Tax Court in this case and the LaMusga case find support in the regulatory language.

AFFIRMED.

¹ In Faulconer v. Commissioner, 748 F.2d 890 (4th Cir. 1984), the Fourth Circuit found that somewhat similar facts indicated a profit motive. That case, however, may be distinguished from the Rubens' case.

First, the ranch in Faulconer realized a net profit in two out of the seven years in question. 748 F.2d at 892. The presence of actual profits raised the presumption under 26 U.S.C. section 183(d) that the ranch was operated for profit. The Rubens do not contend on appeal that the presumption of section 183(d) applies to their ranching operations. Thus, in Faulconer, the Commission bore the burden of proving that the ranch WAS NOT operated for profit. The Rubens bear the burden of proving that their ranch WAS operated for profit.

Second, several of the nine factors from 26 C.F.R. section 1.183-2(b) present a clearer picture of a profit motive in Faulconer than the same factors in the Rubens' case. Unlike the Rubens, Faulconer did not intermingle his personal and ranch finances. Faulconer kept entirely separate books and accounts. Id. at 896. Faulconer grew up on his farm and took over its operation from his father, who had owned and operated the farm until his death. Id. at 896-97. The Rubens did not inherit a family farm or use their farm as a residence. Faulconer, like the Rubens, had other income. His outside income, however, was quite a bit less than that of the Rubens. Id. at 898.