Situational Awareness: Accurate Financial Recordkeeping and Business Deductions

Abstract

The Tax Court held in Skolnick that horse breeding activities conducted by the taxpayers through Bluestone Farms LLC (which was treated as a partnership for federal income tax purposes) were not engaged in for profit. While several factors were indicative of a trade or business, including the keeping of “voluminous” financial records, the Tax Court found many faults with Bluestone’s financial recordkeeping and stewardship, including incomplete documentation of important transactions and the taxpayers’ personal use of Bluestone resources. Moreover, according to the Tax Court, “The manner in which Bluestone conducted its activities shows that it was largely insensitive to costs.”

The decision is now being appealed to the Third Circuit. On appeal, the taxpayers assert that, contrary to the conclusion of the Tax Court, Bluestone kept accurate financial records, and their adequacy should weigh in the taxpayers’ favor. The taxpayers further assert that the court erred in finding that there were significant gaps in Bluestone’s financial records, as well as in finding that those records were not used to increase the profitability of what the taxpayers characterized as a business.

What does an analysis of all the prior case law suggest about the merits of the taxpayers’ appeal? The Blue J Tax algorithm, which develops machine-learning insights based on the Blue J Tax database, shows that, conditional on the Tax Court’s findings of fact, including those concerning the financial records of Bluestone, there is a high likelihood (81 percent) that the court’s decision that there was not a trade or business will be sustained on appeal. But what if the Third Circuit accepts the taxpayers’ position regarding the maintenance of sound financial records? In this event, a different story emerges. Scenario testing reveals that there would be a highly significant improvement (from an 81 percent chance of the appeal failing to a 77 percent chance of its success) if the taxpayers prevail in their position that the financial records were adequately maintained. Indeed, our Blue J analysis of Skolnick shows that the adequacy of financial records is extremely important to the outcome. In fact, analysis shows that it is more important in Skolnick than in any other decision in the Blue J database.

Keywords: horses, hobby losses, trade or business