The Tax Court recently held that a couple of millionaires could deduct the losses incurred in their miniature donkey breeding business because it was entered into for profit. This case can serve as a valuable roadmap to survive an IRS audit for those with a loss-generating activity.

Huff and his wife lived on a farm in New Jersey. They formed an LLC for “agricultural and equestrian or equine purposes including … breeding and raising animals.” Once the business became profitable, they intended to turn it over to their daughter, who lived nearby.

In 2010 through 2018, the LLC reported losses of between $21,000-87,000, which offset their substantial taxable income. The IRS contended that the LLC was not engaged in for profit and assessed the Huffs back taxes, interest, and penalties. Mr. Huff appealed to the Tax Court.

The Tax Court noted that wealthy businessmen who run a real business during the week often own a ‘gentleman’s farm’ as a weekend retreat where they keep horses for recreation for their family and friends. They dabble in breeding horses, with no expectation of ever making a profit, so they can deduct the losses and have Uncle Sam subsidize their weekend farm.

The Tax Court applied nine factors to determine whether the Huffs had a profit motive: (1) the manner in which they conducted the activity; (2) their expertise or that of their advisers; (3) the time and effort they expend in carrying on the activity; (4) their expectation that assets used in the activity may appreciate; (5) their success in other activities; (6) the history of income or losses from the activity; (7) the amount of occasional profits, if any, from the activity; (8) their financial status; and (9) the personal pleasure or recreation they enjoy from the activity.

The Tax Court concluded that although the LLC was not profitable, the Huffs took a long term view and thought it would eventually be profitable because Mr. Huff had been successful in other businesses. Huff used the staff at his company to research donkey breeding and obtained advice from experts in the field. The only factors that hurt the Huffs were that the business assets would not likely appreciate and they had never had a profit from the activity.

On the positive side, the Huffs pursued the activity in a businesslike manner.  They kept good books and records, researched the field, and obtained expert advice. Although their own time in the business was limited, they engaged competent help. The court found that losses in the early years do not indicate a lack of profit motive if the business is still in the startup stage, which it defined as less than five years in operation.

The court also considered Huff’s intention to give the business to his daughter. Huff testified, if he simply wanted to help her financially, “there were … significantly easier ways to do it.”  The donkeys gave him no personal pleasure. He testified that he didn’t cuddle or pet them.  He said they were “quite ugly” and “look like a ‘gigantic hairball.’ “