## Facts

- Victor Prieto and his wife worked together in Victor’s private orthopedic surgery practice, where Victor’s average annual net income exceeded $600,000.
- After their children became interested in horses, the Prietos began purchasing, training, showing, and selling horses through a horse-related activity they reported as a business.
- The Prietos’ children competed in horse events and were permitted to choose which horses to buy.
- The Prietos hired 18-year-old Nicole Shahinian to train the horses and instruct their children; she was a “junior” rider and lacked business or professional training experience.
- From 1991 through 1998, the horse activity generated average annual losses of more than $300,000.
- The Prietos did not maintain strict books and records for the horse activity, and the records they kept contained inconsistencies.
- When the Prietos’ children turned 18, the Prietos discontinued the horse activity.
- The Prietos claimed the horse-activity losses as business deductions on their federal income tax returns.
- The Commissioner determined tax deficiencies and asserted penalties, and the Prietos petitioned the Tax Court for redetermination.

## Issues

1. Whether the Prietos’ horse activity was an activity engaged in for profit, such that the claimed losses were deductible as trade or business (or income-producing) expenses rather than limited under the hobby-loss rules of I.R.C. § 183.
2. Whether the Commissioner’s asserted accuracy-related penalties applied to any underpayments attributable to the disallowed losses.

## Decision

- The court held that the Prietos did not conduct the horse activity with the requisite actual and honest objective of making a profit.
- Because the activity was not engaged in for profit under § 183, the court disallowed the Prietos’ claimed deductions to the extent they exceeded the amount allowable for a not-for-profit activity.
- The court sustained the Commissioner’s deficiency determinations resulting from the disallowance of the claimed horse-activity losses.
- The court upheld the Commissioner’s asserted penalties in connection with the underpayments attributable to the improper deductions.

## Legal Principles

- Under I.R.C. § 183, deductions attributable to an activity “not engaged in for profit” are limited; taxpayers must show a bona fide profit objective to deduct losses as business (or income-producing) expenses.
- Profit objective is evaluated by considering all facts and circumstances, commonly including the factors in Treas. Reg. § 1.183-2(b), such as: the manner in which the activity is carried on, the taxpayer’s and advisers’ expertise, time and effort devoted, history of income or losses, and elements of recreation or personal pleasure.
- Consistent, large losses over many years, weak or inconsistent records, and operation in a way consistent with personal recreation rather than commercial practice are factors that weigh against a profit objective.
- A taxpayer’s substantial income from other sources may support an inference that losses from the activity were used to offset unrelated income rather than reflecting a genuine profit-motivated venture.
- Accuracy-related penalties may be imposed where an underpayment results from negligence or disregard of rules or regulations, or from a substantial understatement, absent a showing of reasonable cause and good-faith reporting.

## Conclusion

In *Prieto v. Commissioner*, the Tax Court determined that the Prietos’ horse activity, conducted while they earned substantial income from an orthopedic surgery practice, lacked a genuine profit motive as shown by years of large losses, inconsistent recordkeeping, and facts indicating a primarily family and recreational purpose; the court therefore limited the deductions under § 183, sustained the resulting deficiencies, and upheld the IRS’s penalties tied to the improper loss deductions.


Prieto v. Commissioner, T.C. Memo. 2001-266 (2001)