Metz v. Commissioner of Internal Revenue, 032315 FEDTAX, 10346-10

Docket Nº:10346-10, 28718-10, 5991-11
Opinion Judge:HOLMES, Judge:
Attorney:Bertram P. Husband, for petitioners. Mayah Solh-Cade, Jordan Scott Musen, Steven Mitchell Roth, and Michael W. Berwind, for respondent.
Case Date:March 23, 2015
Court:United States Tax Court

T.C.Memo. 2015-54




Nos. 10346-10, 28718-10, 5991-11

United States Tax Court

March 23, 2015

Bertram P. Husband, for petitioners.

Mayah Solh-Cade, Jordan Scott Musen, Steven Mitchell Roth, and Michael W. Berwind, for respondent.


HOLMES, Judge:

For over two decades, Henry and Christie Metz have owned an Arabian horse farm known as Silver Maple Farm (SMF). Between 2004 and 2009--the years at issue--their farm lost millions of dollars. The Commissioner determined that any business that lost this much money couldn't possibly be motivated by a desire to turn a profit and disallowed the losses. The Metzes disagree.

The question is: Whom do we believe?


There are three issues in these cases:

• whether the Metzes operated SMF intending to make a profit;

• whether interest the Metzes paid to their brokerage firm qualifies as investment interest; and

• whether the Metzes' failure to report income from the sale of farm property in 2004 should be subject to an accuracy-related penalty.

While the parties dispute the facts underlying these issues, they don't dispute the governing law. So we begin with a brief review of that law.

I. Requisite Profit Motive

Taxpayers can deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business, sec. 162, for the production or collection of income, sec. 212(1), or for the management, conservation, or maintenance of property held for the production of income, sec. 212(2). But before engaging in the "ordinary and necessary" inquiry, taxpayers must pass the section 183 test.1

Section 183(a) generally disallows any deduction attributable to an activity "not engaged in for profit, " and is aimed at disallowing the deduction of the expenses of a hobby that a taxpayer might try to use to offset taxable income from other sources. Section 183(c) defines an "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212." An activity doesn't need to show a profit, but taxpayers must have an actual and honest objective of making one. Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff'd without published opinion, 702 F.2d 1205 (D.C. Cir. 1983). And this expectation need not even be reasonable. See sec. 1.183-2(a), Income Tax Regs.

How do we determine this? We look at all the facts and circumstances with respect to the activity. Id. para. (b). We focus on the taxpayer's subjective intent, but we don't simply take the taxpayer at his word. We look instead to the objective factors that are listed in the regulations. Wolf v. Commissioner, 4 F.3d 709 (9th Cir. 1993), aff'g T.C. Memo. 1991-212.2 Section 1.183-2(b), Income Tax Regs., lists the nine factors to consider:

• manner in which the taxpayers carry on the activity;

• expertise of the taxpayers or that of their advisers;

• time and effort expended on the activity;

• expectation that assets used in the activity may appreciate in value;

• success of the taxpayers in carrying on other similar or dissimilar activities;

• history of income or losses with respect to the activity;

• amount of occasional profits, if any, from the activity;

• financial status of the taxpayers; and

• any elements of personal pleasure or recreation.

This list isn't exclusive, and we don't just tally up the factors for and against taxpayers to determine if they win. Sec. 1.183-2(b), Income Tax Regs. While we consider all the facts and circumstances, we may give more weight to some than to others. See Dunn v. Commissioner, 70 T.C. 715, 720 (1978), aff'd, 615 F.2d 578 (2d Cir.1980); sec. 1.183-2(b), Income Tax Regs.

Horse-farm cases come in herds and not in single stallions, and are among the most frequently litigated under section 183. Each case turns on its facts, see, e.g., Pederson v. Commissioner, T.C. Memo. 2013-54, at *59 (comparing a small sample of five horse-breeding cases with different outcomes), which can vary widely. They range from the wealthy businessman who runs a real business but keeps a gentleman's farm as a weekend retreat whose expenses he tries to subsidize through deductions to sophisticated, well-run operations that just haven't been able to consistently make a profit. See Helmick v. Commissioner, T.C. Memo. 2009-220, 2009 WL 3012725, at *7

These cases blaze a helpful trail to the facts that we should look at in any individual case, but they are not precedents from which one can derive ever more precise statements of law. We must not lose sight of the Ninth Circuit's lodestar: "The proper focus of the test to be applied * * * is the taxpayer's subjective intent." Wolf, 4 F.3d at 713 (quoting Skeen v. Commissioner, 864 F.2d 93, 94 (9th Cir. 1989), aff'g 88 T.C. 1086 (1987)).

II. Investment Interest

The parties also dispute the treatment of certain interest expenses that the Metzes paid over the years. Section 163(a) details the treatment of interest expenses, and states as a general rule that taxpayers may deduct "all interest paid or accrued within the taxable year on indebtedness." There is an exception, however, for personal interest paid or accrued during a tax year. Sec. 163(h)(1). But as so often in tax law, there is an exception to the exception--the Code excludes from this exception investment interest, interest allocable to a trade or business, interest allocable to passive activities (as under section 469), any "qualified residence interest, " as well as a few other categories. Sec. 163(h)(2).

The Metzes claim that the interest they paid is deductible as investment interest, which the Code makes deductible to the extent of a taxpayer's net investment income. Id. subsec. (d). In effect then, where a taxpayer has no net investment income in a given year, he is unable to make use of the investment-interest deduction. The Code, however, allows him to carry any unused deductions forward to later years. Id. para. (2); see Flood v. United States, 33 F.3d 1174, 1178 (9th Cir. 1994). The definition of "investment income" can be a bit fuzzy around the edges: A taxpayer may elect to include in net investment income "certain net capital gain attributable to dispositions of property held for investment, " but to do so must timely file a Form 4952, Investment Interest Expense Deduction. Sec. 163(d)(4)(B)(iii); sec. 1.163(d)-1(a) and (b), Income Tax Regs. For purposes of section 163, "property held for investment" includes property which produces income such as interest, dividends, annuities, and royalties, and is not derived in the ordinary course of a trade or business. Sec. 163(d)(5)(A); see sec. 469(e)(1).

Money is fungible. See Berry Petroleum Co. v. Commissioner, 104 T.C. 584, 643 n.37 (1995), aff'd without published opinion, 142 F.3d 442 (9th Cir. 1998). And that can mean that the connection between interest paid and investment income is difficult to see, especially when a person is also paying interest for money used in his business or for purely personal reasons. Tax law solves--or at least addresses--this problem by telling taxpayers to trace interest expenses through allocation. Temporary regulations stipulate the method of allocating interest expenses as applied to section 163(d) (limitation on investment interest) and 163(h) (disallowance of deduction for personal interest). See generally sec. 1.163-8T, Temporary Income Tax Regs. "In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures." Id. para. (a)(3). Where interest is allocated to an investment expenditure, that expense is investment interest. Sec. 1.163-8T(a)(4)(i)(C), Temporary Income Tax Regs. To summarize: To the extent borrowings can be traced to investment in stocks, securities and the like, associated interest is deductible.

Allocation rules also apply to interest paid on loans to a trade or business or for any "qualified residence." Sec. 163(h)(2)(A), (D). If a taxpayer engages in a trade or business and borrows money to fund the business, then any interest expense allocated to the business is excluded from the personal-interest exclusion and properly deductible; so too for interest allocable to a qualified residence, where "qualified residence interest" means "any interest which is paid or accrued * * * [on] acquisition indebtedness with respect to any qualified residence of the taxpayer * * *." Sec. 163(h)(3)(A)(i). For this purpose, a "qualified residence" includes a taxpayer's principal residence. Sec. 163(h)(4)(A)(i). There is generally a $1 million limitation on acquisition indebtedness that qualifies for the "qualified residence interest" deduction. Sec. 163(h)(3)(B)(ii).

III. Accuracy-Related Penalty

The last issue we have to decide is whether the Metzes' failure to report the sale of farm property in 2004 should result in an accuracy-related penalty under section 6662 for underpayment of tax attributable to "negligence or disregard of rules and regulations" or to a "substantial understatement of income tax." The Commissioner, under section 7491, has the burden of production for this penalty, which means the Commissioner has to produce "sufficient evidence indicating that it is appropriate to impose the relevant penalty." Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Should the Commissioner provide sufficient evidence, it then falls to the taxpayer to provide evidence sufficient to persuade us that the Commissioner is wrong...

To continue reading