Householder v. Commissioner of Internal Revenue, 082318 FEDTAX, 19150-10

Docket Nº:19150-10, 6541-12
Opinion Judge:HOLMES, JUDGE.
Attorney:Kacie N.C. Dillon and Tim Alan Tarter, for petitioners. Michael R. Harrel, Doreen Marie Susi, John R. Gordon, and Brandon Keim, for respondent.
Case Date:August 23, 2018
Court:United States Tax Court

T.C. Memo. 2018-136




Nos. 19150-10, 6541-12

United States Tax Court

August 23, 2018

Kacie N.C. Dillon and Tim Alan Tarter, for petitioners.

Michael R. Harrel, Doreen Marie Susi, John R. Gordon, and Brandon Keim, for respondent.



Scott and Debra Householder deducted $1.3 million in losses for amounts they paid to ClassicStar, a horse-leasing operation that turned out to be a scam. They say they should still get the losses because they materially participated in the trade or business of breeding horses. The Commissioner disagrees--he thinks they were in it only for the losses.


I. Background

A. Scott and Debra1

Scott Householder had an MBA with an emphasis in finance and ten years of experience as a financial adviser with American Express when he founded Householder Group in 1997. Householder Group is a financial advisory firm that earns fees and commissions for selling investments. It is also phenomenally successful, and by 1998 was the fastest growing affiliate of Sun America Securities. Today it has more than forty offices.

Scott's wife Debra always liked horses. She started taking riding lessons when she was nine, showed horses in neighboring states by the time she was fourteen, and showed nationally for a time after high school, hauling her horse Brandy Susie Bar with a truck and trailer that her dad bought her. During college she had internships where she gave riding lessons, trained horses, and participated in the day-to-day aspects of horse breeding--which included artificially inseminating mares.

Debra moved to Colorado when she was 24 and worked for a tour company. There she met Scott, and in the decades that followed she raised three children and went to graduate school. She earned a Ph.D., and in 2011 she became a licensed psychologist.

But even with all their education and obvious intelligence, the Householders got a big surprise when their accountant drafted their 2001 tax return--an extra $466, 000 in income from Sun America. This wasn't sitting in their bank account, but was instead cancellation of indebtedness (COI) income. In their case, the debt Sun America canceled was part of the money Scott had borrowed to start his business, and Sun America forgave the loan because Householder Group had more than met certain performance goals. This COI significantly increased Scott and Debra's taxable income, and Householder Group's success meant there would be more to come in later years.

B. ClassicStar

Enter Bob Holt, a friend of Scott from his days at American Express. Holt sold investments on commission for Private Consulting Group (PCG), and in February 2002 he pitched one to Scott and Debra--ClassicStar's thoroughbred mare-leasing and breeding program. He showed Scott ClassicStar's marketing materials, which included ostensibly independent tax opinions. It was a private-placement program, which means it was not offered to the general public.

The program seemed simple. Participants leased mares from ClassicStar, paid for their board and stud fees to breed them, and owned any foals that resulted. Thoroughbreds are usually bred between February and June and have eleven-month gestation periods, so a single breeding cycle usually stretches across two calendar years. Participants in ClassicStar would pre-pay (mostly with borrowed money) all of the expenses in the year before the mare became pregnant. This would generate net operating losses (NOLs) for that year that participants could carry back to even earlier years. And if they sold a foal when it was a "yearling"--meaning when it was around a year old--any income would be capital.

ClassicStar had a lender lined up for its clients--the National Equine Lending Company (NELC). ClassicStar recommended taking out both "short-term financing" for about 40% of the total cost--which participants would pay back with money from their tax refunds--and "long-term financing" for 50% of the total cost. These loans were secured by the expected foals. ClassicStar said it had "arranged" for the NELC financing, but in reality ClassicStar and NELC were commonly controlled--ClassicStar president S. David Plummer III's brother-in- law, Gary Thompson, ran NELC; all of NELC's business was with ClassicStar; and ClassicStar gave NELC the money to fund the loans, though NELC sometimes returned it the next day.

Scott and Debra testified that they didn't know ClassicStar and NELC were related. But correspondence they received from both ClassicStar and NELC's loan servicer said to direct any questions to Terry Green, who was both ClassicStar's CPA and a member of the firm that serviced the loans. Green also spoke at a ClassicStar event that Scott attended, and even sent Scott and Debra a letter on NELC letterhead.

ClassicStar also offered participants the option of converting their mare-leasing interests into stakes in two related entities--First Equine Energy Partners (FEEP) and Gastar Exploration (Gastar).2 Gastar securities are publicly traded, 3 but FEEP was another private-placement program that claimed to hold interests in both horses and coal-bed methane gas properties. And FEEP's private-placement memorandum explained that NELC would accept FEEP units as substitute collateral for the outstanding loans.

ClassicStar participants have been to our Court before. See generally Raifman v. Commissioner, T.C. Memo. 2018-101 (tax-avoidance-motivated participation); Romanowski v. Commissioner, T.C. Memo. 2013-55 (activity not engaged in for profit); Pederson v. Commissioner, T.C. Memo. 2013-54 (same); Van Wickler v. Commissioner, T.C. Memo. 2011-196 (not carrying on trade or business and expenses unreasonable). We've also encountered Holt before. See generally Goyak v. Commissioner, T.C. Memo. 2012-13 (contribution to PCG-pitched employee benefit plan not deductible).

C. Scott and Debra Sign Up

Back in 2002, however, this all sounded great to Scott and Debra. They sent Holt their recent tax returns, which he said he needed to determine that they were qualified investors. In May 2002 Holt sent them a proposed "Mare Lease and Breeding Activity" report that began with a table labeled "potential net operating loss." That table showed an "NOL needed" of $1.9 million--needed because it matched the amount of taxable income the report said Scott and Debra had from 1997 to 2002. The report also explained that "[u]nder recent signed legislation, Net Operating Losses can be carried back five (5) years" and "Agricultural Mare Lease Deductions are not subject to Alternative Minimum Tax (AMT)." It then laid out a plan to generate a "total mare leasing and breeding loss" of $1.9 million and described how to later convert the mare-leasing interest into a "methane gas working interest," convert that interest into common stock, and then sell it for a capital gain.

In September 2002 the Householders signed both a letter of intent to participate in ClassicStar's mare-leasing program and a confidentiality agreement. Debra wrote ClassicStar a check for $100, 000, and ClassicStar gave them a revised mare-leasing program report. The first page of this revised report showed an $819, 000 "NOL needed," which was the amount of taxable income the report said Scott and Debra would have in 2002 alone. It also had more detailed information about how to convert interests into Gastar stock and exit the program, which included a "strategy timeline" that showed a purchase in 2002 and a liquidation in 2006. That report listed a "put" price for Gastar stock of $3 per share, but also included calculations for "probable" and "potential" share prices of $6 and $10.

Scott and Debra attended ClassicStar's "Breeders' Cup Weekend" in Kentucky in October, which featured a dinner party with a "Hawaiian theme" and the "4th Annual ClassicStar Breeders' Cup Eve Gala Party." There they could hear presentations by Tony Ferguson, who was ClassicStar's chairman and Gastar's executive vice president, and David Plummer.

D. Correspondence from ClassicStar

During the next few months ClassicStar sent Scott and Debra several letters. One had the subject "2002 ClassicStar Mare Lease Program--Financing." It read in part: "ClassicStar has arranged with National Equine Lending Company to provide the Short-term Financing (Tax Refund), which is approximately 40% of the Mare Lease Program. The loan will mature June 1, 2003. It is very important that the client files his/her tax return in a timely manner."

A letter dated October 31, 2002, explained that "[t]o obtain the full tax benefits of the program * * * [participants] must...

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