Engdahl v. Commissioner
72 T.C. 659, 1979 U.S. Tax Ct. LEXIS 92 (1979)
Premium Feature
Subscribe to Lexplug to listen to the Case Podcast.
Rule of Law:
An activity that consistently generates losses may still be considered "engaged in for profit" under IRC § 183, allowing for the deduction of those losses, if the taxpayer can demonstrate a bona fide intention and good-faith expectation of making a profit, as evidenced by objective factors such as business-like conduct, expertise, significant personal effort, and an expectation of asset appreciation.
Facts:
- In 1964, Theodore Engdahl, an orthodontist nearing retirement, and his wife Adeline decided to start an American saddle-bred horse-breeding operation to supplement their retirement income.
- They consulted with veterinarians and trainers who advised that the market for this horse breed was promising and that the start-up phase for such a business was 5 to 10 years.
- In 1967, to make the operation more profitable by reducing boarding costs, the Engdahls purchased a 2.5-acre ranch, moving into a smaller and less attractive home on the property.
- The Engdahls personally performed significant physical labor, spending an average of 35 to 55 hours per week caring for the horses and maintaining the facilities, despite neither of them riding or having personal affection for the animals.
- They maintained detailed financial records for the horse operation, kept in separate ledgers as advised by their CPA, and actively advertised their horses for breeding and sale.
- The operation suffered a series of financial setbacks and continuous losses from 1964 through 1973, which the Engdahls attributed to unforeseen circumstances, including the death of key horses, an ineffective trainer, rising costs, and a decline in the market for their breed of horse.
Procedural Posture:
- Theodore and Adeline Engdahl (petitioners) deducted losses from their horse-breeding operation on their federal income tax returns for 1971, 1972, and 1973.
- The Commissioner of Internal Revenue (respondent) determined that the horse operation was an activity not engaged in for profit and disallowed the claimed loss deductions and related investment tax credits.
- The Commissioner issued a notice of deficiency to the Engdahls for the tax years 1971, 1972, and 1973.
- The Engdahls filed a petition in the United States Tax Court to challenge the Commissioner's determination.
Premium Content
Subscribe to Lexplug to view the complete brief
You're viewing a preview with Rule of Law, Facts, and Procedural Posture
Issue:
Is a horse-breeding operation that has incurred substantial and continuous losses for over a decade an "activity not engaged in for profit" within the meaning of Internal Revenue Code § 183(a), thereby precluding the taxpayers from deducting its operating losses?
Opinions:
Majority - Hall, Judge
No. The horse-breeding operation was an activity engaged in for profit because the petitioners demonstrated a bona fide intention to make a profit. The court determined this by applying the nine factors listed in Treasury Regulation § 1.183-2(b). The court found that the Engdahls conducted the activity in a business-like manner by keeping complete and accurate records, advertising, and altering their methods to improve profitability. They consulted with experts, expended substantial time and hard physical labor, and had a reasonable expectation that their assets, particularly the ranch, would appreciate in value. The court reasoned that their history of losses was attributable to unforeseen circumstances beyond their control and occurred during the business's start-up phase. Finally, the court concluded that the activity lacked elements of personal pleasure, as evidenced by the hard labor involved and the fact that the petitioners did not ride the horses, which negated the respondent's argument that it was a hobby subsidized by Dr. Engdahl's substantial income from his orthodontic practice.
Analysis:
This case serves as a key example of how taxpayers can successfully defend the business nature of an activity despite a long history of losses. The court's decision emphasizes that the ultimate test under IRC § 183 is the taxpayer's subjective intent, which is proven through objective evidence of business-like conduct. It establishes that unforeseen setbacks and a long start-up period can justify sustained losses without automatically converting a business into a hobby. The opinion also importantly clarifies that having substantial outside income does not, by itself, prove a lack of profit motive; it merely raises the question that the taxpayer's conduct must then answer.
