### In the



# United States Court of Appeals

For the Seventh Circuit

____________________

No. 15

‐ 3396

M ERRILL C. R OBERTS

,

Petitioner

‐ Appellant

,

v.

C OMMISSIONER OF I NTERNAL R EVENUE

, Respondent

‐ Appellee

.

____________________

Appeal from the United States Tax Court.

No. 12010

‐ 11

— Elizabeth C. Paris

, Judge

.

____________________

A RGUED A PRIL 1, 2016

— D ECIDED A PRIL 15, 2016

____________________

Before P OSNER

, E ASTERBROOK

, and W ILLIAMS

, Circuit

Judges

.

P OSNER

, Circuit Judge

. The Internal Revenue Code allows

a taxpayer to deduct “all the ordinary and necessary expens

‐

es paid or incurred during the taxable year in carrying on

any trade or business.” 26 U.S.C. § 162(a). But if the activity

giving rise to the expenses “is not engaged in for profit,” sec

‐

tion 183 permits deduction of expenses incurred in the activ

‐ ity “only to the extent that the gross income derived from

such activity [i.e., the not

‐ for

‐ profit activity] for the taxable2 No. 15

‐ 3396

year exceeds the deductions.” 26 U.S.C. § 183(a), (b)(2). The

activities governed by section 183 are usually referred to as

“hobbies,” and the provisions we’ve just quoted allow hob

‐ by expenses to be deducted from hobby profits but not from

any other income that the taxpayer may have.

A provision specific to horse racing states that “in the

case of an activity which consists in major part of the breed

‐ ing, training, showing, or racing of horses,” “if the gross in

‐

come derived from an activity for [2] or more of the taxable

years in the period of [7] consecutive taxable years which

ends with the taxable year exceeds the deductions attributa

‐

ble to such activity (determined without regard to whether

or not such activity is engaged in for profit), then

... such ac

‐ tivity shall be presumed

... for such taxable year to be an ac

‐ tivity engaged in for profit.” 26 U.S.C. § 183(d). But this pre

‐ sumption does not figure in the present case because the

taxpayer’s horse

‐ racing operation yielded no profits in any

of the four years covered by the trial record, or, so far as ap

‐

pears, in any preceding years (except very small profits in

1999).

In 2014 the Tax Court held that the taxpayer, petitioner

Merrill Roberts, had deducted the expenses of his horse

‐ racing enterprise on his federal income tax returns for 2005

and 2006 erroneously because the enterprise was a hobby

rather than a business. The court assessed tax deficiencies of

$89,710 for 2005 and $116,475 for 2006. But it also ruled that

his business had ceased to be a hobby, and had become a

bona fide business, in 2007, and the Internal Revenue Service

has not challenged Roberts’ bona fides since, as far as we

know. Though now in his seventies, he continues to operateNo. 15

‐ 3396 3

his horse

‐ racing business. His appeal challenges the assess

‐

ments for 2005 and 2006.

From 1969, when he was about 28, to the mid

‐ 1990s,

Roberts, who is a Hoosier, grew to be a successful owner and

operator of restaurants, bars, and nightclubs in Indianapolis.

He began withdrawing from the business in the mid

‐ 1990s,

though he remained a paid consultant to the new owners. In

1998 or 1999 a thoroughbred racehorse association invited

him to a dinner and to a tour of a race track facility, trying to

interest him in entering the horse

‐ racing business. His inter

‐

est aroused, in 1999 he bought his first two horses, for $1000

each, and in the first year netted $18,000 in earnings from

racing them. He also built a horse track on land that he

owned in Indianapolis. Two years later his stock of racing

horses had increased to 10 and he also had acquired a breed

‐ ing stallion. The following year he passed the state’s li

‐

censed

‐ trainer test (a test described as “rigorous” by the Tax

Court) and obtained his horse

‐ training license.

In 2005 he decided to build a bigger and better horse

‐ training facility on his land. But encountering opposition

from the City of Indianapolis, he abandoned that idea and

instead in the following year bought a much larger (180

‐

acre) tract of land called the “Mooresville property” for

about $1 million. Between the acquisition of the new land

and the end of the year he invested between $500,000 and

$600,000 in improvements for the training of racehorses on

his property. He trained the horses himself (remember that

he’d become a licensed horse trainer)—he even bathed them

himself. He stated without contradiction that he spent 12

hours a day working with the horses on race days and about

8 hours a day on other days. He was also involved (though4 No. 15

‐ 3396

peripherally) in lobbying the Indiana legislature on behalf of

horse racing. The goal of the lobbying, achieved in 2007, was

legislation that would permit slot machines at racetracks.

Because part of the revenue generated by the slot machines

would be added to the purse money (the money received by

owners of horses that win races), Roberts could expect to

benefit financially from the advent of the slot machines. In

the same period he served on the boards of two professional

horse

‐ racing associations in what the Tax Court’s opinion

describes as “leadership roles.”

Roberts’ horse

‐ racing activities, which included board

‐ ing, breeding, training, and racing horses—racing them not

only in Indiana but also in other states, particularly Ken

‐ tucky—were not profitable in the two

‐ year period that is the

focus of his appeal. In 2005 his expenses exceeded his earn

‐ ings by $153,420. The loss declined to $30,604 in 2006 but in

‐

creased to $98,251 in 2007 and to $291,888 in 2008—though

it’s important to bear in mind that 2007 and 2008 are not in

‐

volved in the appeal. He deducted the losses on his tax re

‐

turns from his other income, mainly income from consulting

in the restaurant business and from renting and selling real

estate.

The record ends in 2008, when Roberts had a considera

‐

ble loss owing to his horses’ being quarantined for much of

the race season. Apparently the Internal Revenue Service has

challenged no deductions of expenses of his horse

‐ racing

business that Roberts began taking in 2007.

The Tax Court’s ruling that Roberts’ horse

‐ racing enter

‐ prise was a hobby in 2005 and 2006 but became a business in

2007 and remained so in 2008, and apparently has been one

in every year since given the IRS’s failure to challenge hisNo. 15

‐ 3396 5

horse

‐ racing deductions for any year since 2008, is untena

‐

ble; it amounts to saying that a business’s start

‐ up costs are

not deductible business expenses—that every business starts

as a hobby and becomes a business only when it achieves a

certain level of profitability. Yet Roberts’ 2007 “business”

(conceded to be such by the Tax Court) did not begin that

year, but rather evolved from his decision in 2005 to build a

larger training facility and his attempt to do so on his exist

‐ ing property (which however the City of Indianapolis pre

‐ vented); the large land purchase that he had made in 2006;

and the improvements (enabled by the purchase) in his

horse

‐ training facility that he had made that year. The Tax

Court’s finding that his land purchase and improvements

were irrelevant to the issue of profit motive until he began

using the new facilities is unsupported and an offense to

common sense. He intended the land and improvements for

his horse

‐ racing business

, and intent to make a profit is what

makes an activity a business. The fact that he became in

‐

volved in horse racing because he was greatly reducing his

involvement in his original business (thus signaling a career

change), and the further fact that he assisted in lobbying de

‐ signed to increase the profitability of horse racing, also con

‐

tradict the hobby hypothesis.

The Tax Court acknowledged that “the startup phase and

unforeseen expenses balance the history of large losses, and

[therefore that] this factor [the losses] is neutral for all tax

years in issue,” and that “by tax year 2005 petitioner devoted

time and effort appropriate to demonstrate a profit objective

for all the tax years in issue” (emphasis added). We cannot

square these statements with the court’s decision. For imag

‐

ine a person who wants to profit from being a landlord but

must take two years to acquire land and build the building.6 No. 15

‐ 3396

No one would say that his rental business was a “hobby” for

the first two years because no tenant could move in and as a

result he could obtain no income and thus no profit until

year three. But that’s what the Tax Court ruled in this case.

Remarkably in light of its ultimate ruling, the court said

that “petitioner did not purchase the [Mooresville] property

[in 2006] to have a place to enjoy the golden years of his re

‐

tirement but instead purchased the property to run a busi

‐

ness ” (emphasis added). Inconsistently the opinion later

states that “petitioner’s profit objective was first shown in

2007 when he began operating his horse

‐ related activities at

the Mooresville property.” The judge seems not to have un

‐

derstood that the decision to build the facility, and its con

‐

struction, are also indications of a profit motive.

Further undermining its conclusion, the court remarked

that the “petitioner knew that prize purses were increasing

in Indiana. In other words, the ultimate profit potential

would significantly increase. Further, one of petitioner’s

horses was nominated to run in the Triple Crown Races,

showing that his horses have the potential to race at a very

high level and possibly earn significant profits. Accordingly,

petitioner’s expectation of future profits was consistent with

the existence of a profit objective for all the tax years in issue ”

(emphasis added; footnote omitted). This was the same point

the court had made in a passage we quoted earlier (though

the court might have qualified it by noting that if prize purs

‐

es were increasing, this might attract more competition in

horse racing, which might lower profits). “All the tax years

in issue” include of course 2005 and 2006.

We mustn’t be too hard on the Tax Court. It felt itself im

‐ prisoned by a goofy regulation (26 C.F.R. § 1.183–2, Treas.No. 15

‐ 3396 7

Reg. § 1.183–2: Activity Not Engaged in for Profit Defined;

see, e.g., Faulconer v. Commissioner

, 748 F.2d 890 (4th Cir.

1984)) that we feel bound to set forth in its full tedious

length:

(b) Relevant factors

. In determining whether an activity

is engaged in for profit, all facts and circumstances with

respect to the activity are to be taken into account. No one

factor is determinative in making this determination. In

addition, it is not intended that only the factors described

in this paragraph are to be taken into account in making

the determination, or that a determination is to be made on

the basis that the number of factors (whether or not listed

in this paragraph) indicating a lack of profit objective ex

‐

ceeds the number of factors indicating a profit objective, or

vice versa. Among the factors which should normally be

taken into account are the following:

(1) Manner in which the taxpayer carries on the activity

. The fact that the taxpayer carries on the activity in a busi

‐

nesslike manner and maintains complete and accurate

books and records may indicate that the activity is en

‐ gaged in for profit. Similarly, where an activity is carried

on in a manner substantially similar to other activities of

the same nature which are profitable, a profit motive may

be indicated. A change of operating methods, adoption of

new techniques or abandonment of unprofitable methods

in a manner consistent with an intent to improve profita

‐ bility may also indicate a profit motive.

(2) The expertise of the taxpayer or his advisors

. Prepara

‐

tion for the activity by extensive study of its accepted

business, economic, and scientific practices, or consultation

with those who are expert therein, may indicate that the

taxpayer has a profit motive where the taxpayer carries on

the activity in accordance with such practices. Where a8 No. 15

‐ 3396

taxpayer has such preparation or procures such expert ad

‐

vice, but does not carry on the activity in accordance with

such practices, a lack of intent to derive profit may be indi

‐

cated unless it appears that the taxpayer is attempting to

develop new or superior techniques which may result in

profits from the activity.

(3) The time and effort expended by the taxpayer in carrying

on the activity

. The fact that the taxpayer devotes much of

his personal time and effort to carrying on an activity, par

‐ ticularly if the activity does not have substantial personal

or recreational aspects, may indicate an intention to derive

a profit. A taxpayer’s withdrawal from another occupation

to devote most of his energies to the activity may also be

evidence that the activity is engaged in for profit. The fact

that the taxpayer devotes a limited amount of time to an

activity does not necessarily indicate a lack of profit mo

‐

tive where the taxpayer employs competent and qualified

persons to carry on such activity.

(4) Expectation that assets used in activity may appreciate in

value

. The term profit encompasses appreciation in the

value of assets, such as land, used in the activity. Thus, the

taxpayer may intend to derive a profit from the operation

of the activity, and may also intend that, even if no profit

from current operations is derived, an overall profit will

result when appreciation in the value of land used in the

activity is realized since income from the activity together

with the appreciation of land will exceed expenses of op

‐

eration. See, however, paragraph (d) of § 1.183–1 for defi

‐

nition of an activity in this connection.

(5) The success of the taxpayer in carrying on other similar

or dissimilar activities

. The fact that the taxpayer has en

‐ gaged in similar activities in the past and converted them

from unprofitable to profitable enterprises may indicateNo. 15

‐ 3396 9

that he is engaged in the present activity for profit, even

though the activity is presently unprofitable.

(6) The taxpayer’s history of income or losses with respect to

the activity

. A series of losses during the initial or start

‐ up

stage of an activity may not necessarily be an indication

that the activity is not engaged in for profit. However,

where losses continue to be sustained beyond the period

which customarily is necessary to bring the operation to

profitable status such continued losses, if not explainable,

as due to customary business risks or reverses, may be in

‐

dicative that the activity is not being engaged in for profit.

If losses are sustained because of unforeseen or fortuitous

circumstances which are beyond the control of the taxpay

‐

er, such as drought, disease, fire, theft, weather damages,

other involuntary conversions, or depressed market condi

‐

tions, such losses would not be an indication that the activ

‐ ity is not engaged in for profit. A series of years in which

net income was realized would of course be strong evi

‐

dence that the activity is engaged in for profit.

(7) The amount of occasional profits, if any, which are

earned

. The amount of profits in relation to the amount of

losses incurred, and in relation to the amount of the tax

‐ payer’s investment and the value of the assets used in the

activity, may provide useful criteria in determining the

taxpayer’s intent. An occasional small profit from an activ

‐ ity generating large losses, or from an activity in which the

taxpayer has made a large investment, would not general

‐ ly be determinative that the activity is engaged in for prof

‐

it. However, substantial profit, though only occasional,

would generally be indicative that an activity is engaged in

for profit, where the investment or losses are comparative

‐ ly small. Moreover, an opportunity to earn a substantial ul

‐

timate profit in a highly speculative venture is ordinarily

sufficient to indicate that the activity is engaged in for10 No. 15

‐ 3396

profit even though losses or only occasional small profits

are actually generated.

(8) The financial status of the taxpayer

. 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. Substantial income from sources

other than the activity (particularly if the losses from the

activity generate substantial tax benefits) may indicate that

the activity is not engaged in for profit especially if there

are personal or recreational elements involved.

(9) Elements of personal pleasure or recreation

. The pres

‐

ence of personal motives in carrying on of an activity may

indicate that the activity is not engaged in for profit, espe

‐ cially where there are recreational or personal elements in

‐

volved. On the other hand, a profit motivation may be in

‐

dicated where an activity lacks any appeal other than prof

‐

it. It is not, however, necessary that an activity be engaged

in with the exclusive intention of deriving a profit or with

the intention of maximizing profits. For example, the

availability of other investments which would yield a

higher return, or which would be more likely to be profit

‐

able, is not evidence that an activity is not engaged in for

profit. An activity will not be treated as not engaged in for

profit merely because the taxpayer has purposes or moti

‐

vations other than solely to make a profit. Also, the fact

that the taxpayer derives personal pleasure from engaging

in the activity is not sufficient to cause the activity to be

classified as not engaged in for profit if the activity is in

fact engaged in for profit as evidenced by other factors

whether or not listed in this paragraph.

Notice in the introductory paragraph (the one labeled

“Relevant factors”) that “No one factor is determinative”

and that not “ only the factors described in this paragraph areNo. 15

‐ 3396 11

to be taken into account in making the determination” (em

‐ phasis added) whether the taxpayer’s activity is a business

or a hobby. In other words, the test is open

‐ ended—which

means that the Tax Court was not actually required to apply

all of those factors to Roberts’ horse

‐ racing enterprise. It

could have devised its own test, with its own factors, as long

as it explained why the factors that “should normally be tak

‐

en into account” were insufficient.

Notice too that the factors in the Treasury Regulation

overwhelmingly favor Roberts’ claim that even in 2005 and

2006 his horse

‐ racing enterprise was a business. He conduct

‐

ed it in a businesslike way (factor 1). He prepared by exten

‐

sive study (to obtain a training license) (factor 2). He largely

withdrew from his previous businesses in order to devote

“most of his energies” to his horse

‐ racing enterprise (factor

3). He expected to derive an eventual profit from the enter

‐ prise, including profit in the form of appreciation of the val

‐

ue of the land and buildings used in the enterprise (factor

4)—it’s not as if he were a billionaire indifferent to the mod

‐

est profit that probably was all he could expect from horse

racing. Entering the restaurant business on a small scale in

his twenties, Roberts had suffered setbacks that prevented

his business from being an immediate success—indeed his

first restaurant burned down and the insurance settlement

was too small to enable him to rebuild it as a full

‐ service es

‐

tablishment. Yet he “grew” the business to large dimensions

over time, a pattern consistent with his attempting to repeat

the process in his horse

‐ racing venture in 2005 and 2006 (fac

‐

tor 5). “A series of losses during the initial or start

‐ up stage

of the activity may not necessarily be an indication that the

activity is not engaged in for profit” (factor 6)—that’s this

case, all right. A “substantial profit, though only occasional,12 No. 15

‐ 3396

would generally be indicative that an activity is engaged in

for profit” (factor 7). The Tax Court awarded this factor to

Roberts because he earned money from racing his first two

horses and the growth in the prize purses (owing to the slot

machines) could be expected to increase his income in the

future; that one of his horses was nominated to run in the

Triple Crown Races suggested that his horses might eventu

‐ ally achieve greater success.

“The fact that the taxpayer does not have substantial in

‐

come or capital from sources other than the activity may in

‐

dicate that an activity is engaged in for profit” is factor 8. In

2005 and 2006 Roberts reported adjusted gross income of

$297,881 and $1,359,339 even after deducting his horse

‐ racing losses, but he happened to have sold a large piece of

land in 2006, and the Tax Court found that he is “not an ex

‐ cessively wealthy individual.” The court concluded that this

factor favored the IRS, but we believe the existence of other

income has little weight when many other factors indicate a

profit objective.

As for the last factor—“the availability of other invest

‐

ments which would yield a higher return, or which would

be more likely to be profitable, is not evidence that an activi

‐

ty is not engaged in for profit. An activity will not be treated

as not engaged in for profit merely because the taxpayer has

purposes or motivations other than solely to make a profit.

Also, the fact that the taxpayer derives personal pleasure

from engaging in the activity is not sufficient to cause the

activity to be classified as not engaged in for profit if the ac

‐ tivity is in fact engaged in for profit as evidenced by other

factors whether or not listed in this paragraph.” This is sen

‐

sible since obviously many businessmen derive pleasure,No. 15

‐ 3396 13

self

‐ esteem, and other nonmonetary “goods” from their

businesses, and horse racing is just the kind of business that

would generate such “goods” for participants such as the

owners and trainers (Roberts is both) of the horses.

About factor 9 the court added that “there is likely no

profit objective where the taxpayer combines horse racing

with social and recreational activities.” That is contrary to

what factor 9 says, and in addition no social or recreational

activities engaged in by Roberts are listed, let alone de

‐

scribed, by the court. The court does say that “petitioner’s

involvement with the professional horse racing associations

demonstrates that he engaged in some social aspect of the

industry,” but that’s like saying that serving on a corporate

board of directors is a “social” activity.

So: nine factors—all actually either supportive of or at

least consistent with Roberts’ claim that his horse

‐ racing en

‐ terprise even as early as 2005 was a business, not a hobby. It

may have been a fun business, but fun doesn’t convert a

business to a hobby. If it did, Facebook would be a hobby,

Microsoft and Apple would be hobbies, Amazon would be a

hobby, etc. ad infinitum.

Even the Tax Court deemed only two factors to favor the

Internal Revenue Service—8 and 9, and we’ve seen that nei

‐

ther supported the court’s determination that Roberts was a

hobbyist until 2007. Numerous remarks in its opinion,

moreover, support the existence of a profit motive, as when

the court said that between 1999 and 2001—the period in

which Roberts increased his stock of horses from 2 to 10—he

was “enticed by the profit potential of racing more horses.”

Profit goes with businesses, not hobbies. The court also re

‐

marked that “around the time petitioner bought the Morris14 No. 15

‐ 3396

Street property [where he started his horse

‐ racing enter

‐ prise], he was contemplating a career change.” A person de

‐ ciding whether to take up a hobby is not “contemplating a

career change.” A hobby is not a career.

And remember the dinner that Roberts attended at the

invitation of the thoroughbred horse

‐ race association? About

this event the Tax Court remarked that told by the associa

‐

tion of “the potential financial gains associated with the ac

‐ tivity,” Roberts “was interested in the financial prospect of

horse racing” (emphasis added). It was shortly after that that

he bought his first two horses, yet as we noted in the preced

‐ ing paragraph he was “enticed by the profit potential of rac

‐ ing more horses.” The court further remarked that “petition

‐

er credibly testified that he spent significant effort and time

to match the right horse to the right race. He spent this time

matching each horse to a race with the expectation of making a

profit ” (emphasis added).

The court careens from profit motive to pleasure motive

and back. All that emerges from the opinion and the record,

so far as bears on profit motive or the absence thereof, is that

Roberts enjoys his new career. But “a business will not be

turned into a hobby merely because the owner finds it

pleasurable; suffering has never been made a prerequisite to

deductibility. Success in business is largely obtained by

pleasurable interest therein.” Jackson v. Commissioner

, 59 T.C.

312, 317 (1972).

Considering that most commercial enterprises are not

hobbies, the Tax Court would be better off if rather than

wading through the nine factors it said simply that a busi

‐

ness that is in an industry known to attract hobbyists (and

horse racing is that business par excellence), and that losesNo. 15

‐ 3396 15

large sums of money year after year that the owner of the

business deducts from a very large income that he derives

from other (and genuine) businesses or from trusts or other

conventional sources of income, is presumptively a hobby,

though before deciding for sure the court must listen to the

owner’s protestations of business motive. For an analysis

along these lines see our decision in Estate of Stuller v. United

States

, 811 F.3d 890, 896–98 (7th Cir. 2016).

The Tax Court’s judgment, insofar as it upholds the defi

‐

ciencies assessed against the petitioner by the Internal Reve

‐

nue Service for business deductions in 2005 and 2006, is re

‐

versed with instructions to void the deficiencies.