Estate of Stuller v. United States, 15–1545.

• Decision Date: 26 January 2016
• Docket Number: No. 15–1545.,15–1545.
• Parties: ESTATE OF Harold STULLER, deceased, Wilma Stuller, and L.S.A., Inc., Plaintiffs–Appellants, v. UNITED STATES of America, Defendant–Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

811 F.3d 890

ESTATE OF Harold STULLER, deceased, Wilma Stuller, and L.S.A., Inc., Plaintiffs–Appellants,

v.UNITED STATES of America, Defendant–Appellee.

No. 15–1545.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 30, 2015.

Decided Jan. 26, 2016.

Timothy James Londrigan, Attorney, Londrigan & Londrigan, David R. Reid, Attorney, Springfield, IL, for Plaintiffs–Appellants.

Richard Caldarone, Attorney, Austin Furman, Bruce R. Ellisen, Attorney, Department of Justice, Washington, DC, for Defendant–Appellee.

Before ROVNER and WILLIAMS, Circuit Judges, and SHAH, District Judge.^*

SHAH, District Judge.

Wilma Stuller and her late husband, Harold, bred Tennessee Walking Horses on their horse farm in Tennessee.¹ They incorporated the horse-breeding operation as L.S.A., Inc., and claimed its substantial losses as deductions on their tax returns. But the IRS determined that the horse-breeding was not an activity engaged in for profit and so assessed taxes and penalties against the Stullers. The IRS also penalized the Stullers for failing to timely file their 2003 return. After paying up, the appellants, Wilma Stuller, Harold's estate, and LSA, sued the government for a refund. At a bench trial, the district court excluded the Stullers' proposed expert, found that LSA was not run as a for-profit business under 26 U.S.C. § 183, and determined that the Stullers lacked reasonable cause for failing to timely file their 2003 tax return. The court also denied a request to amend the judgment and effectively refund the taxes paid by the Stullers on rental income received from LSA. We affirm.

I

The Stullers lived in Springfield, Illinois, and owned several Steak ‘n Shake franchises throughout central Illinois. They also bred horses. In 1985, they decided to move their horses to a warmer climate and bought a farm in Petersburg, Tennessee. At some point, the Stullers entered into an oral agreement with horse trainer Mack Motes to train their horses and manage the farm. Under this agreement, Motes received payments for training the horses, a 50% interest in horses born at the farm, prize money won by the horses, the right to breed his horses with their horses (for free), and the right to trade his horses with theirs. In 1992, the Stullers founded L.S.A., Inc., an S corporation, as a horse-breeding operation. LSA was owned entirely by the Stullers. A few years later, the Stullers started purchasing property in Eagleville, Tennessee, to relocate the horse farm to a larger property. By 1999, they had purchased a house and adjoining 332 acres for around $800,000. This property was owned by the Stullers individually or by each as trustees of a revocable trust, with each other as a beneficiary. The Stullers, however, lived at their home in Springfield, Illinois, where they cared for their granddaughter.

LSA was not profitable. From 1994 to 2009, it lost money every year except 1997, when its annual profit was $1,500. From 1999 to 2005, its annual losses ranged between around $130,000 to around $170,000 per year. During this time, LSA was only able to continue operating because it received around $1.5 million in loans from the Stullers, which were not repaid. For tax years 2003 to 2005, LSA reported losses totaling around $430,000 (about $130,000 to $150,000 per year). Because an S corp's losses pass through to its share-holders, the Stullers claimed deductions for LSA's losses on their individual tax returns. The Stullers also reported income on their tax returns from LSA's annual rental payments of $80,000 for use of the Tennessee property.

Tragedy struck on January 6, 2003, when a fire broke out at the Stullers' Springfield home. Harold died, and the house was destroyed. Wilma Stuller and her granddaughter survived, although Stuller was hospitalized for double pneumonia

. While waiting for her house to be rebuilt, Stuller lived at various rental properties. She also hired a personal assistant. Stuller managed to file a timely federal income tax return for the year 2002 for herself and her husband, but she did not file their 2003 joint return until February 2005.

Following an audit of the 2003 joint return and Stuller's 2004 and 2005 individual tax returns, the IRS determined that the horse-breeding was not an activity engaged in for profit under 26 U.S.C. § 183 and therefore the Stullers could not claim deductions for the S corp's losses. The IRS also imposed penalties for the late filing of the 2003 return. The Stullers paid the resulting assessments in full and filed suit in the district court for a refund.² The case proceeded to a bench trial.

Section 183 of the Internal Revenue Code permits tax deductions for losses from S corp activities engaged in for profit (i.e., business losses). 26 U.S.C. § 183. Treasury Regulation § 1.183–2(b) provides a non-exclusive list of relevant factors for determining whether an activity is engaged in for profit, including: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer; (4) the expectation that assets may appreciate in value; (5) the taxpayer's success in other similar or dissimilar activities; (6) the taxpayer's history of income or losses; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; (9) elements of personal pleasure or recreation. No one factor is determinative; instead, all relevant facts and circumstances are to be taken into account. Id. In considering whether an operation was a business activity engaged in for profit, more weight is given to objective facts than a taxpayer's statement of intent. Burger v. Commissioner, 809 F.2d 355, 358 (7th Cir.1987) ; see Treas. Reg. § 1.183–2(a).

Before trial, citing Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 113 S.Ct. 2786, 125 L.Ed.2d 469 (1993), the government moved to preclude Motes from testifying as an expert on whether the Stullers' horse-breeding was carried on with the intent to earn a profit. The district court allowed Motes to testify, reserving its ruling on the Daubert motion. After trial, the district court granted the motion. It determined that Motes's expertise did not extend to the financial or business aspects of a horse-breeding operation and he lacked a reliable methodology to opine on the Stullers' intent.³

The district court held that LSA was not operated with a good faith intent to profit, and therefore its losses were not deductible as business expenses. The objective factors most significant to the district court were the unbusinesslike manner in which the Stullers operated LSA, the Stullers' history of steady losses with only one barely profitable year, and the substantial tax benefit LSA provided to the Stullers, given their income from other business ventures.

The district court also found that the Stullers did not establish reasonable cause for the untimely filing of the 2003 return.

II

The Stullers argue that the district court's exclusion of Motes's expert testimony failed to follow the Daubert framework and ignored the record. Review of a district court's application of Daubert is de novo. If the court adhered to the Daubert framework, then its decision on admissibility is reviewed for abuse of discretion. C.W. ex rel. Wood v. Textron, Inc., 807 F.3d 827, 835 (7th Cir.2015).

The district court followed Daubert. It considered whether Motes was qualified in the relevant field (i.e., the business and financial aspects of horse-breeding) based on his education, training, or experience, per Federal Rule of Evidence 702. The court then examined whether Motes used a reliable methodology and analyzed the bases for his conclusions, the materials that Motes did or did not review, and whether Motes considered any factors outlined in Treasury Regulation § 1.183–2(b) or any other relevant factors. In making its determination, the district court did not ignore the Stullers' arguments and did not ignore evidence in the record. Indeed, the court recognized that Motes was a horse trainer and that he was testifying based on his observations from day-to-day operations of the farm; the court simply disagreed that there was sufficient foundation for expert testimony.

The district court's determination that Motes lacked the requisite expertise and methodology was well-supported, and not an abuse of discretion. The issue for which Motes was offered as an expert was whether LSA's horse-breeding activity was run with the intent to profit. A witness may be qualified as an expert through "knowledge, skill, experience, training, or education." Fed.R.Evid. 702. Acknowledging that Motes had over fifty years of experience in training and breeding horses, the district court found that Motes's expertise did not extend to the financial and business aspects of running a horse-breeding operation. This was quite clearly correct. Motes testified that he did not breed horses to make money, it had been years since he sold a horse that he had bred, and his income was largely derived from training horses.

The district court also did not abuse its discretion in finding that Motes lacked a reliable methodology. The Stullers admit that Motes was unaware of and did not consider the nine, non-exhaustive factors relevant to determining whether an activity is engaged in for profit, as listed in § 1.183–2(b). He was also unfamiliar with LSA's finances and did not review any of its business or financial records. Instead, his method was to draw a conclusion based on his observations of the farm over the years and his oral agreement with the Stullers. Rule 702, however, requires an expert's testimony to have "a reliable basis in the knowledge and experience of [the relevant] discipline." Kumho Tire Co. v. Carmichael, 526 U.S. 137, 149, 119 S.Ct. 1167, 143 L.Ed.2d 238 (1999) (quoting Daubert, 509 U.S. at 592, 113 S.Ct. 2786 ); see Bielskis v. Louisville Ladder, Inc., 663 F.3d 887, 894 (7th Cir.2011). Given...