Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

Gains & Losses

Prior business success lends credence to donkey breeder's proft motive

The Tax Court held that the owner of a large investment management firm and his wife who conducted a sideline miniature donkey breeding business had a profit motive for the activity as required by Sec. 183 and therefore could deduct the losses from the activity for the years at issue.

Background

William Huff was the founder of the investment management firm W.R. Huff Asset Management Co. LLC (Huff Asset Management). Using a research-driven investment philosophy implemented by Huff, the company was highly successful, at one point having approximately $25 billion in assets under its management. This made Huff an extremely wealthy man, with Forbes magazine reporting his 2005 net worth at $750 million.

Huff had one child, a daughter named Jennifer. At her request, Huff started a dog grooming business for her. Huff, besides providing funding, was active in the startup, picking the location of the business, negotiating the lease for its premises, and paying the cost to construct the necessary facilities. He and some of his Huff Asset Management employees also advised her on marketing and bookkeeping. While Jennifer apparently was able after some years to keep the doors open without her father's financial support, the business showed a net operating loss on its tax returns from 2008 to 2019.

In 1987, Huff bought a 31.35-acre tract of farmland in New Jersey. Later, he bought a 7.5-acre tract adjoining that property on which Jennifer and her husband lived. In 2004, Huff formed Ecotone, a partnership he owned with his wife, which according to its operating agreement was organized for agricultural, equestrian, and equine purposes.

In 2010, Huff began looking for a use for his farmland. To this end, he talked to Arthur Papetti, a fellow businessman. Papetti was primarily in the egg business, but he also had extensive experience in the field of miniature donkeys and their breeding. Papetti beguiled Huff with talk of the considerable profits to be made by breeding high-quality miniature donkeys.

Huff took an interest in the idea and had his research team at Huff Asset Management look into the practicalities involved in miniature donkey breeding. The team did extensive research on miniature donkey nutrition and husbandry. As part of this research, Huff Asset Management employees talked to various veterinary and other specialists. Huff 's research also made him aware of how a breeding venture could qualify as a commercial farm in New Jersey, which would entitle it to valuable protections under state law.

After completing extensive preliminary research, Huff decided to give breeding miniature donkeys a try. Although he had been a city boy who grew up in the Hell's Kitchen neighborhood of Manhattan, Huff thought himself well positioned for success, given his unused farmland, his deep research into husbandry, and the expertise of Papetti, who had agreed to help him with his venture. The breeding operation was to be conducted through Ecotone.

However, according to the Tax Court, Huff 's main objective for going into the miniature donkey breeding business was not his own profit. Instead, it was for Jennifer, who, although independent from her parents, had only modest earnings. Although Jennifer had at that time no real experience with miniature donkey breeding, Huff believed that once he had the breeding operation properly established, he could turn it over to her and it would provide her a stream of income in future years.

The Huffs dedicated 25% of their farmland to Ecotone for the miniature donkey breeding operation. The land used, the location of buildings and fencing, and the materials used for the buildings and fencing were all carefully chosen by Huff, based on Huff Asset Management employees' previous research, Papetti's personal experience, research conducted personally by Huff, and the advice of other experts.

Ecotone bought five miniature donkeys between May and August 2010 and bought another 20 over the next eight years. The miniature donkeys that Ecotone purchased were largely chosen on Papetti's advice, which Huff did not always take. Ecotone also sold 20 miniature donkeys during that time. Throughout the years, one thing remained constant: Ecotone paid substantially more to acquire miniature donkeys than it sold them for, paying $92,985 for the ones it purchased and receiving only $23,500 for the ones it sold.

Initially, Huff relied on Papetti's advice almost exclusively for breeding his miniature donkeys. The original plan was to breed each female donkey as often as possible, which was generally once a year. After experiencing problems early on with stillborn and genetically defective foals, Huff changed the breeding strategy, limiting Ecotone's female donkeys to breeding once every two years. He believed that this would overall increase Ecotone's returns over the breeding life of its female miniature donkeys by producing fewer but superior quality foals.

In response to the deaths in the early years of a number of donkeys from cold winter temperatures, Huff made changes to their sheds, changed their feeding schedules (in hopes of raising their metabolism to keep them warmer), and quit making them wear jackets (because the jackets may have made them less resistant to the cold). To prevent disease, he began rotating the animals' paddocks and, believing that their feed might be causing problems, he experimented with supplemental feeds.

During the years at issue...