DocketNumber： Docket No. 15562-10
Citation Numbers： 105 T.C.M. 1379, 2013 Tax Ct. Memo LEXIS 56, 2013 T.C. Memo. 55
Judges： GOEKE
Filed Date： 2/20/2013
Status： Non-Precedential
Modified Date： 4/17/2021
Decision will be entered for respondent as to the deficiencies and for petitioners as to the penalties.
GOEKE,
(2) whether petitioners are liable for the accuracy-related penalties under
At the time the petition was filed, petitioners resided in California. Petitioners were married during all relevant years.
Mr. Romanowski graduated from Boston College in 1988 with a degree in general management and an emphasis in marketing. After graduating from college *57 he played for nearly 16 years in the National Football League. Mr. Romanowski's career ended in September 2003 after he sustained a severe concussion. During Mr. Romanowski's football career Mrs. Romanowski cared for petitioners' children. Neither petitioner has significant experience in the field of tax.
From the late 1990s until early 2004 petitioners employed a financial adviser, Kathy Lintz. According to Mrs. Romanowski, Ms. Lintz "Basically * * * took care of everything" regarding petitioners' finances, including managing their portfolio and allocating them a monthly stipend. Ms. Lintz also 2013 Tax Ct. Memo LEXIS 56">*58 collected relevant information from petitioners in order to have their tax returns prepared by a certified public accountant (C.P.A.) and reviewed the completed tax returns before sending them on to petitioners. Ms. Lintz is a certified financial planner, but she is not an accountant or an attorney.
During late 2003 petitioners had some tax issues regarding a real estate investment they had made in Colorado. Ms. Lintz advised them to seek help from a tax attorney in the area and put them in touch with Rodney Atherton in October 2003. Mr. Atherton was a partner at Greenberg Traurig, LP (Greenberg Traurig), and worked in several areas of law, including tax. He received a Juris Doctorate *58 from Washburn University in 1989 and an LL.M. in tax from the University of Denver in 1990. He was not knowledgeable in the field of horse breeding.
During October 2003 Mr. Romanowski met with Mr. Atherton at the Greenberg Traurig office in Denver. At the meeting they discussed petitioners' real estate investment issues as well as certain other issues. Mr. Atherton told Mr. Romanowski about a horse-breeding business, ClassicStar, which had retained Greenberg Traurig in July 2003 in connection with certain 2013 Tax Ct. Memo LEXIS 56">*59 transaction and tax issues, including review of a tax opinion ClassicStar had received from another law firm. ClassicStar was working with Mr. Atherton, among others at Greenberg Traurig, to review the tax opinion.
Shortly after the meeting between Mr. Romanowski and Mr. Atherton, petitioners decided to retain Greenberg Traurig, and Mr. Romanowski expressed interest in receiving additional information about ClassicStar. Mr. Atherton provided petitioners with a variety of promotional materials regarding ClassicStar, as well as a booklet entitled "Due Diligence & Mare Lease Information Booklet" that contained information about the ClassicStar breeding program (program). None of the materials provided were prepared by Greenberg Traurig; rather, ClassicStar had given the materials to Mr. Atherton. Through these materials and conversations with Mr. Atherton, petitioners learned that the program involved *59 leasing mares owned by ClassicStar, which would provide boarding and care for the mares and breed the mares to stallions. Any foals produced from the breeding would belong to petitioners.
The due diligence booklet petitioners received contained approximately 60 pages of form contracts and 2013 Tax Ct. Memo LEXIS 56">*60 other information about the program. In addition, the booklet contained: (1) a 53-page opinion letter from the law firm Handler, Thayer & Duggan, LLC (Handler Thayer), regarding tax aspects of the horse-breeding business; (2) a 22-page opinion letter from the accounting and consulting firm Karren, Hendrix & Associates, P.C. (Karren Hendrix), regarding tax aspects of the horse-breeding business; and (3) a 6-page opinion letter from Karren Hendrix regarding tax aspects of NOLs arising from a horse-breeding business. Each of the opinion letters was addressed to David Plummer, president of ClassicStar. Both the Handler Thayer opinion letter and the 22-page Karren Hendrix opinion letter advised individual ClassicStar participants to consult with their own tax advisers about the tax consequences of participation in the program.
On October 23, 2003, Terry Green, an employee of Karren Hendrix who did accounting work for ClassicStar, sent an "NOL illustration" regarding petitioners to Mr. Atherton. He was the C.P.A. who had completed the Karren Hendrix opinion letters included in the ClassicStar due diligence booklet. In the *60 NOL illustration Mr. Green estimated that petitioners needed an NOL 2013 Tax Ct. Memo LEXIS 56">*61 of $13,092,732 to offset their taxable income from 1998 to 2003. Mr. Green prepared the NOL illustration using certain items of petitioners' financial information which had been provided to him.
At some point on or about November 3, 2003, Mr. Romanowski reviewed the materials provided to petitioners by Mr. Atherton. Mr. Atherton and Mr. Romanowski traveled to Kentucky to visit the ClassicStar facilities for a tour and to meet with ClassicStar employees. On November 9, 2003, Mr. Atherton and Mr. Romanowski again traveled to Kentucky. By this time Mrs. Romanowski had reviewed the materials and also made the trip to Kentucky. On the second trip petitioners toured the ClassicStar operation, saw horses, visited horse auction houses, and met with ClassicStar personnel. Petitioners were impressed with what they saw.
Petitioners reviewed multiple aspects of the program with Mr. Atherton and decided to enter the program during November 2003. Petitioners planned to spend $13 million on the program. *61 to the proposed $13 million dollar deal, which was based on her general impressions of the program 2013 Tax Ct. Memo LEXIS 56">*62 gathered from what Mr. Romanowski and Mr. Atherton told her. However, Ms. Lintz did not review the specifics of the program. Ms. Lintz repeatedly told petitioners and Greenberg Traurig of her opposition to the deal, believing it to be a tax scheme and a significant threat to petitioners' financial security.
On December 15, 2003, petitioners created Romanowski Thoroughbreds, LLC (Romanowski Thoroughbreds), through which they would operate their activities. Petitioners were the sole owners, officers, and directors of Romanowski Thoroughbreds. During the tax years at issue, Romanowski Thoroughbreds did not maintain any bank accounts, credit cards, or lines of credit separate from petitioners'.
On December 26, 2003, petitioners wrote a $300,000 check to ClassicStar as a deposit toward the cost of their participation in the breeding program. On December 31, 2003, they signed a mare lease and board agreement (mare lease agreement) with ClassicStar on behalf of Romanowski Thoroughbreds. The mare lease agreement states that ClassicStar "is 2013 Tax Ct. Memo LEXIS 56">*63 engaged in the business of leasing Thoroughbred mares for breeding purposes". Petitioners signed the mare lease agreement in the presence of Mr. Atherton and ClassicStar representatives while *62 on another trip to the ClassicStar facilities in Kentucky. On the same day, petitioners also signed secondary documents with ClassicStar on behalf of Romanowski Thoroughbreds, including a boarding agreement, a foal agreement, and a nominee agreement.
Pursuant to the mare lease agreement Romanowski Thoroughbreds agreed to spend $13,092,072 *63 (Key Bank). 2013 Tax Ct. Memo LEXIS 56">*64 Both petitioners signed the Key Bank promissory note in their individual capacities. Petitioners also signed disbursement requests for both the Key Bank and NELC loans under which the proceeds of each loan were purportedly distributed directly to ClassicStar, minus certain fees.
Each loan was secured by the prospective foals and Romanowski Thoroughbreds' rights under the mare lease agreement. Mr. Atherton and/or ClassicStar suggested that petitioners use Key Bank and NELC for their breeding program loans, and petitioners did not shop for loans from other lenders. NELC's accounting was handled by Mr. Green, the CPA who did work for ClassicStar, and all NELC loan payments were to be mailed 2013 Tax Ct. Memo LEXIS 56">*65 to the Karren Hendrix office at which Mr. Green worked. Petitioners were told that they were personally liable on the NELC loans; however, they actually were not. It appears that Mr. Atherton was the person who told this to petitioners, as he was present and assisting petitioners when they signed the NELC loan documents.
When petitioners signed the mare lease agreement, they had not negotiated or seen a list of the horse pairings they would receive for their breeding program. Rather, they relied on ClassicStar to pick the horse pairings they would receive and to set the fees and expenses they would pay for each pairing. The same day petitioners signed the mare lease agreement they received a list of the horse pairs *64 which they would receive; this list indicated that petitioners would receive 68 pairings. However, Mr. Atherton recognized that very few of the horses were thoroughbreds and alerted petitioners. In fact, only 4 of the 68 listed pairings were thoroughbred horses; the remaining pairings were quarter horses. 2013 Tax Ct. Memo LEXIS 56">*66 The total cost to produce foals from the four listed thoroughbred breeding pairings was $1,047,419 of the $13,092,072 in total expenses.
Petitioners initially intended to lease only thoroughbred horses. 2013 Tax Ct. Memo LEXIS 56">*67 Despite the fact that over 90% of the horses on the schedule were quarter horses, petitioners chose to continue with the program, after consulting with Mr. Atherton. Petitioners claim that they had an oral agreement with ClassicStar under which it would substitute an unknown number of thoroughbred pairings in for the listed quarter horse pairings. However, petitioners did not receive any written assurance/agreement stating that ClassicStar would substitute thoroughbred pairings for the listed quarter horse pairings. Petitioners also claim they later made several attempts to get ClassicStar to substitute thoroughbreds for the listed *65 quarter horses without success; these claims are addressed further
Petitioners received two other schedules of horse pairings during 2004. The first additional schedule is undated and reflects 60 horse pairings (of which five are thoroughbred pairings) costing a total of $13,092,732. The listed cost on the schedule to produce the five thoroughbred foals is $1.5 million. The final schedule is dated December 15, 2004, and reflects only six horse pairings costing a total of $1.5 million. All pairings on the final schedule are thoroughbred pairings. Only three of these six pairings were listed on the original schedule received on December 31, 2003. However, each of these three remaining pairings had a price to produce a foal that was different from the price on the original schedule. All changes to the schedules of horses were made by ClassicStar. Petitioners received no additional horse pairings in later years.
Each of the six thoroughbred pairings listed on the final schedule of horses was bred in 2004 and produced a foal in 2005 after an 11-month gestation period. Petitioners received some updates on the pregnancies of their mares and a notification 2013 Tax Ct. Memo LEXIS 56">*68 upon the birth of each of the six foals. On April 2, 2005, petitioners contributed their six foals (two of which had not yet been born) to ClassicStar *66 2005 PowerFoal Stable, LLC (PowerFoal). According to a letter to petitioners from ClassicStar, multiple thoroughbred foal owners contributed their foals to PowerFoal as a form of risk sharing/reduction. Petitioners received a 5.88% interest in PowerFoal that was based upon a value assigned to their foals of $1.5 million.
At some point petitioners' six former foals were sold by PowerFoal at what Mr. Romanowski described as "a little bit of a fire sale" without petitioners' knowledge. The sale of the foals was completed at the direction of ClassicStar personnel. Sale receipts showed that two of the foals were sold in August 2006 for a total of $875,000 and another foal was sold in October 2006 for $50,000. Each of these three foals was sold through Fasig-Tipton Kentucky, Inc., a thoroughbred horse auctioneer. Information regarding sales of the remaining three foals was not produced.
Petitioners received an income and expense summary for 2003 from ClassicStar which showed total expenses of $13,092,732, comprising board and mare care expenses 2013 Tax Ct. Memo LEXIS 56">*69 of $1,020,000, breed fees of $868,000, mare lease fees of $9,496,200, and insurance expenses of $1,708,532. The income and expense summary listed no income. Petitioners listed these expenses and income on their 2003 Schedule F, Profit or Loss From Farming, and claimed a resulting deduction *67 of $13,092,732. This deduction offset their 2003 income and NOLs were carried back to 1998, 1999, 2000, 2001, and 2002.
Petitioners made notes of their hours spent on activities related to horse breeding during 2003. They gave these notes to Mr. Atherton, who compiled a log reflecting 193 hours spent by petitioners on horse-breeding activities. Most of the hours were attributable to petitioners' visits to Kentucky, discussions with Mr. Atherton and ClassicStar personnel, and review of the ClassicStar materials provided to them. Petitioners also subscribed to and read horse magazines as part of their activities.
On their 2004 Schedule F petitioners listed total farming expenses of $488,451 and no farming income. The expenses comprised $482,055 in interest expenses, $5,181 in travel expenses, and $1,215 in meals and entertainment expenses. 2013 Tax Ct. Memo LEXIS 56">*70 A time log for 2004 showed petitioners spent 88 hours on their horse-breeding activities during that year.
Key Bank and ClassicStar had a financial relationship dating back to 2001, when the two entities established a program whereby borrowers would "use the *68 proceeds of * * * [a Key Bank] loan to enter into a Mare Lease tax deferred strategy with ClassicStar." According to a Key Bank document regarding such loans, Key Bank would not rely "on the cash flow from the investment as a source of repayment". The document also stated that Key Bank would make such "loans based largely on the prospect for significant future business from these borrowers". On December 21, 2001, ClassicStar and Key Bank entered into a formal agreement regarding the loans; this agreement included a provision stating that ClassicStar would buy loans made under the agreement which were in default as well as certain other provisions designed to protect Key Bank from loan losses.
The Romanowskis paid interest on their Key Bank loan in both 2004 and 2005. ClassicStar made a $1,017,379 payment to Key Bank on January 17, 2006, satisfying the outstanding Key Bank loan principal and interest. According 2013 Tax Ct. Memo LEXIS 56">*71 to Mr. Romanowski, this payment was made using proceeds from the sales of foals held by PowerFoal.
On April 16, 2007, petitioners received a 2006 Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., from PowerFoal reflecting their share of income of $921,104 and property distributions to them of $900,470. It appears that the Schedule K-1 was sent as a result of sales of horses by PowerFoal. *69 Petitioners informed their return preparer 2013 Tax Ct. Memo LEXIS 56">*72 which includes forclosure [sic]." A similar letter dated July 9, 2007, was sent to Mr. Romanowski (on behalf of Romanowski Thoroughbreds) regarding the long-term NELC loan. That note demanded payment of interest and principal totaling $8,068,760. Mr. Atherton reviewed the notices and advised petitioners not to pay the outstanding amounts because ClassicStar had not "fulfill[ed] their end of the deal" with petitioners regarding exchanging leased quarter horse pairings for thoroughbred pairings.
*70 In October 2004 petitioners received a Federal income tax refund of approximately $3.9 million. On November 17, 2004, they made a payment of $3 million on the short-term NELC loan by bank wire. 2013 Tax Ct. Memo LEXIS 56">*73 It is not clear who made this payment. Similarly, an amortization schedule for the long-term NELC loan shows that a payment of $8,058,122 was made on that loan by an unknown party on June 30, 2007, satisfying all outstanding amounts of loan interest and principal. In addition, a PowerFoal distribution worksheet for January 2007 shows that Romanowski Thoroughbreds was to receive $44,893 from PowerFoal that month, but that instead of sending a check to Romanowski Thoroughbreds, PowerFoal would send a check "to NELC on behalf of *71 Romanowski Thoroughbreds." The amortization schedules for the NELC loans do not reflect a payment of $44,893 at any point.
ClassicStar filed for chapter 11 bankruptcy protection on September 14, 2007. Petitioners filed a claim in the bankruptcy proceeding and also filed separate claims against ClassicStar (and related persons/entities) and Greenberg Traurig in Federal and State court, respectively, for financial damages incurred as a result of their participation in the program.
Mr. Atherton extensively advised petitioners on the tax treatment of their transactions relating to the program both 2013 Tax Ct. Memo LEXIS 56">*74 before and after they entered the program. Petitioners relied on Mr. Atherton's advice in claiming the previously discussed tax deductions attributable to their participation in the program.
As previously stated, Mr. Atherton and others at Greenberg Traurig represented ClassicStar regarding certain legal matters. Petitioners were aware of the dual representation and signed a waiver of conflicts acknowledging that Greenberg Traurig did work for both petitioners and ClassicStar. The waiver also states that ClassicStar would pay the legal fees associated with petitioners' *72 participation in the program but does not state that Mr. Atherton or Greenberg Traurig would receive any other benefits as a result of petitioners' participation in the program.
Although he testified multiple times to the contrary, the evidence is clear that Mr. Atherton received improper payments from ClassicStar as a result of petitioners' choosing to enter the program. Mr. Atherton claimed that multiple documents regarding payments he received from ClassicStar were sent to him (from ClassicStar) in error. Many of those documents were chain emails which contained conversations between Mr. Atherton and ClassicStar employees 2013 Tax Ct. Memo LEXIS 56">*75 in which Mr. Atherton used terms such as "fee splits" and "percentage" when discussing the amount of money ClassicStar would pay to him or Greenberg Traurig for bringing people into the program.
Mr. Atherton's claim that he did not receive improper payments as a result of petitioners' (and other's) participating in the program seems to be based on how Mr. Atherton accounted for these payments. It appears that once a client of Mr. Atherton's entered into the program, ClassicStar would pay Mr. Atherton/Greenberg Traurig a percentage of the amounts actually paid to *73 ClassicStar by that client. 2013 Tax Ct. Memo LEXIS 56">*76 Mr Atherton would then sequester those funds and bill against them at an hourly rate much higher than his normal hourly rate. For example, in an email to a client other than petitioners, Mr. Atherton stated: "Here is what I propose, I simply bill my time on your clients at a premium—I usually bill 365 an hour. Are [sic] okay if I bill 1000 an hour and just charge an hourly rate?" In the email Mr. Atherton further states that it might be best to "cap my fees at 3%."
Mr. Atherton never told petitioners of his improper relationship with ClassicStar. At some point Ms. Lintz became aware that Mr. Atherton was receiving a "due diligence fee". *74 Ms. Lintz had several heated conversations with Mr. Atherton and others at Greenberg Traurig regarding Mr. Atherton's relationship with ClassicStar. However, exactly what Ms. Lintz told petitioners about Mr. Atherton's independence is somewhat unclear. Ms. Lintz testified that she "indicated" to petitioners that Mr. Atherton "was not independent" and that they "should get [an] independent review" of the program. However, it appears Ms. Lintz never directly told petitioners 2013 Tax Ct. Memo LEXIS 56">*77 that Mr. Atherton was receiving a financial benefit from ClassicStar as a result of petitioners' entry into the program. Mr. Watson Petitioners' 2003 and 2004 Federal tax returns were prepared 2013 Tax Ct. Memo LEXIS 56">*78 by Timothy Watson. Mr. Watson also prepared petitioners' Forms 1045, Application for Tentative Refund, for years 1998 through 2002, as well as petitioners' tax returns for years after 2004. He remains petitioners' current tax return preparer. *75 Mr. Watson is a C.P.A. licensed in Colorado, has a bachelor of science in accounting from the University of Colorado, a master's in business administration and a master's in tax from the University of Denver, had over two decades of accounting experience at the time he prepared petitioners' 2003 and 2004 tax returns, and was a partner in the accounting firm Hulet, Watson & Associates, P.C. In addition, Mr. Watson had previously completed Schedules F for other clients and was familiar with the rules regarding claiming NOLs as a result of farming activities. Mr. Atherton recommended Mr. Watson to petitioners in January 2004 and petitioners hired Mr. Watson in either late January or early February 2004. Mr. Watson had no prior relationship with Mr. Atherton and no relationship with ClassicStar. Petitioners paid Mr. Watson for preparing their tax returns and Forms 1045 and relied on him to properly prepare those documents. In connection with preparing 2013 Tax Ct. Memo LEXIS 56">*79 petitioners' tax returns, Mr. Watson discussed ClassicStar with one of the accountants in his firm who had previously prepared a tax return for a ClassicStar client. This accountant had visited the ClassicStar facilities. Mr. Watson also reviewed certain documents relating to petitioners' participation in the program, 2013 Tax Ct. Memo LEXIS 56">*80 discussed the program with Mr. Atherton, and had *76 at least one discussion with petitioners. Mr. Atherton told Mr. Watson all loans taken by petitioners in connection with the program were recourse loans, an assertion Mr. Watson took at face value. Mr. Watson was not aware that Mr. Atherton received commissions from ClassicStar. In addition, Mr. Watson appears never to have asked for information regarding the horses leased by petitioners and was never told that there were issues regarding quarter horses and thoroughbred substitutions at the time he prepared the relevant tax returns and Forms 1045. However, Mr. Watson indicated that he received all documents and information which he requested from petitioners. On February 4, 2004, Ms. Lintz resigned as petitioners' financial adviser, partially because of petitioners' investment in the program. Ms. Lintz's resignation letter states that petitioners choose to "enter into an aggressive tax shelter", presumably the program. The resignation letter also cites petitioners' purchase of a new home and certain real estate investments as reasons for the *77 resignation but does not mention anything about Mr. Atherton's having a conflict of interest regarding ClassicStar. On February 10, 2004, Ms. Lintz sent petitioners another letter identifying two independent horse/tax experts whom petitioners could contact if they "need[ed] further assistance". The letter states that one of the experts told Ms. Lintz that ClassicStar had "come on strong in the last couple of years" and that there had been "No scandals thus far" even though "some of the principals were involved in bad prior deals." The letter does not mention Mr. Atherton. During his football career Mr. Romanowski took several nutritional supplements which he credits with helping him play professional football for 16 years. During the later years of his football career Mr. Romanowski became familiar with a company named Cytosport, which provided supplements for his team. When he realized in late 2003 that he would never play football again, Mr. Romanowski sought to get involved with the nutritional supplements business and became a paid consultant for Cytosport in January 2004. Mr. Romanowski had several duties in this position, including involvement in sales and distribution of Cytosport products. *78 One of the Cytosport employees, Robert Fritz, had his own company, Animal Naturals, which sold a product called Show & Go. Animal Naturals advertised Show & Go as an "Equine Health, Performance & Body Builder" which would help horses perform and look better. Mr. Romanowski had several talks with Mr. Fritz about the product during 2004 and had Mr. Fritz send free samples of Show & Go to several horse stables, including ClassicStar. Mr. Romanowski also had Mr. Fritz send a sample to Mr. Atherton. Mr. Fritz sent these samples in the hopes of gaining 2013 Tax Ct. Memo LEXIS 56">*82 customers. Expert Witnesses and Their Reports Both respondent and petitioners submitted expert reports, and petitioners also submitted a rebuttal report. Respondent's expert was Andrew Havens, and petitioners' expert was Michelle Stallings. Mr. Havens is president of a company which represents horse owners at auctions, among other services. Ms. Stallings has extensive experience in equine appraisals and other aspects of the equine industry. The parties agreed that both experts were qualified to testify in this case. *79 Mr. Havens' expert report concluded that petitioners' horse-breeding activities "had absolutely no chance of making a profit". Mr. Havens criticized petitioners on a variety of grounds, including that they: (1) allowed ClassicStar to make all horse selection and pricing decisions; (2) significantly overpaid for the leased mares "to a truly astounding degree"; (3) overpaid for related items, 2013 Tax Ct. Memo LEXIS 56">*83 such as insurance expenses; and (4) lacked any way to determine which horses were actually bred for them. While Mr. Havens estimated the values of the mares on various horse-breeding schedules petitioners received, he did not provide a method of appraisal or estimate values for prospective foals produced by the pairings listed on the breeding schedules. At trial Mr. Havens testified that he valued the horses using a combination of age, pedigree, and racing winnings, among other factors. In her rebuttal report, Ms. Stallings agreed with Mr. Havens "that there was absolutely no chance that any of the non-Thoroughbred horses listed on * * * [petitioners' breeding schedules] would produce profitable foals." However, she disagreed with his assessment of petitioners' breeding program as a whole, on the basis of her opinion that the quarter horses were never intended to be bred. Rather, Ms. Stallings stated that the quarter horses "were obviously placeholders" and that if ClassicStar "had honored their contract and provided Thoroughbred *80 mares of at least the same quality as those * * * [eventually bred for petitioners] then there was definitely profit potential." Ms. Stallings also stated 2013 Tax Ct. Memo LEXIS 56">*84 that: (1) the various expenses charged to petitioners for items such as insurance were not unreasonable, and (2) "there was no reason to suspect that the mare leasing program was not legitimate at the time the Romanowskis signed up to participate." In addition, she testified that exchanging one horse for another was not uncommon in the breeding industry. In her original expert report Ms. Stallings gave a total fair market value appraisal of prospective foals *81 appraised value of the six prospective foals was overstated by approximately $2 million, and her extrapolated estimate including 18 additional mares was overstated by approximately $8 million. Even considering this error, Ms. Stallings concluded that petitioners' breeding activities were profitable, 2013 Tax Ct. Memo LEXIS 56">*85 assuming that they received the hypothetical 18 additional mares. The amount of projected profit using her error-free appraisal value and including the hypothetical additional 18 mares was approximately $4 million. In appraising the six thoroughbred pairings petitioners actually received, Ms. Stallings used only the sale prices of other foals sired by the stallions (but not the mares) petitioners received in their pairings, reasoning that such foals would be comparable to the foals petitioners would receive. Out of these comparables, she favored "the highest priced foal[s]" because petitioners "were supposed to receive the best mares" from ClassicStar. Her basis for this belief was representations made by ClassicStar in documents such as the promotional materials and the due diligence 2013 Tax Ct. Memo LEXIS 56">*86 booklet. Before their involvement with ClassicStar, petitioners had owned a quarter horse for less than a year. Petitioners did not breed, race, or otherwise attempt to make money on this horse. Petitioners gave the horse away when Mr. *82 Romanowski was traded to a different football team and had no other involvement with horses until the ClassicStar deal. On April 30, 2010, respondent issued a notice of deficiency to petitioners for 1998, 1999, 2000, 2001, 2002, 2003, and 2004 determining deficiencies resulting from the disallowance of all Schedule F expenses petitioners claimed for 2003 and 2004, disallowance of related NOLs, and certain computational adjustments. Petitioners timely filed a petition contesting the deficiencies and penalties. Generally, taxpayers bear the burden of proving, by a preponderance of the evidence, that the determinations of the Commissioner are incorrect. An activity is engaged in for profit if the taxpayer entertained an actual and honest profit objective in engaging in the activity. The fact that a taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Petitioners intended to contract for thoroughbred pairings. However, the schedule of horses they received the same day they signed the mare lease agreement reflected only 4 thoroughbred pairings out of 68 total pairings. In spite of this, petitioners did not cancel the deal or get anything in writing stating that ClassicStar had an obligation to substitute out the 64 quarter horse pairings for (an unknown number of) thoroughbred pairings. Rather petitioners claim to have had an oral agreement with ClassicStar 2013 Tax Ct. Memo LEXIS 56">*91 regarding substitution of thoroughbreds for quarter horses. Petitioners also claim that they continually sought to have ClassicStar actually make the substitutions beginning in early 2004, without success. Considering the millions of dollars at stake and ClassicStar's continuous failure to make the substitutions, we find petitioners' failure to abrogate the mare lease agreement or to get anything in writing regarding a substitution agreement is strong evidence that their horse-breeding activities were not carried on in a businesslike manner. Petitioners testified that they could have made a profit in their horse-breeding activities by selling or racing any foals they would own, as well as getting involved in the horse supplement business. However, petitioners took no *87 steps toward racing the foals (indeed, all foals were contributed to PowerFoal either before or shortly after birth) they owned, and their "involvement" in the horse supplement business ended after Mr. Romanowski asked Mr. Fritz to send out free samples of Show & Go to various stables. Petitioners never had a monetary interest in Show & Go, never discussed a partnership or other deal with Mr. Fritz, and provided no evidence 2013 Tax Ct. Memo LEXIS 56">*92 that they ever seriously considered developing, distributing, or otherwise profiting from another horse supplement. Petitioners ended up contributing their six foals (some before birth) to PowerFoal, an LLC with a substantial relationship to ClassicStar. This was in spite of the fact that petitioners claim ClassicStar repeatedly refused to provide them with the remaining thoroughbred horse pairings to which they were entitled. PowerFoal proceeded to sell the foals at what Mr. Romanowski described as "a little bit of a fire sale" without petitioners' knowledge. This sale was completed at the direction of ClassicStar personnel, and details of only three of the six sales were provided. Petitioners failed to take action when ClassicStar listed placeholder quarter horses instead of thoroughbreds on their initial and second schedule of horses. Instead, they claim to have relied on the oral assurances of ClassicStar, even *88 though ClassicStar continually failed to substitute the quarter horses for thoroughbreds. Petitioners proceeded to contribute the thoroughbred foals they did receive to an entity with a substantial relationship to ClassicStar, even though they had millions of dollars on the 2013 Tax Ct. Memo LEXIS 56">*93 line and had already been shortchanged by ClassicStar. These are not the markings of an activity which is carried on for profit. We find this factor favors respondent. Preparation for an activity by extensive study of its accepted business and economic practices or consultation with those who are expert therein, may indicate that a taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Although petitioners claim to have relied on the advice of ClassicStar, ClassicStar was not an expert hired by petitioners. Rather, it was a for-profit company with which petitioners (through Romanowski Thoroughbreds) had entered into business. We do not believe reliance on such advice was reasonable. *89 Mr. Atherton was not an expert in the horse-breeding industry and did not give petitioners advice on which horses to breed. He 2013 Tax Ct. Memo LEXIS 56">*94 testified that he had no "knowledge about [thoroughbred] bloodlines" and that he did not select any horse pairings for petitioners. Even if we accept petitioners' claim to have relied on Mr. Atherton "to review the business opportunity and offer legal and financial advice", such advice would not reach the heart of petitioners' venture: horse breeding. Petitioners' logs reflect that they collectively spent 193 hours during 2003 and 88 hours during 2004 participating in horse-breeding-related activities such as visiting the ClassicStar facilities and reading about the industry. However, the expert reports and testimony make it clear that the horse industry is a difficult industry and that it takes years of experience to succeed in without expert advice. In spite of the difficulty of the business, petitioners entered into a breeding contract for over $13 million relying only on a nominal amount of education, the advice of a for-profit company which was the other party to the contract, and an attorney who was not an expert in horse breeding. We find this factor favors respondent. The fact that the taxpayer devotes much 2013 Tax Ct. Memo LEXIS 56">*95 of his personal time and effort to carrying on an activity may indicate an objective to derive a profit, particularly if *90 the activity does not have substantial personal or recreational aspects. Considering the number and quality of hours petitioners spent related to their breeding activities, we find this factor is neutral. A taxpayer may intend, despite a loss from current operations, that an overall profit will result when appreciation in the value of assets used in the activity is realized. We first note that petitioners engaged in a circular transaction with respect to the six thoroughbred pairings that were actually bred for them. The foals resulting from these six pairings were contributed to PowerFoal and (it appears) ClassicStar paid off petitioners' Key Bank loan as a result of the contribution. As previously discussed, PowerFoal had a substantial relationship to ClassicStar and the financial details regarding PowerFoal and the sale of petitioners' six (former) foals are murky; petitioners were not aware their former foals were being sold, and records for 2013 Tax Ct. Memo LEXIS 56">*97 only three of the sales were produced. Petitioners contributed the foals to PowerFoal in spite of their claim that ClassicStar continually failed to uphold its end of the mare lease agreement by not substituting thoroughbred pairings for quarter horse pairings. We believe that petitioners never intended to profit from the contribution of their six foals to PowerFoal. Rather, we believe that petitioners merely contributed these horses to PowerFoal with the understanding that their Key Bank loan would be paid off as a result of the contribution. There is no evidence that *92 petitioners would not have taken part in a similar deal with respect to the NELC loans had they received any additional thoroughbred foals. Indeed, petitioners' past actions coupled with the suspect relationship between NELC and ClassicStar (Mr. Green did accounting work for both entities and all payments on NELC loans were to be mailed to the office at which Mr. Green worked) make such a potential circular transaction seem likely to occur. In addition to the circular transaction aspect of their deal with ClassicStar (and the potential for another/other circular transaction(s) had petitioners received any additional thoroughbred 2013 Tax Ct. Memo LEXIS 56">*98 foals), petitioners' claim that they expected their horse-breeding activities to become profitable had ClassicStar made the thoroughbred substitutions is vague. Petitioners never indicated how many thoroughbred pairings they expected to eventually receive from ClassicStar, and they had no idea which horses would have made up such pairings. Petitioners' expert, Ms. Stallings, based her conclusion that petitioners' activities had an expected profit on petitioners' receiving an additional 18 thoroughbred pairings of similar quality to the 6 pairings that were bred for petitioners. Not only did she assume the number and quality of the additional pairings; Ms. Stallings also failed to account for the fact that petitioners entered into a circular transaction (apparently without any profit potential) with respect to *93 the six foals they did receive. In addition, Ms. Stallings' prospective foal appraisals relied on ClassicStar's representations that petitioners would receive high-quality mares even though ClassicStar repeatedly showed itself to be a devious and untrustworthy entity. We do not find Ms. Stalling's conclusion regarding the profitability of petitioners' horse-breeding activities 2013 Tax Ct. Memo LEXIS 56">*99 to be credible. Considering petitioners' vague claim of an expected profit in conjunction with the circular thoroughbred foal transactions which apparently did occur, we believe petitioners did not expect their (mostly hypothetical) foals to appreciate in value to the point where they would recognize a profit as a result of their horse-breeding activities. We find this factor favors respondent. The fact that a taxpayer has engaged in similar or dissimilar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable. Where losses continue to be sustained beyond the period which customarily is necessary to bring an operation to profitable status, such continued losses, 2013 Tax Ct. Memo LEXIS 56">*100 if not explainable as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. The amount of any occasional profits the taxpayer earned from the activity may show that the taxpayer had a profit motive. We find this factor favors respondent. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit. The losses sustained by petitioners did provide them with significant tax benefits. Not only did petitioners attempt to offset their income from 2003 and 2004 with the losses; petitioners also carried back losses to 1998, 1999, 2000, *96 2001, and 2002. In addition many of the losses petitioners claimed were not actual economic losses. Petitioners 2013 Tax Ct. Memo LEXIS 56">*102 were apparently involved in a circular transaction to pay off the Key Bank loan and only partially paid one of the NELC loans (using a portion of their tax refund). Petitioners made no further payments on either of the NELC loans, and on June 30, 2007, an unknown person/entity made payments totaling approximately $11.5 million in satisfaction of the outstanding principal and interest on petitioners' NELC loans. We recognize that tax planning is often a consideration when deciding whether to enter a business. However, this case does not represent a normal instance of tax planning. Rather, we believe petitioners' participation in the program was almost entirely motivated by tax benefits available to them through such participation. We find this factor favors respondent. The presence of personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. We find this factor favors petitioners. Considering the factors discussed above, we find that petitioners' horse-breeding activities were not engaged in for profit, and the related expenses are therefore not deductible under Respondent determined that petitioners are liable for 20% accuracy-related penalties under Pursuant to The U.S. Supreme Court has stated that— When an accountant or attorney Petitioners are unsophisticated in the field of tax. They were referred to Mr. Atherton by Ms. Lintz and knew Mr. Atherton to be an accomplished lawyer familiar with tax law. They relied on the advice of Mr. Atherton in claiming tax deductions based on their participation in the program. In addition to Mr. Atherton, petitioners also hired Mr. Watson, who was a very experienced and highly accomplished accountant. 2013 Tax Ct. Memo LEXIS 56">*106 Mr. Watson echoed Mr. Atherton's statements that petitioners' claimed deductions were proper. While he does not contest the qualifications of Mr. Atherton and Mr. Watson, respondent argues petitioners did not reasonably and in good faith rely on the advice given to them by Mr. Atherton and Mr. Watson. It has been clearly shown that Mr. Atherton had a conflict of interest regarding ClassicStar. Less clear is whether petitioners were aware (or reasonably should have been aware) of this conflict of interest. Ms. Lintz testified that she "indicated" to petitioners that Mr. Atherton "was not independent" and that they *100 "should get [an] independent review" of the program. Ms. Lintz also testified that she believed petitioners were aware that Mr. Atherton was paid a fee by ClassicStar for his services. Ms. Lintz admitted she did not know how any fee was calculated and thus could not have relayed such information to petitioners. The mere fact that petitioners were aware that Mr. Atherton received some financial benefit as a result of their participation in the program is not sufficient to show that they could not rely on him in good faith, as petitioners were aware that Mr. Atherton would bill 2013 Tax Ct. Memo LEXIS 56">*107 the hours he spent working on the transaction. At trial Mr. Atherton repeatedly claimed that he did not receive improper fees from ClassicStar for bringing prospective clients into the program. His testimony is clearly untrue. We believe that Mr. Atherton was similarly dishonest *101 with petitioners in an attempt to earn their trust. Although Ms. Lintz alerted petitioners to the possibility that Mr. Atherton might not be independent of ClassicStar, it is not clear exactly what she told them. In addition, petitioners had a number of reasons for continuing to trust Mr. Atherton, 2013 Tax Ct. Memo LEXIS 56">*108 including: (1) Ms. Lintz's letter dated February 10, 2004, in which she told petitioners that an independent expert had told her that ClassicStar had "come on strong in the last couple of years" and that there had been "No scandals thus far"; (2) that Mr. Atherton was open with petitioners about the fact that his firm was representing ClassicStar with regard to other matters; (3) that Mr. Atherton had already informed petitioners that ClassicStar would pay their legal fees for work done by Mr. Atherton with respect to their participation in the program; and (4) that Mr. Atherton seemingly demonstrated his independence from ClassicStar by alerting petitioners to the fact that not all the horses on the first schedule of horses were thoroughbreds (a fact it seems ClassicStar was not up-front about). However, we believe the most important fact supporting petitioners' trust in Mr. Atherton was the fact that they hired Mr. Watson, an experienced C.P.A. independent of Mr. Atherton and ClassicStar, who also told petitioners that their ClassicStar-related expenses were tax deductible. *102 We do recognize the fact that Mr. Watson relied upon Mr. Atherton's statement that the NELC loans were recourse 2013 Tax Ct. Memo LEXIS 56">*109 loans, when those loans were in fact nonrecourse. However, not only was there no indication that Mr. Watson ever asked petitioners themselves for any information regarding the NELC loans; petitioners were also unaware that the NELC loans were nonrecourse. 2013 Tax Ct. Memo LEXIS 56">*110 could affect the tax deductions they were claiming. While a taxpayer familiar with the field of tax would have done several things differently from petitioners, petitioners were not sophisticated or *103 knowledgeable in the field of tax. Petitioners had good reasons for the trust they placed in Mr. Atherton. Considering the relevant facts, we conclude that petitioners reasonably and in good faith relied on the advice supplied to them by Mr. Watson and Mr. Atherton to assess their proper tax liabilities. Accordingly, petitioners are not liable for the We find petitioners are not entitled to deductions for their horse-breeding expenses incurred through their participation in the program. We further find that petitioners are not liable for accuracy-related penalties under In reaching our holdings herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit. To reflect the foregoing,
1. All dollar amounts are rounded to the nearest dollar.↩
2. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
3. Most of the $13 million would be financed with loans, as discussed further
4. The parties stipulated this figure, but a schedule of horses received the same day reflects expenses of $13,092,746. In addition, a 2003 income and expense summary petitioners later received showed $13,092,732 in expenses.↩
5. These expenses included a fee to lease the mare, the breeding fee for the stallion, additional mare expenses, and prospective foal insurance expenses. Prospective foal insurance is obtained after pregnancy of a mare, to pay in the case of a failed pregnancy or foal death after birth.↩
6. The two breeds of horses petitioners dealt with were thoroughbreds and quarter horses. Certain rules apply to the breeding of the different breeds. Thoroughbred horses are generally worth more than quarter horses.
7. The parties stipulated that "On the same day petitioners signed their mare lease contracts, ClassicStar told petitioners they did not have sufficient thoroughbred mares with which to fulfill its contractual obligations to petitioners."
8. Timothy Watson prepared petitioners' 2006 tax return, as well as their 2003 and 2004 returns. Further information about Mr. Watson is discussed
9. It was not clear whether Mr. Atherton had already advised petitioners not to pay the NELC loans at this point.↩
10. Notably, the percentage commission was calculated only on the amounts actually received by ClassicStar—i.e., personal funds paid by clients and funds received by ClassicStar resulting from recourse loans (the Key Bank loan in petitioners' case). Mr. Atherton/Greenberg Traurig did not receive any proceeds based on the amount of nonrecourse loans (the NELC loans in petitioners' case).
11. Ms. Lintz had a discussion with Mrs. Romanowski relating to Mr. Atherton's receipt of some form of additional money; the record is unclear whether Mrs. Romanowski referred to the additional money as a bonus paid by Greenberg Traurig to Mr. Atherton or another type of payment. In any event, Ms. Lintz became suspicious and called Mr. Atherton, who told her that he received a "due diligence fee".↩
12. Most of Ms. Lintz's conversations were with Mrs. Romanowski. At one point during testimony Ms. Lintz was asked "Do you recall what Julie Romanowski's response was to any of the fees that were being paid to [Mr. Atherton?]" Ms. Lintz responded "Well,
13. The documents Mr. Watson reviewed included the opinion letters contained in the ClassicStar due diligence booklet provided to petitioners, petitioners' participation logs, petitioners' past tax returns, the 2003 income and expense summary prepared for petitioners by ClassicStar, and certain other documents relating to petitioners' horse-breeding activities
14. Mr. Fritz did not receive sale orders from any of the stables which he sent the samples to.↩
15. Ms. Stalling appraised prospective foals rather than the actual foals produced because the actual foals had not been born at the time the mare lease agreement was signed.↩
16. The "18 additional mares" figure was made up by Ms. Stallings as part of an example; there is no evidence that petitioners were ever offered or led to believe ClassicStar would be providing them with 18 additional thoroughbred mares.↩
17. Most of these arguments are not addressed in this opinion because we decide the case in respondent's favor on the basis of
18. As previously stated, it appears that Mr. Atherton told petitioners the NELC loans were recourse. We have also reviewed the NELC loan documents and believe that it would not be clear to a layperson that the loans were nonrecourse; the notes contain a large amount of technical language discussing items such as "successor interests".↩
Allen v. Commissioner , 72 T.C. 28 ( 1979 )
Keanini v. Commissioner , 94 T.C. 41 ( 1990 )
United States v. Boyle , 105 S. Ct. 687 ( 1985 )
Filios v. Commissioner , 224 F.3d 16 ( 2000 )
neonatology-associates-pa-v-commissioner-of-internal-revenue-tax-court , 299 F.3d 221 ( 2002 )
Indopco, Inc. v. Commissioner , 112 S. Ct. 1039 ( 1992 )
James P. Thomas and Mary Lou Thomas v. Commissioner of ... , 792 F.2d 1256 ( 1986 )