Ruben v. Commissioner

BARNEY C. RUBEN AND ELEANOR RUBEN 1, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Ruben v. Commissioner Docket No. 5788-82. United States Tax Court T.C. Memo 1986-260; 1986 Tax Ct. Memo LEXIS 348; 51 T.C.M. (CCH) 1268; T.C.M. (RIA) 86260; June 24, 1986. John P. Callahan, for the petitioners. Rosa Berman, for the respondent. CLAPP MEMORANDUM FINDINGS OF FACT AND OPINION CLAPP, Judge: Respondent determined deficiencies in petitioners' Federal income tax as follows: Year Deficiency 2 [1976] $28,323 [1977] 48,140 [1978] 35,567 *350 The issue for decision is whether petitioners' horse operations constituted an activity engaged in for profit. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by this reference. Petitioners resided in California at the time they filed their petition in this case. Petitioner-husband is a successful and busy real estate businessman. He built and sold homes and buildings for over 40 years. To conduct his real estate business, he formed the following corporations: Oxnard & Cedros Co., Inc.; Kesto, Inc.; 14830 Oxnard Street Inc.; Kester & Oxnard Co., Inc.; Kester Avenue Land Corp.; Ruben Homes, Inc.; Ruben Land Corp.; Ruben Investment Co., Inc.; and Burvan Properties, Inc. In 1972, he formed an investment company from which he received a salary ranging from $73,500 in 1972 to $100,000 in 1978. Before taking into consideration the losses and property taxes of the ranch, petitioners' adjusted gross income for 1976, 1977 and 1978, the years at issue, was $370,326, $315,544 and $370,962, respectively. In addition to petitioner-husband's real estate business, petitioners*351 were involved in breeding, boarding and racing horses. Petitioners purchased their first horse in 1943. Over the years, petitioners have owned four ranches: Van Nuys Ranch, El Bar Ranch, Running Springs Ranch at Newberry Park, California (Running Springs Rach I) and Running Springs Ranch at Santa Yuez, California (Running Springs Ranch II). Petitioners purchased the Van Nuys, Ranch in 1943. It had 60 acres of land and a one-half mile track. Petitioners subdivided the ranch and built houses on it in 1947. Petitioners purchased the El Bar Ranch in 1947. It had 40 acres of land and approximately 15 horses. Petitioner-husband did not like the location of the ranch because it was too far away from his real estate business. Petitioners sold the ranch in 1954. Petitioners purchased Running Springs Ranch I in 1954. It had 272 acres and 11 horses. The value of the land appreciated because of an increase in the population in the area and its potential for residential and/or commercial development. The value of the land did not appreciate because of its use as a horse ranch. Petitioners became dissatisfied with the location of the ranch and, in 1962, sold the ranch to a real estate*352 developer for residential and/or commercial development. Petitioners reported a gain on the sale of the ranch on the installment method. Petitioners' capital gain, and interest income on a note from the sale, was reported as follows: Year Capital Gain Interest Total [1962] $ 570,363 $ 0 $ 570,363 [1963] 256,503 62,494 318,997 [1964] 256,503 98,494 354,997 [1965] 4,275 78,743 83,018 [1966] 207,156 60,572 267,728 [1967] 85,501 67,840 153,341 [1968] 85,501 60,840 146,341 [1969] 399,718 53,840 453,558 [1970] 257,905 40,044 297,949 TOTAL $2,123,425 $522,867 $2,646,292 In 1962, petitioners purchased Running Springs Ranch II, a 1,000 acre ranch petitioner-husband still owns. It has a main residence, a pool, two detached guest bedrooms, a guest house, a manager's apartment, employee quarters, a 24 stall barn, 17 paddocks, a 4-stall broodmare barn, a 7/16 mile training track and 55 acres of pasture and grazing land. Petitioners usually stayed at the ranch from Thursday night until Monday. While at the ranch, petitioner-husband spent most of his time gardening and petitioner-wife, who had taken genetics classes, maintained breeding records*353 and filed foaling and breeding reports with various associations. Petitioner-husband was president of the California Harness Horse Breeders Association from 1953 to 1955 and a member of the California Standardbred Sires Stakes Committee from 1976 to 1978. Both petitioners were active in horse industry associations. Petitioners employed several people to assist them with the activities and record keeping of the ranch. They employed a maid who helped with the housekeeping and a ranch manager who had only an adequate reputation. Accountants maintained records of petitioners' personal, ranch and business affairs and prepared their tax returns from 1962 through 1982. Petitioner-husband did not review the tax returns prepared by his accountants but did keep some informal ranch records of his own. Petitioners did not prepare budgets for the ranch and used the same bank account for their personal and ranch expenditures. As the owners of Running Springs Ranch II, petitioners were able to breed, board and race standardbred harness horses, activities which gave petitioners a great deal of pleasure. During 1976, 1977 and 1978, petitioners owned 30 brood mares and several stallions. During*354 this same 3-year period, 48 mares were bred at the ranch. Petitioners raced 9 horses in 1976, 10 horses in 1977 and 7 horses in 1978. Breeding fees, boarding revenue, racing purses, other miscellaneous revenues, total expenses and net income for 1976, 1977 and 1978 were as follows: [1978] Breeding fees $719 $3,716 $3,238 Boarding revenues 12,585 31,031 26,149 Racing purses 48,711 86,479 87,080 Other revenues 32,253 7,733 13,135 Total expenses (135,037) (198,914) (181,639) Net Income ($40,769) ($69,955) ($52,037) An itemization of the revenues and expenses associated with Running Springs Ranch II from 1962 to 1982 follows: Line Income: [1] Sales of Horse $200 $1,500 $400 $1,000 [2] Pasture & Boar 9,218 10,397 7,272 4,717 [3] Breeding Fees [4] Racing Purses 15,835 20,059 7,609 29,508 [5] Leasing & Misc 5,000 [238] 3,932 [7] Total Income $30,718 $32,674 $15,519 $40,018 [9] Expenses [10] Advertising [11] Bad Debts [12] Blacksmith [13] Breeding Fees [14] Commissions [15] Depreciation [16] Dues & Subs. [17] Feed [18] Gas and Oil [19] Insurance [20] Misc. [21] Payroll Taxes [22] Repairs [23] Salaries [24] Seed & Fertilizer [25] Stake Fees [26] Supplies [27] Taxes & Licenses [28] Telephone [29] Training/Drivers [30] Travel [31] Trucking [32] Utilities [33] Veterinary [35] Total Expens 93,590 118,418 98,762 114,862 [37] Net Income $ -62,872 $ -85,744 $ -83,243 $ -74,844 [38] *355 Line Income: [1] Sales of Horse $2,650 $11,625 $6,810 $12,770 [2] Pasture & Boar 3,621 3,068 6,722 13,969 [3] Breeding Fees [405] 1,799 [4] Racing Purses 37,717 5,481 [834] 9,695 [5] Leasing & Misc 1,465 [275] 2,029 [7] Total Income $45,763 $20,995 $15,046 $40,262 [9] Expenses [10] Advertising [11] Bad Debts [12] Blacksmith [13] Breeding Fees 5,150 [14] Commissions [15] Depreciation 21,884 22,092 [16] Dues & Subs. [17] Feed 5,935 7,929 [18] Gas and Oil 2,709 1,372 [19] Insurance 4,423 3,338 [20] Misc. [21] Payroll Taxes 1,445 1,267 [22] Repairs 8,493 5,151 [23] Salaries 17,492 13,370 [24] Seed & Fertilizer [25] Stake Fees [26] Supplies 2,568 1,435 [27] Taxes & Licenses 8,612 8,757 [28] Telephone 1,546 [29] Training/Drivers 16,517 40,622 [30] Travel [31] Trucking [607] 2,383 [32] Utilities 3,666 1,867 [33] Veterinary 1,753 2,043 [35] Total Expens 127,525 102,423 105,336 115,747 [37] Net Income $ -81,762 $ -81,428 $ -90,290 $ -75,485 [38] *356 Line Income [1] Sales of Horse $52,715 $36,000 $5,000 [2] Pasture & Boar 19,216 23,584 36,475 [3] Breeding Fees 3,529 [818] 1,788 [4] Racing Purses 30,451 18,417 24,541 [5] Leasing & Misc 3,456 1,162 [7] Total Income $109,367 $79,981 $68,584 [9] Expenses [10] Advertising [11] Bad Debts [12] Blacksmith 1,116 2,312 2,855 [13] Breeding Fees [200] 2,229 [14] Commissions [15] Depreciation 21,232 21,500 23,079 [16] Dues & Subs. [430] 1,055 2,195 [17] Feed 22,829 8,051 29,149 [18] Gas and Oil 1,382 1,989 3,157 [19] Insurance 2,472 2,551 2,000 [20] Misc. [21] Payroll Taxes 1,588 1,343 2,049 [22] Repairs 5,285 4,782 9,353 [23] Salaries 10,928 10,631 19,295 [24] Seed & Fertilizer [25] Stake Fees [26] Supplies [569] 2,565 [27] Taxes & Licenses [28] Telephone [29] Training/Drivers 32,455 14,148 33,000 [30] Travel [31] Trucking 1,905 2,025 1,200 [32] Utilities [877] 1,268 1,111 [33] Veterinary 3,004 3,969 7,308 [35] Total Expens 108,069 78,371 140,859 [37] Net Income $1,298 $1,610 $ -72,275 [38] *357 Line Income: [1] Sales of Horse $10,310 $10,849 $12,421 [2] Pasture & Boar 29,404 38,028 32,957 [3] Breeding Fees [925] 2,720 1,175 [4] Racing Purses 11,683 25,321 48,437 [5] Leasing & Misc [7] Total Income $52,839 $77,130 $94,990 [9] Expenses: [10] Advertising [11] Bad Debts 1,400 [12] Blacksmith [13] Breeding Fees 1,239 1,229 [14] Commissions [15] Depreciation 23,581 21,757 21,178 [16] Dues & Subs. 2,803 [17] Feed 5,648 6,371 11,763 [18] Gas and Oil 2,618 3,515 2,557 [19] Insurance 2,364 1,716 2,041 [20] Misc. [21] Payroll Taxes 1,321 1,335 1,290 [22] Repairs 5,911 4,620 3,135 [23] Salaries 16,028 17,190 15,303 [24] Seed & Fertilizer [25] Stake Fees 2,740 2,700 [26] Supplies [75] 2,125 [27] Taxes & Licens 1,273 1,300 3,363 [28] Telephone [29] Training/Drive 25,861 41,425 52,747 [30] Travel [31] Trucking 3,160 4,920 [32] Utilities 1,153 1,366 1,450 [33] Veterinary 4,283 3,404 2,279 [35] Total Expense $99,712 $114,692 $124,836 [37] Net Income $ -46,873 $ -37,562 $ -29,846 [38] Line Income: [1] Sales of Horse $32,253 $6,471 $13,135 [2] Pasture & Boar 12,585 31,031 26,149 [3] Breeding Fees [719] 3,716 3,238 [4] Racing Purses 48,711 86,479 87,080 [5] Leasing & Misc 1,262 [7] Total Income $94,268 $128,959 $129,602 [9] Expenses: [10] Advertising [11] Bad Debts [12] Blacksmith [13] Brooding Fees 3,646 4,274 [14] Commissions [15] Depreciation 18,441 17,710 16,578 [16] Dues & Subs. [17] Feed 8,643 2,316 11,029 [18] Gas and Oil 2,267 2,221 [19] Insurance 2,234 2,292 2,571 [20] Misc. [21] Payroll Taxes 1,116 1,280 1,162 [22] Repairs 4,532 2,306 2,384 [23] Salaries 12,035 13,895 14,624 [24] Seed & Fertilizer [25] Stake Fees [900] 2,745 [26] Supplies 3,451 9,431 [27] Taxes & Licens 2,176 1,134 2,098 [28] Telephone [29] Training/Drive 65,017 114,197 102,035 [30] Travel [31] Trucking 6,381 15,010 11,747 [32] Utilities 1,649 2,073 1,578 [33] Veterinary 4,833 7,665 9,279 [35] Total Expense $135,037 $198,914 $181,639 [37] Net Income $ -40,769 $ -69,955 $ -52,037 [38] *358 Line Income: [1] Sales of Horse $17,000 $12,570 $58,905 $34,329 [2] Pasture & Boar 25,840 90,344 72,552 111,472 [3] Breeding Fees 3,442 [910] 1,415 4,353 [4] Racing Purses 28,914 18,157 27,126 68,861 [5] Leasing & Misc [7] Total Income $75,196 $122,481 $159,998 $219,015 [9] Expenses: [10] Advertising [11] Bad Debts [12] Blacksmith 2,399 1,896 [13] Breeding Fees [14] Commissions 3,600 6,191 9,802 4,474 [15] Depreciation 15,341 14,462 18,022 11,436 [16] Dues & Subs. 1,197 [63] 1,327 [17] Feed 7,030 20,851 18,720 34,368 [18] Gas and Oil [19] Insurance 4,666 5,017 2,971 3,016 [20] Misc. 2,014 1,535 [21] Payroll Taxes [22] Repairs 1,798 2,505 3,846 4,286 [23] Salaries 28,064 32,377 34,737 32,957 [24] Seed & Fertilizer [25] Stake Fees 1,620 2,865 4,625 7,575 [26] Supplies 1,926 1,175 1,422 [27] Taxes & Licens 3,186 2,848 3,296 3,274 [28] Telephone [29] Training/Drive 47,524 18,040 33,705 65,388 [30] Travel [31] Trucking 22,487 1,352 10,296 5,840 [32] Utilities 1,574 1,858 [826] 1,036 [33] Veterinary 4,574 1,127 2,826 1,145 [35] Total Expense $149,306 $114,577 $145,539 $177,235 [37] Net Imcome $ -74,110 $7,904 $14,459 $41,700 [38] *359 As reflected in the charts, Running Springs Ranch II was not profitable. It suffered a substantial loss in each year during the 18-year period 1962-1979. In 1970 and 1971, and through 1982, petitioners' accountants improperly reported real property taxes. If the real property taxes had been properly reported, the net income of Springs Ranch II for 1970 3 and 1971 would have been ($7,202) and ($7,060), respectively. From 1962 to 1979, Running Springs Ranch suffered total losses of over $1,000,000. The examination of petitioners' returns for the years at issue began in 1979. In 1980, Running Springs Ranch II began to show a profit. The profit was a result of a lease agreement between petitioners and the Southern California Racing Association (SCRA), the President of which was a long-time friend and business associate. Under the agreement, petitioners leased to SCRA 65 acres of pasture and other various facilities. No horses were ever*360 boarded at the ranch pursuant to the agreement. SCRA paid petitioners $36,000 in 1980 and $40,000 in each of the years 1981, 1982 and 1983. In 1984, SCRA sold its only asset and dissolved. The purchaser of SCRA's asset was the successor in interest to the lease between petitioners and SCRA. The purchaser decided it did not need the boarding facilities at Runnings Springs Ranch II and cancelled the lease in 1984. ULTIMATE FINDING OF FACT Petitioners' horse operations did not constitute an activity engaged in for profit during the years 1976, 1977 and 1978. OPINION Section 183(a) provides generally, if an activity is not engaged in for profit, no deduction attributable to such activity shall be allowed except as otherwise provided for in that section. Section 183(c) defines "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable * * * under section 162 or * * * paragraph (1) or (2) of section 212." Section 1.183-2(b), Income Tax Regs.*361 , provides a list of nine factors to consider in the determination of whether an activity is engaged in for profit. 4 However, the resolution of the issue is to be based on all the facts and circumstances. Engdahl v. Commissioner,72 T.C. 659, 666 (1979). In order for the taxpayer to prevail, the facts and circumstances must indicate that the taxpayer entered into, or continued, the activity with an actual and honest objective of making a profit. Dreicer v. Commissioner,78 T.C. 642, 645 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983). *362 In the present case, the evidence does not support a finding that petitioners' activities were engaged in for profit. First, petitioners did not carry on the activity in a businesslike manner. Although petitioner-husband kept some informal records or notes and petitioner-wife kept breeding records, nothing in the record suggests that petitioners had anything but a vague understanding of the finances of the ranch. Petitioners did not prepare a budget for the ranch. They advertised in only two years; in 1970 they spent $325 on advertising and in 1971 they spent $344. Petitioners did not maintain a separate bank account for the ranch. Secondly, petitioners did not devote a significant amount of time to the activities of the ranch. Although they each kept some records, they usually spent only weekends at the ranch, and even then, petitioner-husband devoted most of his energies to gardening. Lack of time devoted to an activity is not necessarily indicative of a lack of profit motive where other competent and qualified people carry on the activity. Section 1.183-2(b)(3), Income Tax Regs.*363 In the present case, however, petitioners' ranch manager had only an adequate reputation and we were not informed as to the reputation of petitioners' other employees. Finally, Running Springs Ranch II suffered a loss in each year during the 18-year period 1962-1979. During this period, the losses totalled over $1,000,000. During 1976, 1977 and 1978, the years at issue, Running Springs Ranch II had a net income (loss) of ($40,769), ($69,955) and ($52,037), respectively. The only apparent rewards petitioners received from the ranch were the tax benefits associated with the losses and the personal pleasure derived from the activities of the ranch. Petitioners argue that because they reported the capital gain and interest income from the sale of Running Springs Ranch I on the installment method, their ranching operations actually were profitable from 1962 through 1970. We disagree. When 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. *364 5 In the present case, the appreciation of Running Springs Ranch I was attributable to its potential residential and/or commercial development, not to its use as a horse ranch. Thus, the capital gain and interest income from the sale of Running Springs Ranch I should not be taken into account when evaluating petitioner's profits and losses from their ranching operations. Cf. section 1.183-1(d)(1), Income Tax Regs. Petitioners also argue on brief that their ranch was profitable from 1980 through 1982. 6 Respondent contends that the profits in those years are a result of a bogus lease between petitioner and SCRA. We need not decide whether petitioners took steps in 1980 to make Runnings Springs Ranch II profitable or whether the lease was in fact a sham. The years at issue are 1976, 1977 and 1978. During these years, the ranch was unprofitable and petitioners were not engaged in an activity for profit. *365 Decision will be entered under Rule 155. Footnotes 1. Mrs. Ruben died February 15, 1985 prior to trial.↩ 2. In an amendment to answer, respondent alleged that the correct amounts of the deficiencies are $34,785.23, $54,976.14 and $40,282.06 for the years 1976, 1977 and 1978, respectively. The increased deficiencies are a result of respondent's shifting real property taxes associated with petitioners' ranch from Schedule A to Schedule F. Petitioner has conceded that the change is correct. Section 183(b)↩ provides that deductions attributable to an activity not engaged in for profit are allowable in a certain order, starting with deductions otherwise allowable, e.g., taxes and interest. The remaining deductions, which would be allowable if they had been incurred in an activity engaged in for profit, are then allowed to the extent that gross income from the activities exceeds the deductions which were allowed first. Here, the real property taxes shifted from Schedule A to Schedule F are deducted first and result in increased deficiencies if petitioner's activities were not engaged in for profit. 3. For any taxable year beginning after December 31, 1969, a presumption that horse related activities are engaged in for profit applies if the activities are profitable in two out of seven consecutive years. Sections 183(d) and (e)(1)↩. 4. The factors are: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the 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 loss 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.↩ 5. LaMusga v. Commissioner,T.C. Memo. 1982-742. Cf. Engdahl v. Commissioner,72 T.C. 659, 668↩ (1979) (appreciation in value of ranch based on its use as a horse ranch). 6. At trial, petitioners contended that these years were irrelevant because they dealt with years subsequent to the years at issue.↩