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August 1, 2012
Is the Tax Law Subsidizing Ann Romney's Horse?

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by Lee A. Sheppard

Ann Romney's horse went to the Olympics. Might have been better if her husband had stayed home.

Former Massachusetts Gov. Mitt Romney questioned London's readiness to host the Olympics, which was not the most politic thing to say as his hosts were giving him very nearly head-of-state treatment. He was photographed entering No. 10 Downing Street through the front door.

Romney's observation that there were "disconcerting" things about London's Olympic preparations was not wrong. Thousands of soldiers had to be called up to replace security guards that private contractor G4S failed to deliver, and airport customs employees threatened to strike.

It was a gaffe. Gaffe is newspaper lingo for suddenly blurting out the truth about some important matter, as defined by political commentator Michael Kinsley. Newsies live for these little admissions against interest. Even the Democrats gleefully reacted to Romney's apparent diplomatic blunder.

But it's not as though Ann Romney, who is often sent out to humanize her husband, avoids blunders. "I don't even consider myself wealthy, which is an interesting thing," she told friendly Fox News. "It can be here today and gone tomorrow." Yes, investors can lose money, but the Romneys have so much that her lifestyle wouldn't take a hit.

Ann Romney with Rafalca after the horse qualified for the Olympics. (Amy Dragoo/Polaris/Newscom)Ann Romney's horse, Rafalca, will compete in team dressage on August 2 at Greenwich Park in southeast London. The 15-year-old bright bay Oldenburg mare, a dressage champion who has competed in the last three World Cup finals, is causing a stir stateside.

The Romneys reported passive losses from Rob Rom Enterprises, the LLC that owns the horse. Ann Romney is an officer of Rob Rom, but apparently does not participate sufficiently in decision-making to be considered active.

Ann Romney has two partners: the stable owner Amy Roberts Ebeling and her friend Beth Myers. Her riding instructor, Jan Ebeling, a German immigrant who is ranked ninth among U.S. dressage riders, trains and rides Rafalca in competitions.

Yes, Olympic horse sports are a rich man's game. Many participants have inherited money and ride their own horses. Zara Phillips, granddaughter of Queen Elizabeth, competed in the three-day event, one component of which is dressage, riding a horse aptly named High Kingdom. She became the first royal to win a medal when the British team finished second in team competition.

U.S. Olympic horses usually have investors, because horse sports do not get U.S. Olympic Committee funding. Often their riders have to raise funds to compete, and they do this by schmoozing rich people. Ebeling does not come from wealth, but has always aspired to ride at the top level. This is his first Olympics.

Ebeling was fortunate to hook up with Amy Roberts, whom he later married, and the Romneys. Ann Romney is his angel investor. She has also lent money to the Ebelings' stable, with the size of the loan estimated to be between $250,000 and $500,000.

Dressage, mostly identified with the Lippizaners of the Spanish Riding School of Vienna, is a rarified corner of the horse world in which horses emulate maneuvers originally taught to war horses. Many of the sport's greatest exponents are German. Ebeling's own instructor is managing the Austrian team at the Olympics.

Dressage horses don't dance so much as perform to music in three-quarter time, which is the same as a horse's gait. Rafalca uses music from the movie The Mission¸ chosen by Mitt Romney, in competitions. He doesn't want to talk about "Ann's sport," no doubt because he doesn't want voters focusing on the boxcar numbers she spends on it. Voters don't understand profits interests, but they can understand an expensive horse.

Even in high-level international competitions, horses don't perform airborne maneuvers made famous by the Lippizaners, so dressage can be difficult to appreciate. Ann Romney took up dressage riding 12 years ago to ameliorate her multiple sclerosis. Animals have therapeutic benefits, but dogs are cheaper than horses.


Passive Activity

Ann Romney incurred $77,731 of expenses related to Rob Rom in 2012. The Romneys did not deduct $77,731 of horse-related expenses. The passive loss rules don't let them do that. They deducted $49, the proportionate amount covered by passive income.

The publicity given the matter so far makes it appear that the LLC owns only one horse. We don't know how large Ann Romney's equity interest is, but the partnership agreement requires her to pay for two-thirds of Rafalca's expenses.

That would imply that Rafalca costs nearly $10,000 per month for upkeep, training, and flying around the world to shows. Sounds like a lot, but it is within the usual range of expenses for such a horse. Rafalca went to London on a chartered jet.

One website estimated a partial breakdown for the $77,731 figure: housing ($29,000 -- the price the Ebelings charge customers), food ($1,200 -- might be low), clothing ($10,000), medical care ($2,000 -- also might be low), and transport to shows ($15,000). (See http://current.com/groups/news-blog/93813208_raising-romneys-horse-vs-an-american-family-which-costs-more.htm.)

Clothing? Rafalca has T-shirts and hats that are sold to her fans, with some proceeds being given to the PATH International therapeutic riding program. Publicity has given the horse a following, but $10,000 would buy a lot of T-shirts. Clothing might include the farrier.

Enacted as an important part of the Tax Reform Act of 1986, section 469 walls off passive activities from the investor's other income, including investment income. Intended to combat tax sheltering of ordinary earned income, the passive activity loss rules are a true schedular system, modeled on the British rules for investment income.

Passive losses are a net number. The taxpayer's passive income and losses from all passive activities are lumped together on Form 8582, then losses are allowed proportionally to offset passive income.

The Romneys were only permitted to deduct $49 of the $77,731 expense attributed to Rafalca. The math required is a function of the statutory term "passive activity loss," which is a net number. Section 469(j)(4) empowers the Treasury to require allocation of the passive activity loss across all the taxpayer's passive activities on a pro rata basis.

First, the $77,731 must be divided by the Romneys' total losses of $2,276,385. That produces the passive loss ratio of 0.034.

Second, the passive loss ratio of 0.034 is multiplied by the unallowed losses on the front of Form 8582. For the Romneys, this amount is $2,274,956, consisting of passive income of $2,170 netted against current losses of $1,102,776, and carryover losses of $1,174,350. When $2,274,956 is multiplied by 0.034, the result is $77,682.

Third, $77,682 is subtracted from $77,731. The difference is $49. That amount is what the Romneys are permitted to deduct. So the taxpayers bought Rafalca a bag of oats or some morning vitamins.

Passive losses, however, may be carried forward and used to offset gain on the sale of the entire investment to an unrelated person in a taxable transaction (section 469(g)(1)(A)). So if Ann Romney sells her LLC equity interest to an outsider, or Rafalca is sold and the LLC liquidated, the Romneys can use the remaining $77,682 loss.

For the passive loss rules to apply to limit the use of the Romneys' losses, the costs of the care and feeding of Rafalca have to be section 162 business expenses in the first place, not section 183 hobby losses.


Hobby Loss?

No return preparer ever takes the position that a client's activity is a hobby, according to Steve Bankler, the San Antonio CPA who helps us analyze the presidential tax returns every year. Whether an activity is a hobby is for the IRS to raise, should it decide to challenge the claimed deductions.

There is a special, more generous section 183(c) rule for horses, which not only covers racing stables, but also breeding, training, and showing horses. Gross income must exceed attributable deductions in two out of seven years, rather than the stiffer three years out of five for other activities. This is a rebuttable presumption, so the IRS could challenge the business status.

Rafalca is valued at $500,000. A good dressage horse sells for six figures. Dressage practitioners enter competitions for the glory, not the prize money, which is much lower than in racing. Grand prix means big prize in French, but not literally in this sport.

At the 2013 Aachen World Equestrian Festival, a major tournament, the total prize money in the entire competition is €287,500 ($362,000) -- roughly the purchase price of a good dressage horse. The winner of the freestyle Grand Prix will get €5,600. The winner of the Deutsche Bank-sponsored Grand Prix Final will get €43,000. That purse is less than half what Ann Romney and her partners spent on Rafalca in 2010.

Jan Ebeling, who brokered the purchase of Rafalca in 2006, said he intends to use her for breeding when her show career, now in its 11th year, is finished. Dressage practitioners believe in bloodlines. The sire of her dam, Rubinstein, was regarded as a super horse in dressage. Rafalca is thought to resemble Rubinstein in talent, looks and disposition.

Breeding could be an after-the-fact rationalization. Rafalca is 15 years old. Factors in addition to age matter. Competition is stressful. Flying back and forth to Europe for international competitions from California is very stressful. So Rafalca might not have too many breeding years, if any. Any foal would have to command $500,000 or more to recoup Rafalca's maintenance costs incurred since 2006, if 2010 is a representative year.

It disturbs the person on the street that the tax law allows a horse owner to claim that there is a business on tax returns and wait for this characterization to be challenged. There is no preapproval process for section 162 deductions in the tax law. Primarily factual questions are on the no-rule list. (See Rev. Proc. 2012-3, 2012-1 IRB 113, Doc 2011-27277 or 2012 TNT 1-25.)

The lack of a preapproval process means that the IRS can't tell a horse business from a riding hobby without an audit. The government becomes a silent partner in every business, without prior knowledge, whether the taxpayer is a skilled businessperson or not. Moreover, with the courts recognizing that most businesses lose money starting up, and the seven-year presumption of section 183(c), it may be years before a horsey dilettante sees deductions disallowed.

The IRS is beginning to correct lax auditing. The IRS's new Global High Wealth audit project is trundling along. But the IRS has audited only 18 returns reporting incomes of $1 million or more in each of 2011 and 2012. Only 101 agents have been assigned to the project, but the IRS recently said it had 100 enterprises (individuals and their businesses) under audit (Tax Notes, Apr. 16, 2012, p. 260, Doc 2012-7520, 2012 TNT 70-2).

The IRS has challenged horse owners about their business claims. Case law is harsh. The courts hold the horse owners to a high standard of business conduct. A flush taxpayer's ability to soak up endless horse expenses with no effect on his or her lifestyle is a bad fact. The courts frown on a casual attitude toward spending on horse sports.

A typical case involves claimed business expenses for a daughter's show horse. Ann Romney would have an obvious tax problem if she rode Rafalca, but she has never ridden the horse. She owns several other horses -- she won't say how many -- for herself and Ebeling to ride. She competes in amateur dressage and has won prizes.

In the recent case of Logene L. Foster et ux. v. Commissioner; T.C. Memo. 2012-207, Doc 2012-15624, 2012 TNT 142-13, the taxpayer was engaged in quarter horse racing for two decades before the IRS successfully challenged his deductions. Quarter horses are stocky little horses that race a quarter of a mile. This kind of racing is popular in the Southwest.

Many racing stables lose money. Indeed, some of the problems with drugs at American tracks are traceable to increases in prize money that make it profitable to abuse racehorses. There is prize money to be won, despite the relatively expensive upkeep of racehorses.

The taxpayer, a successful lawyer, spent a sizable chunk of his income on his horses. The taxpayer's family had operated a racing stable for 20 years before the three tax years at issue. It had lost money every single year.

The taxpayer's sons were licensed horse trainers, and one trained full time. Family members actively participated in the activity, which was carried on at their 12-acre ranchette, where a training track, stables, and a horse walker had been built. The family also bred horses and trained yearlings.

The stable had a separate checking account and accounting software, but records were poorly maintained. Record keeping was so bad that there were no records for years before 2002. There was no business plan. Nonetheless, an IRS audit of their activity for 1992-1994 saw the IRS concede the hobby loss issue at Appeals.

Purses were reduced in Texas, where the family lived. The facts before the court showed that the stable lost buckets of money every year, including the period that included the three tax years at issue (2004 through 2006). So it flunked the section 183(c) presumption.

Tax Court Judge Mary Ann Cohen noted that the expectation of a profit need not be reasonable, but that the taxpayer must conduct the activity with the actual and honest objective of making a profit (Keanini v. Commissioner, 94 T.C. 41 (1990)).

Cohen demanded businesslike conduct on the part of the taxpayers and did not find it. The court wanted budgets, forecasts, and evidence of financial management and attempts to remedy what wasn't working in the business. She chastised the taxpayers for failing to give up on activities that were not profitable.

Cohen viewed what records the taxpayers did have as having been maintained for tax reporting purposes. The taxpayer testified that he wasn't paying attention to the losses. "We are not persuaded that petitioners carried on their horse activity in a businesslike manner," the judge wrote, despite the decreasing trajectory of the losses.

Cohen was satisfied that the taxpayers were knowledgeable and devoted sufficient time to their stable. But the court held the taxpayer to a high standard of business management because his law firm income amply covered the costs. The judge found the satisfaction of being around horses to be a neutral factor.

Foster says that it is not enough to be a good horseman. A stable proprietor must also be a good businessman. The taxpayer in Golanty v. Commissioner, 72 T.C. 411, 425 (1979), affirmed without published opinion, 647 F.2d 170 (9th Cir. 1981), was neither.

The taxpayer, an unemployed biologist with little experience with horses, bought an Arabian stallion with her husband's inherited money. Such horses are judged primarily on looks, and stud fees can be charged for successful ones. The court examined the taxpayer's business management and motives in detail.

The horse never earned a stud fee. The taxpayer didn't have the best advice, but tried to learn. She bought a mare, bred her to the stallion, and got a foal with the worst qualities of both. Undaunted, the taxpayer threw good money after bad. She bought more horses and two ranches to house them. In seven years, she bought 19 horses, selling or returning all but six. She bred 23 foals, retaining nine of them.

Judge Simpson applauded the taxpayer's efforts to learn, but concluded that her horse operation never had a prayer of earning back the money sunk into it. Her homebred Arabians didn't sell for prices sufficient to earn back her expenses. The court threw out a couple of sales at decent prices as unrepresentative, and rejected the profitable sale of one ranch as unconnected to horse breeding.

The court also considered her husband's ample income and the couple's ability to absorb losses without a hit to lifestyle (reg. section 1.183-2(b)(8)). Simpson duly noted that the horse-related deductions took the taxpayers below the 50 percent bracket, giving them a net after-tax benefit. The taxpayer had good records, but the court characterized them as tax records, not business tools.

Simpson observed that the trappings of a business would not convert the taxpayer's haphazard operation from an expensive hobby into a business. And the court was skeptical that there was a serious market for the caliber of horses that the taxpayer was breeding. (In the horse world, there's a saying: A bad horse costs just as much to feed as a good one.)

There are many people, like the Ebelings, who are genuinely in the business of training show horses and running commercial riding stables where clients like Ann Romney keep their horses. One would surmise that as the full-time proprietors, the Ebelings have decent records. The Ebelings' Ventura County operation, called The Acres, has a stable for 40 horses, a dressage ring, and other rich clients.

What do these cases say to Ann Romney? Her passive losses do not concern her loan to the general business of the Ebelings' riding stable.

She is a passive investor in Ebeling's effort to win a medal at the Olympics. Rob Rom invested in a particular project -- getting one horse into international competition. It's not clear that this project has a lot of moneymaking potential even if it succeeds in winning an Olympic medal. Rafalca may well be too old to breed, and prize money may be insufficient to cover her costs.


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