ACCT 612 Week 3 Tax Research Memo 2 Example

Is the Horse Farm a Business? A Tax Research Memo on Section 183 and a Dentist's Breeding Losses

Memo Header

To: Partner, Tax Department. From: Staff Accountant. Date: Module/Week 3. Re: Dr. Ellis, deductibility of Arabian horse breeding losses under Section 183.

Facts

Dr. Karen Ellis, a dentist with practice income of about $410,000 a year, began breeding Arabian horses on a 40-acre farm in 2019. The farm has reported losses every year, between $58,000 and $94,000, mostly for feed, veterinary care, a full-time trainer and depreciation on a barn. She keeps a separate bank account and accounting records for the farm, hired a breeding consultant in 2023 after three years of losses, reduced her herd from 22 to 14 horses and began selling young horses at auctions rather than privately. In 2025, she sold three horses for a combined gain, though the farm still showed a net loss. She spends about 15 hours a week at the farm and rides for pleasure on weekends. Her prior accountant deducted the farm losses on Schedule F without comment. The IRS has not examined any year, but Dr. Ellis received a letter from a colleague whose own horse farm losses were disallowed, and she has asked whether her position would hold up.

Issue

Does Dr. Ellis carry on her horse breeding with the profit objective Section 183 requires, so that its losses may offset her other income?

Conclusion

Probably yes, though the position is not secure. The presumption in Section 183(d) does not yet apply, but the factors in the regulations, particularly the separate books, the consultant, the changes in operations after losses and the recent sales, support a profit motive, while the long history of losses, her large other income and the recreational element weigh against it. I would characterize the position as having substantial authority, provided the records described below are maintained. Sawyers and Gill (2018) describe that standard as a weighing of the authorities on each side, which is the exercise the analysis below carries out.

Analysis

The statute and the presumption

Under Section 183, when a taxpayer pursues an activity without a profit objective, its expenses are deductible only within the limits the section sets, so a hobby's losses cannot reduce tax on wages or business income (I.R.C. § 183, 2025). Section 183(d) offers a safe harbor: an activity that earns more than it spends in three years out of any five in a row is treated as a business unless the IRS proves otherwise, and for an operation that mainly breeds, trains, shows or races horses, two profitable years out of seven are enough. Dr. Ellis has had no profitable year, so the presumption does not help her now. If it applied, it would shift to the IRS the burden of showing that she lacks a profit motive; without it, she bears the usual burden of proving the deductions she claims. Section 183(e) allows a taxpayer to elect to postpone the determination until the end of the fourth year (sixth for horses) after the activity begins, which can be useful for a newer activity. Because Dr. Ellis began in 2019, the election period for her activity has likely passed, so the analysis must rest on the factors.

The regulatory factors

The regulations list nine factors, none of them controlling (Treas. Reg. § 1.183-2, 2025). Applied here: (1) Manner of carrying on the activity favors her, given separate books, a consultant and changes after losses. (2) Expertise favors her, through the consultant and the trainer. (3) Time and effort, 15 hours a week, is moderately favorable. (4) The expectation that land and breeding stock may appreciate is somewhat favorable if documented. (5) Success in other activities is neutral. (6) The history of losses weighs against her, although losses in a start-up phase are recognized as consistent with a profit motive. (7) The occasional sale gains are modestly favorable. (8) Her substantial dental income, which makes the losses tax-advantaged, weighs against her. (9) Riding for pleasure is an element of personal recreation that weighs against her.

Case law

The test is the taxpayer's genuine intent to earn a profit; the expectation need not be reasonable, so long as it is sincerely held (Dreicer v. Commissioner, 1982). In Engdahl v. Commissioner (1979), the Tax Court held that a couple's horse breeding operation was engaged in for profit despite years of losses, emphasizing businesslike operation and changes made to improve profitability. In Nickerson v. Commissioner (1983), the Seventh Circuit reversed a ruling against taxpayers who were rebuilding a run-down dairy farm, reasoning that early losses are what one would expect while a farm is being restored to working order. Courts look less at whether the farm has made money than at whether the owner has run it as if she needed it to. These cases support Dr. Ellis on the factors she controls, while warning that recreation and large other income invite scrutiny. The disallowed colleague's case, by contrast, likely lacked the operational changes and expert advice that distinguish Dr. Ellis's farm.

Recommendations

Dr. Ellis should prepare a written business plan with projections to profitability, keep minutes of meetings with the consultant, document each operational change and its reason, obtain an appraisal of the land and breeding stock, and track hours spent on business tasks separately from riding. If the farm becomes profitable in two of the next seven years, the presumption will apply. Given the stakes, these steps are worth their modest cost. If the IRS did disallow the losses, the tax on roughly $75,000 a year at her marginal rate would be substantial, and accuracy-related penalties could apply to years without adequate support.

References

Dreicer v. Commissioner, 78 T.C. 642 (1982).

Engdahl v. Commissioner, 72 T.C. 659 (1979).

I.R.C. § 183 (2025).

Nickerson v. Commissioner, 700 F.2d 402 (7th Cir. 1983).

Sawyers, R. B., & Gill, S. L. (2018). Federal tax research (11th ed.). Cengage Learning.

Treas. Reg. § 1.183-2 (2025).