T.C. Memo. 2018-136



                         UNITED STATES TAX COURT



SCOTT A. HOUSEHOLDER AND DEBRA A. HOUSEHOLDER, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 19150-10, 6541-12.               Filed August 23, 2018.



      Kacie N.C. Dillon and Tim Alan Tarter, for petitioners.

      Michael R. Harrel, Doreen Marie Susi, John R. Gordon, and Brandon Keim,

for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      HOLMES, Judge: Scott and Debra Householder deducted $1.3 million in

losses for amounts they paid to ClassicStar, a horse-leasing operation that turned

out to be a scam. They say they should still get the losses because they materially
                                         -2-

[*2] participated in the trade or business of breeding horses. The Commissioner

disagrees--he thinks they were in it only for the losses.

                                FINDINGS OF FACT

I.    Background

      A.     Scott and Debra1

      Scott Householder had an MBA with an emphasis in finance and ten years

of experience as a financial adviser with American Express when he founded

Householder Group in 1997. Householder Group is a financial advisory firm that

earns fees and commissions for selling investments. It is also phenomenally

successful, and by 1998 was the fastest growing affiliate of Sun America

Securities. Today it has more than forty offices.

      Scott’s wife Debra always liked horses. She started taking riding lessons

when she was nine, showed horses in neighboring states by the time she was

fourteen, and showed nationally for a time after high school, hauling her horse

Brandy Susie Bar with a truck and trailer that her dad bought her. During college

she had internships where she gave riding lessons, trained horses, and participated




      1
        The record shows that Debra sometimes goes by Householder and
sometimes by Davis, her maiden name. To avoid confusion, we will sometimes
use the Householders’ first names.
                                        -3-

[*3] in the day-to-day aspects of horse breeding--which included artificially

inseminating mares.

      Debra moved to Colorado when she was 24 and worked for a tour company.

There she met Scott, and in the decades that followed she raised three children and

went to graduate school. She earned a Ph.D., and in 2011 she became a licensed

psychologist.

      But even with all their education and obvious intelligence, the Householders

got a big surprise when their accountant drafted their 2001 tax return--an extra

$466,000 in income from Sun America. This wasn’t sitting in their bank account,

but was instead cancellation of indebtedness (COI) income. In their case, the debt

Sun America canceled was part of the money Scott had borrowed to start his

business, and Sun America forgave the loan because Householder Group had more

than met certain performance goals. This COI significantly increased Scott and

Debra’s taxable income, and Householder Group’s success meant there would be

more to come in later years.

      B.     ClassicStar

      Enter Bob Holt, a friend of Scott from his days at American Express. Holt

sold investments on commission for Private Consulting Group (PCG), and in

February 2002 he pitched one to Scott and Debra--ClassicStar’s thoroughbred
                                        -4-

[*4] mare-leasing and breeding program. He showed Scott ClassicStar’s

marketing materials, which included ostensibly independent tax opinions. It was a

private-placement program, which means it was not offered to the general public.

      The program seemed simple. Participants leased mares from ClassicStar,

paid for their board and stud fees to breed them, and owned any foals that resulted.

Thoroughbreds are usually bred between February and June and have eleven-

month gestation periods, so a single breeding cycle usually stretches across two

calendar years. Participants in ClassicStar would pre-pay (mostly with borrowed

money) all of the expenses in the year before the mare became pregnant. This

would generate net operating losses (NOLs) for that year that participants could

carry back to even earlier years. And if they sold a foal when it was a “yearling”--

meaning when it was around a year old--any income would be capital.

      ClassicStar had a lender lined up for its clients--the National Equine

Lending Company (NELC). ClassicStar recommended taking out both “short-

term financing” for about 40% of the total cost--which participants would pay

back with money from their tax refunds--and “long-term financing” for 50% of the

total cost. These loans were secured by the expected foals. ClassicStar said it had

“arranged” for the NELC financing, but in reality ClassicStar and NELC were

commonly controlled--ClassicStar president S. David Plummer III’s brother-in-
                                        -5-

[*5] law, Gary Thompson, ran NELC; all of NELC’s business was with

ClassicStar; and ClassicStar gave NELC the money to fund the loans, though

NELC sometimes returned it the next day.

      Scott and Debra testified that they didn’t know ClassicStar and NELC were

related. But correspondence they received from both ClassicStar and NELC’s

loan servicer said to direct any questions to Terry Green, who was both

ClassicStar’s CPA and a member of the firm that serviced the loans. Green also

spoke at a ClassicStar event that Scott attended, and even sent Scott and Debra a

letter on NELC letterhead.

      ClassicStar also offered participants the option of converting their

mare-leasing interests into stakes in two related entities--First Equine Energy

Partners (FEEP) and Gastar Exploration (Gastar).2 Gastar securities are publicly

traded,3 but FEEP was another private-placement program that claimed to hold

interests in both horses and coal-bed methane gas properties. And FEEP’s private-




      2
       The record refers to both Gastar Exploration, Ltd., and Gastar Exploration,
Inc. The Commissioner says these are the same entity at different times, and Scott
and Debra don’t disagree.
      3
        Gastar’s 2005 annual report says it’s traded on the Toronto and American
Stock Exchanges, and the parties introduced into evidence a table of its historic
trading prices.
                                         -6-

[*6] placement memorandum explained that NELC would accept FEEP units as

substitute collateral for the outstanding loans.

      ClassicStar participants have been to our Court before. See generally

Raifman v. Commissioner, T.C. Memo. 2018-101 (tax-avoidance-motivated

participation); Romanowski v. Commissioner, T.C. Memo. 2013-55 (activity not

engaged in for profit); Pederson v. Commissioner, T.C. Memo. 2013-54 (same);

Van Wickler v. Commissioner, T.C. Memo. 2011-196 (not carrying on trade or

business and expenses unreasonable). We’ve also encountered Holt before. See

generally Goyak v. Commissioner, T.C. Memo. 2012-13 (contribution to PCG-

pitched employee benefit plan not deductible).

      C.     Scott and Debra Sign Up

      Back in 2002, however, this all sounded great to Scott and Debra. They

sent Holt their recent tax returns, which he said he needed to determine that they

were qualified investors. In May 2002 Holt sent them a proposed “Mare Lease

and Breeding Activity” report that began with a table labeled “potential net

operating loss.” That table showed an “NOL needed” of $1.9 million--needed

because it matched the amount of taxable income the report said Scott and Debra

had from 1997 to 2002. The report also explained that “[u]nder recent signed

legislation, Net Operating Losses can be carried back five (5) years” and
                                        -7-

[*7] “Agricultural Mare Lease Deductions are not subject to Alternative Minimum

Tax (AMT).” It then laid out a plan to generate a “total mare leasing and breeding

loss” of $1.9 million and described how to later convert the mare-leasing interest

into a “methane gas working interest,” convert that interest into common stock,

and then sell it for a capital gain.

       In September 2002 the Householders signed both a letter of intent to

participate in ClassicStar’s mare-leasing program and a confidentiality agreement.

Debra wrote ClassicStar a check for $100,000, and ClassicStar gave them a

revised mare-leasing program report. The first page of this revised report showed

an $819,000 “NOL needed,” which was the amount of taxable income the report

said Scott and Debra would have in 2002 alone. It also had more detailed

information about how to convert interests into Gastar stock and exit the program,

which included a “strategy timeline” that showed a purchase in 2002 and a

liquidation in 2006. That report listed a “put” price for Gastar stock of $3 per

share, but also included calculations for “probable” and “potential” share prices of

$6 and $10.

       Scott and Debra attended ClassicStar’s “Breeders’ Cup Weekend” in

Kentucky in October, which featured a dinner party with a “Hawaiian theme” and

the “4th Annual ClassicStar Breeders’ Cup Eve Gala Party.” There they could
                                          -8-

[*8] hear presentations by Tony Ferguson, who was ClassicStar’s chairman and

Gastar’s executive vice president, and David Plummer.

      D.     Correspondence from ClassicStar

      During the next few months ClassicStar sent Scott and Debra several letters.

One had the subject “2002 ClassicStar Mare Lease Program--Financing.” It read

in part: “ClassicStar has arranged with National Equine Lending Company to

provide the Short-term Financing (Tax Refund), which is approximately 40% of

the Mare Lease Program. The loan will mature June 1, 2003. It is very important

that the client files his/her tax return in a timely manner.”

      A letter dated October 31, 2002, explained that “[t]o obtain the full tax

benefits of the program * * * [participants] must spend a minimum of 100 hours”

per year participating on a “continuous, regular and substantial basis,” and it

suggested they record their participation in a journal. It also recommended

opening a checking account for the “equine business” and creating either an S
                                         -9-

[*9] corporation4 or an LLC,5 which Scott and Debra did--in December they

formed an LLC called Medaca Investments (Medaca) and the following year they

transferred all of their mare-leasing interests to it. They also used Medaca’s

checking account to pay unrelated expenses, such as utility bills and their monthly

payment on a Land Rover.

      A November 26, 2002, email from ClassicStar’s VP of operations Jennifer

Stahle reiterated that the Householders needed to show regular, continuous, and

substantial participation in order to claim losses. That email had an attachment

which listed various ClassicStar activities that could count as participation--

including “WebEx Conference Call[s],” meeting with David Plummer, touring

ClassicStar facilities, and even watching horse races on TV. And a letter dated

December 12, 2002, began with “[e]nclosed is the compiled material and



      4
         An S corporation is a business that meets the requirements of section 1361
and elects to have its income and losses flow through to its shareholders without
paying corporate tax. See secs. 1362(a), 1363(a) and (b). (All section references
are to the Internal Revenue Code in effect for the years at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.)
      5
         LLC stands for “limited liability company,” a hybrid form of business
entity that shares some of the characteristics of a partnership and some of the
characteristics of a corporation. Unless it elects to be taxed as a corporation, an
LLC’s profits and losses “pass through” to its owners, who are called members.
See sec. 301.7701-3(a) and (b)(1), Proced. & Admin. Regs.
                                       - 10 -

[*10] information you requested” and explained how to get discounted

subscriptions to the magazines “The Blood-Horse” and “Thoroughbred Times.”

      E.    Stallworthy

      Scott and Debra tried to get their CPA, Margaret Stallworthy, involved. She

told them that she wasn’t qualified to give an opinion about ClassicStar’s horse-

breeding program, but she did explain that the IRS might consider it an active

investment, a passive investment, or even a hobby depending on “how well * * *

[Scott and Debra] could document the level of their participation and expertise.”

      At Scott’s urging Stallworthy met with Holt in November 2002. Holt

showed her a marketing brochure for ClassicStar, which she thought “was clearly

an investment for high net worth individuals.” Holt also brought a private offering

memorandum to the meeting, but he refused to show it to Stallworthy because she

wouldn’t sign a nondisclosure agreement. Her only followup from the meeting

was to tell Holt that Scott and Debra’s 2002 taxable income would be between

$810,000 and $830,000.
                                        - 11 -

[*11] II.    Mare Leasing

      A.     The 2002 Program

             1.     The Paperwork

      On December 21, 2002, Scott and Debra signed a “mare lease and breeding

agreement” that said they “desire[d] to lease from * * * [ClassicStar] the mare or

mares selected by * * * [Scott and Debra] on the attached schedule A.” But there

was no schedule A attached to the agreement--or anywhere else. At trial the

Householders’ own expert said that horse breeders don’t usually sign agreements

without knowing what horses are involved, which the Commissioner’s expert

explained is so because the characteristics of the specific horses are what

determine whether a breeding operation will be successful. This seems so obvious

that an expert shouldn’t be necessary to support a finding that it’s true, but we’ll

just find their testimony credible on this point. No matter--Scott gave ClassicStar

a check for $226,000, and Debra gave one for $50.

      Debra testified that there was a “verbal [i.e., oral] schedule A” because she

told Spencer Plummer--David Plummer’s son6--which mares she wanted to lease

and which stallions she wanted to breed them with. She claims she picked seven


      6
       Other ClassicStar employees included Shane Plummer and Nick Plummer.
ClassicStar appears to have been a family business.
                                       - 12 -

[*12] pairings and expected she would get three or four of them. But the

agreement Debra and Scott signed said: “This Agreement shall constitute the

entire agreement between the parties and any prior understanding or

representation, both written and oral, of any kind preceding the date of this

Agreement shall not be binding upon either party except to the extent incorporated

in this Agreement.” It also said that any subsequent modification was binding

only if it was in writing. So, regardless of what Debra did or didn’t discuss with

ClassicStar before signing this agreement--and we’re not convinced that she

discussed anything--she paid hundreds of thousands of dollars to breed horses

without knowing which horses were to be bred.

      Scott and Debra also signed three other agreements with ClassicStar. One

was a boarding agreement in which they hired ClassicStar “to board and care for

the mare or mares described on the attached schedule A”--though this agreement

lacked a schedule A as well. A second agreement made ClassicStar the nominee

for “the foals set forth on Exhibit A attached,” on which each space where foals

and their parents should have been listed was blank. The third agreement said

ClassicStar agreed to board “[f]oals identified on Exhibit A, which is attached,”

but once again there was no Exhibit A.
                                        - 13 -

[*13] On, or within days of, signing these riderless agreements, Scott and Debra

took out a $75,000 short-term loan and a $401,000 long-term loan with NELC.

They also executed a revised letter of intent that listed the $100,000 Debra had

paid in September, the $226,000 that Scott and Debra had paid that month, the

$75,000 funded by the short-term loan, and the $401,000 funded by the long-term

loan--for a total of $802,000.

      In early February 2003 ClassicStar sent the Householders a letter to remind

them that the sooner they filed their tax return and received their refund, the

sooner they could pay off their short-term loan. It also said that Jennifer Stahle--

who signed the letter--and Terry Green were available to answer any questions.

And later Shane Plummer sent them a timeline reminding them that they should

“[l]og at least 100 hours of Material Participation before December 31.”

              2.   The Breeding Season

      The actual breeding for the 2002 breeding program should have happened in

early 2003. ClassicStar’s materials said that pregnancy checks would be

performed 17 and 28 days after breeding and that the unknown foals’ sexes would

be determined at 62 days. But ClassicStar didn’t tell Scott and Debra whether any

pregnancies had begun, or anything else about their mares--and neither of them

ever asked.
                                        - 14 -

[*14]         3.    Trips

                    a.      The 2003 Kentucky Derby

        In May 2003 Scott and Debra traveled to Kentucky for ClassicStar’s

“exclusive” Kentucky Derby weekend, where they went on tours, had dinners, and

mingled with other ClassicStar clients. Debra said that during that trip she

received a written schedule that purported to list the mares she and Scott had

leased for the 2002 program. Debra said she never saw it again after the trip, and

it wasn’t produced at trial. According to her, it listed pairings, some of which

included quarter horses--which are generally less expensive than thoroughbreds

and cost much less to breed. Debra says Spencer Plummer told her the quarter

horses were “placeholders”--a practice Debra said she’d heard about during her

internships but which we specifically find is not common in the horse-breeding

industry. Scott said he thought the reason ClassicStar hadn’t told Debra and him

which horses they’d paid to breed even by the end of the breeding season was that

it was “administratively challenged.”

        Debra also testified that during the 2003 Kentucky Derby trip ClassicStar

paraded a thoroughbred mare named GoGo past its clients and announced that

Scott and Debra Householder had selected her. This surprised her because she had

researched GoGo when she looked up ClassicStar’s horses, wasn’t interested in
                                      - 15 -

[*15] her, and didn’t select her. But there was something else even odder about

GoGo--ClassicStar didn’t own her in May 2003. It bought her only in November

2003 at the Keeneland sale (perhaps the premiere thoroughbred auction); and

when it bought her, she was already pregnant by a stallion called Mr. Greeley.

                   b.    Yellowstone and the Virgin Islands

      At the end of July Scott and Debra went on another ClassicStar trip--this

time to David Plummer’s house near Yellowstone. They met there with “other

ClassicStar owners,” participated in “[a]fternoon activities,” and discussed FEEP.

      Yellowstone was Debra’s last ClassicStar trip for 2003, but Scott made one

more--to the U.S. Virgin Islands. Scott had to pay his own way to Tampa, where

he met with Tony Ferguson. From there on, ClassicStar paid his expenses. The

agenda included talks by David Plummer, Tony Ferguson, and Terry Green--who

spoke about material-participation logs. It also included golf, shopping, gambling,

and cocktails.

      B.    The 2003 Program

      By August 2003 Scott and Debra still hadn’t received any updates about the

2002 breeding program, but that month they nevertheless executed on behalf of

Medaca a letter of intent to participate in the 2003 program. After handwriting

some adjustments to the numbers typed on the letter, they said they would pay
                                       - 16 -

[*16] $500,000--which was also the “NOL needed” on an October 28, 2003, report

they received from ClassicStar. That report showed that $200,000 would be from

“Tax savings and refunds,” $250,000 would be from a loan, and $50,000 would be

a downpayment from the lessee. In November Scott paid ClassicStar the $50,000

with a check from Medaca. Scott and Debra also got a $200,000 “short-term” loan

and a $250,000 “long-term” loan from NELC.

      A month later in December 2003 Scott and Debra--again on behalf of

Medaca--executed a Mare Lease and Breeding Agreement, a boarding agreement,

a foal agreement, and a nominee agreement, all for the 2003 program. These again

referred to a schedule A that was supposed to show the specific mares and

stallions to be bred. There actually was a schedule A for this program--although

it’s undated.

      That schedule A lists five pairings for a total cost of $500,000, but only one

of the horses is a thoroughbred--GoGo, the mare Debra says she saw at

ClassicStar’s 2003 Kentucky Derby weekend. The schedule A paired GoGo with

a cutting horse--a less-expensive type of horse--for a “breed fee” of $10,000, even

though his normal stud fee was only $2,500. The other listed horses were all

quarter horses, and one of the horses in the mare column was actually a gelding--a

male horse that had been castrated. The listed pairings were therefore worth much
                                       - 17 -

[*17] less than what the Householders paid, and at least one couldn’t have

produced a foal.

      Scott and Debra nevertheless signed this schedule A.

      As with the 2002 program, Scott and Debra neither received nor asked for

any updates about the leased mares’ pregnancies.

      C.    The 2004 Program

      In May 2004 Scott and Debra signed up for a third year, again planning to

generate $500,000 in NOLs. They paid half themselves--$100,000 with a check

from Medaca in May and $150,000 with a check from the Householder Group in

September. But they later backed out of the 2004 program, and ClassicStar

refunded their $250,000 in November 2004.

      D.    Cashing Out

      On May 24, 2004--three days after they’d signed up for the 2004 program--

Scott and Debra told ClassicStar’s parent company GeoStar that they wanted to

exchange part of their “Mare Lease Breeding * * * Business” for a “working

interest” in GeoStar’s “2004 Coalbed Methane Drilling Program.” In November

2004 they traveled with Holt and his wife to a Gastar property in Australia, and on

the last day of 2004 exchanged the majority of their interest in the 2002 breeding

program and their entire interest in the 2003 breeding program for units of FEEP
                                        - 18 -

[*18] and shares of Gastar. They got 797,000 FEEP units--which their

subscription documents valued at $1 each--and 75,000 Gastar shares--which were

trading for $16 a share, but which the purchase agreements valued at $3 each,

same as the “put” price on the initial mare-lease program reports they’d received.

These shares came with the restriction that Scott and Debra couldn’t sell them for

one year without Gastar’s permission.

      In February 2007 Scott and Debra gave all 797,000 of their FEEP units to

NELC in satisfaction of the $400,000 long-term loan from 2002 and the $250,000

long-term loan from 2003.

      E.    Phoenix Heat

      Although they’d supposedly paid for multiple horse pairings in 2002 and

2003, Scott and Debra received only one foal--Phoenix Heat. Phoenix Heat was

born in February 2004, and ClassicStar had purchased her mother in foal at the

Keeneland sale in November 2003. Debra saw Phoenix Heat for the first time

during ClassicStar’s Kentucky Derby weekend in May 2005. The foal had some

problems--it was pigeon toed and had “parrot mouth” (basically an overbite)--that

Scott and Debra spent $1,600 to correct. Debra put Phoenix Heat up for auction at

the November 2005 Keeneland sale, during which she signaled Nick Plummer to
                                       - 19 -

[*19] place bids on her behalf in order to drive up the price. Phoenix Heat sold for

$200,000, from which Scott and Debra got $180,000 after a commission.

       F.    ClassicStar’s Demise

       The IRS raided ClassicStar’s offices in February 2006. In October 2009,

David Plummer, Spencer Plummer, and Terry Green each pleaded guilty to

conspiring to defraud the United States by impairing and impeding the Internal

Revenue Service with ClassicStar’s mare-leasing program. During the plea

hearing, David Plummer admitted he’d helped people take tax deductions they

weren’t entitled to; Spencer Plummer admitted that the NELC loans were the

source of the deductions, that ClassicStar didn’t own enough mares for its

program, and that FEEP interests were worthless; and Terry Green said he’d

helped people under audit provide misleading and back-dated documents to the

IRS.

       ClassicStar itself collapsed into bankruptcy. In November 2007 Scott and

Debra filed a proof of claim for $4.7 million--which included the $250,000 Scott

paid for the 2004 program that ClassicStar had refunded in November 2004.7 The

bankruptcy court reduced their claim by the $1.9 million they’d listed for

       7
       The $4.7 million figure also double counted the amount Scott and Debra
paid ClassicStar by adding separate lines for out-of-pocket and borrowed money
paid with a line for “total program.”
                                        - 20 -

[*20] “Assessed, Paid, and Expected Tax/Penalties/Interest (2001-2009)” and

“Estimated tax for debt forgiveness,”8 and they ultimately received $23,000 from

the bankruptcy trustee. Scott said he didn’t sue Holt--although Holt’s other clients

did--because he didn’t think Holt had stolen from him, and he didn’t sue

ClassicStar because he didn’t think he’d get any money back.

III.   The Householders’ Tax Returns

       A.    2001

       The Householders’ CPA prepared all their returns. The amended 2001 joint

tax return that Scott and Debra filed in November 2002 showed almost $900,000

in adjusted gross income (AGI), which included the $400,000 COI income from

Sun America, and a tax liability of $308,000. But in 2004 they filed a second

amended return, on which they reduced their AGI to under $400,000. The

adjustment included a $37,000 NOL carryback from 2003.

       B.    2002

       ClassicStar emailed Holt instructions on how Scott and Debra should fill out

the Schedule F, Profit or Loss from Farming, on their 2002 tax return. It said:




       8
         It also reduced their claim by the $180,000 they’d received for the sale of
Phoenix Heat, although they’d already shown that amount as “cash received” on
their initial claim.
                                       - 21 -

[*21]          Board and mare care
                expenses                        $45,000--line 18
               Board fees                       212,000--line 33
               Mare lease                       440,340--line 26b
               Insurance                        104,600--line 22
                Total expenses                  801,940--line 36

Scott gave these instructions to Stallworthy and told her to follow them. After

Scott assured her that he and Debra had really participated in a business,

Stallworthy transcribed the numbers from the email onto the Schedule F.

Although Scott and Debra had around $771,000 in wage, business, and Schedule E

income, the AGI they reported for 2002 was a loss of $4,800.

        C.    2003

        On their 2003 tax return Scott and Debra reported $515,000 in Schedule F

losses related to their involvement with ClassicStar. This made their 2003 AGI

negative and created the NOL carryback they reported on their amended 2001

return.

IV.     The Audit

        A.    Debra’s Notebook

        The Commissioner began an audit in 2005. In November of that year a

revenue agent met with Debra and asked her for the names of the horses she’d
                                        - 22 -

[*22] leased. Debra couldn’t name any. And even at trial Scott said he had no

idea how many pairings he’d paid for or which mares he’d leased.

      During the audit, the agent repeatedly asked Scott and Debra to turn over

any documents showing their due diligence and the horses involved. They never

did send any original documents in response to these requests, but in 2007 they

gave the revenue agent a document labeled “Householder Outline of Facts” that

listed “Original Pairings” and “Trade Out[s]” for the 2002 and 2003 programs.

Several of the horses listed were also quarter horses--including some listed after

the trade-outs.

      Despite not producing any original documents during the years-long audit, a

few weeks before trial the Householders turned over a coverless spiral notebook

full of handwritten notes they say Debra made between 2002 and 2004 while

researching ClassicStar’s horses. Loose inside were printouts of spreadsheets that,

according to Debra, showed information on horse sales that she found on the

internet. It also listed pairings that Debra said are the ones she wanted for the

2002 program.

      Debra said she hadn’t turned over the notebook in the nine years since the

audit began because it was misfiled in Scott’s office. At trial the Householders

called a nanny they’d employed in 2002 to testify that it was Debra’s notebook and
                                        - 23 -

[*23] that it originally had a green cover with a picture of a horse on it. Except for

its missing cover, it was in very good condition for a twelve-year-old notebook,

and the notes--which bear dates spanning two years--all appear to have been

written with the same type of pen. The nanny also testified that in 2002 and 2003

Debra spent a few hours each Monday through Thursday evening, as well as some

weekend hours, in her home office. The nanny believed Debra was both making

spreadsheets of horses and working on her schoolwork at those times.

      B.     Scott’s Notes

      Scott also turned over handwritten notes about ClassicStar shortly before

trial. He too testified that he hadn’t turned them over earlier because they’d been

misfiled. He had, however, previously provided a printout of a 2006 article from

bloodhorse.com about the criminal case against ClassicStar on which he’d written

“[d]iscuss w/ Debby.” He testified that he’d discussed the article with his wife

around the time it was written in 2006, but the print date in the lower right corner

of the page is “9/6/2007 8:52 a.m.” We do not find these late-produced materials

reliable, and they reduced the credibility of the Householders’ testimony on other

issues.
                                        - 24 -

[*24] C.     The Material Participation Log

      In 2006 the Householders did turn over a participation log that covered

February 2002 through December 2003. For February 2002, they listed 3 hours

each for their meeting with Holt, where they “[d]iscussed ClassicStar investment

opportunities.” Between February and May they logged a total of 38 hours of

research on ClassicStar and its horses. In each of those months and in every

subsequent month Debra also listed 4 hours for “[r]ead[ing] Thoroughbred Times

and Blood Horse”--the magazines ClassicStar sent them a letter about in

December 2002. Starting in May 2002 Scott and Debra also listed a total of 4

hours each month for “[r]ead[ing] ClassicStar emails and articles of interest.” For

twelve of the twenty-three months in the log, reading emails, articles of interest,

and magazines were the only activities Scott and Debra logged.

      Scott and Debra’s trips make up most of the rest of the activities in the log.

Debra logged 3 hours for “[b]ook[ing] Breeder’s Cup weekend” for that October

2002 trip, and 1.5 hours for “[f]irm[ing] up plans for Breeder’s Cup Weekend”;

and together they logged 42 hours for traveling to Kentucky, meeting ClassicStar

staff, going on tours, and attending the Hawaiian-themed dinner.

      They recorded a similar amount of time for their 2003 Kentucky Derby trip.

Debra logged 3 hours for planning the trip, and she and Scott together logged 58
                                        - 25 -

[*25] hours for activities such as “Travel to and from Lexington,” “Dinner at

Embassy Suites,” “Tour Kentucky Horse museum,” and “mingle with other

[ClassicStar] clients.” For the Yellowstone trip, they logged 26 hours for travel,

meeting with “other ClassicStar owners,” “[a]fternoon activities with group,” and

discussing FEEP. And for his U.S. Virgin Islands trip, Scott logged 27.5 hours for

travel, dinner meetings, and reviewing and signing documents. This all amounted

to 170 hours for 2002 and 222.5 hours for 2003.

      D.     The Notices of Deficiency

      During the audit Scott and Debra signed several consents to extend the

statute of limitations, but in 2010 the Commissioner finally sent Scott and Debra a

notice of deficiency for the 2001, 2002, and 2003 tax years. It determined several

adjustments for each year, though the only ones still at issue by the time of trial

were 2001’s $37,000 NOL carryback, 2002’s $802,000 Schedule F loss; 2003’s

$515,000 Schedule F loss; and section 6662(a) penalties for negligence and

substantial understatement for all three years. The Commissioner also sent them a

notice of deficiency for the 2006 tax year. The parties have settled all of the issues

it raised, but in their amended petition Scott and Debra claimed an $843,000 theft

loss, and that contention remains before us.
                                        - 26 -

[*26] V.     Petitions and Trial

      Scott and Debra filed timely petitions. They lived in Phoenix, Arizona

when they filed their petitions, and that is where we tried these cases.

      Each side had expert witnesses. The Commissioner’s expert, who evaluated

the pairings on the “Householder Outline of Facts,” was of the opinion that the

amounts Scott and Debra had paid for leasing, inseminating, and boarding mares

were “grossly inflated and unwarranted.” The Householders’ expert thought those

amounts were reasonable, but represented “a premium.” But he didn’t evaluate the

same pairings--the pairings he considered were ones the Householders’ lawyer

told him to, and his report makes clear that his opinion was “based upon the

assumption that the Householders requested the matings discussed in [his] report.”

      There is also a Graev issue here: Although he determined section 6662(a)

penalties in the notices of deficiency, at trial the Commissioner didn’t introduce

any evidence that he’d complied with section 6751(b)(1). See Graev v.

Commissioner (Graev III), 

___, ___ (slip op. at 13-15) (Dec. 20, 2017)

(citing Chai v. Commissioner, 

, 221 (2d Cir. 2017), aff’g in part,

rev’g in part T.C. Memo. 2015-42), supplementing and overruling in part 

 (2016). After we released Graev III, the Commissioner moved to reopen the

trial record to fix his omission for a portion of the section 6662(a) penalties; he’s
                                         - 27 -

[*27] conceded the rest. We recently granted his motion and consider the

Commissioner’s additional evidence here.

                                      OPINION

I.    The Parties’ Arguments

      Scott and Debra argue that horse breeding was a trade or business they

engaged in for profit, and they also say they meet the regulatory standards for

material participation. They claim they would’ve made a profit if ClassicStar

hadn’t been a scam, and they think they should get a theft loss in 2006 because in

that year they both realized they’d been swindled and determined there was no

reasonable chance of getting their money back. They also argue that they

shouldn’t have to pay penalties because they had reasonable cause, acted in good

faith, and relied on substantial authority.

      The Commissioner replies that Scott and Debra didn’t materially participate

in horse breeding, that their involvement with ClassicStar wasn’t a trade or

business, and that they shouldn’t get a theft loss because the only thing they lost

was impermissible tax savings. And he says Scott and Debra should pay penalties

because they knew exactly what they were doing.
                                       - 28 -

[*28] We must therefore answer four questions:

      !      Did Scott and Debra materially participate in a horse-breeding
             activity?

      !      Was the horse-breeding activity a trade or business?

      !      Are Scott and Debra entitled to a theft loss deduction in 2006 for
             amounts they paid ClassicStar in 2002 and 2003?

      !      Are Scott and Debra liable for section 6662(a) penalties?

We address each in turn.9

II.   Material Participation

      Taxpayers can usually deduct the ordinary and necessary expenses of

carrying on a trade or business or otherwise producing income. Secs. 162(a),

212(1). But they can’t deduct “passive activity” losses that exceed their “passive

activity” income. Sec. 469(a), (d)(1). Passive activities include “the conduct of

any trade or business * * * in which the taxpayer does not materially participate,”

sec. 469(c)(1), and the Code tells us that “material participation” means being


      9
        The Commissioner also argued that the amounts of the long-term loans
were never at risk, a theory Scott and Debra say the Commissioner failed to
mention in his notice of deficiency. Whether those amounts were at risk doesn’t
affect our decisions in these cases, so we don’t need to determine when the
Commissioner first raised the issue or who would have the burden of proof. Scott
and Debra also contest the admissibility of some exhibits the Commissioner
proffered--82-R, 84-R, 85-R, 126-R, 128-R, 149-R, and 206-R. We didn’t rely on
those exhibits, and we will exclude them.
                                        - 29 -

[*29] “involved in the operations of the activity” on a regular, continuous, and

substantial basis, sec. 469(h)(1). The regulations say that a taxpayer is a material

participant only if he meets one of seven enumerated tests. Sec. 1.469-5T(a),

Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).

      Scott and Debra say they’re entitled to the losses they claimed for 2002 and

2003--and the associated NOL carryback they reported on their amended 2001

return--because they satisfy two of those tests. We consider each.

      A.     500 Hours

      The Householders first say they satisfy the test in section 1.469-5T(a)(1),

Temporary Income Tax Regs., supra, which says an individual materially

participates if he “participates in the activity for more than 500 hours during * * *

[the] year.” Their participation log shows that together they spent only 170 hours

on horse-breeding-related activities in 2002 and only 222.5 such hours in 2003.

Undeterred by their own records, they point out that we may find the extent of an

activity by “any reasonable means,” sec. 1.469-5T(f)(4), Temporary Income Tax

Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), and urge us to find that Debra alone

spent 500 hours a year on horse breeding because their nanny testified that in 2002

Debra spent both Monday through Thursday evenings and some weekends in her

home office working on horse business.
                                         - 30 -

[*30] We were not persuaded. The nanny gave only vague indications of when

this practice began and ended. She knew it started around the time Scott and

Debra met with Holt in early 2002, but said that by 2003 Debra’s office time

“varied more” and “[i]t wasn’t Monday through Thursday always necessarily.”

Plus she was usually taking care of the children whenever Debra was in the office

and only occasionally actually saw Debra working. The nanny also acknowledged

that Debra did her schoolwork in the evenings. Though we can use any reasonable

means to estimate the hours a taxpayer spends on an activity, see Tolin v.

Commissioner, T.C. Memo. 2014-65, at * 27-*28, we don’t accept “ballpark

guesstimate[s],” Jordan v. Commissioner, T.C. Memo. 2009-223, 

, at *16, aff’d, 469 F. App’x 460 (6th Cir. 2012). We do not find that the

nanny’s testimony makes it more likely than not that Debra spent at least 500

hours a year on horse-breeding-related activities--especially when Debra’s own

log lists less than half as much time.

      B.     Regular, Continuous, and Substantial

      The Householders also argue that they satisfy the test in section 1.469-

5T(a)(7), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), which

mirrors the Code by saying a taxpayer materially participates if “[b]ased on all of

the facts and circumstances * * * [he] participates in the activity on a regular,
                                         - 31 -

[*31] continuous, and substantial basis.” But an individual who tries to clutch this

exception still has to spend at least 100 hours a year on related activities, see sec.

1.469-5T(b)(2)(iii), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25,

1988)--though Scott and Debra together count as an “individual” because they’re

married, see sec. 1.469-5T(f)(3), Temporary Income Tax Regs., 53 Fed. Reg. 5727

(Feb. 25, 1988). “Management” activities, however, count toward the 100 hours

only if no one else gets paid for them or spends more time on them. Sec. 1.469-

5T(b)(2)(ii), Temporary Income Tax Regs., supra.

      And all the material-participation tests--including the 500-hour test we

discussed above--disregard work an individual does “as an investor * * * unless

the individual is directly involved in the day-to-day management or operations of

the activity.” Sec. 1.469-5T(f)(2)(ii)(A), Temporary Income Tax Regs., 53 Fed.

Reg. 5727 (Feb. 25, 1988). According to the regulations, working as an investor

includes “(1) [s]tudying and reviewing financial statements or reports on

operations of the activity; (2) [p]reparing or compiling summaries or analyses of

the finances or operations of the activity for the individual’s own use; and (3)

[m]onitoring the finances or operations of the activity in a non-managerial

capacity.” Sec. 1.469-5T(f)(2)(ii)(B), Temporary Income Tax Regs., supra.

      Let’s look at the activities that the Householders logged.
                                        - 32 -

[*32]         1.    Initial Research

        Scott and Debra’s log says they spent 38 hours researching ClassicStar and

6 hours meeting with Holt to discuss “ClassicStar investment opportunities”

between February and April 2002--well before they signed their first letter of

intent in September 2002. We have specifically found that research done before

deciding to raise livestock doesn’t count as material participation in the raising of

livestock. Syed v. Commissioner, T.C. Memo. 2017-226, at *19. We think the

same here--the Householders’ initial research doesn’t count--it was at best work

they did as investors researching a potential investment.

              2.    Reading, Talking, and Thinking

        Starting in March 2002, Scott and Debra logged 4 hours a month for reading

the magazines “Thoroughbred Times” and “The Blood-Horse,” and starting in

May they logged an additional 4 hours each month for “[r]ead[ing] ClassicStar

emails and articles of interest.” They logged these hours every month until the end

of 2003, and these hours constitute 72 of 170 hours for 2002 and 96 of 222.5

hours for 2003. Almost all of the rest of the hours they logged--46.5 hours in

2002 and 111.5 hours in 2003--were spent planning and going on trips. During

these trips, they logged hours for so-called breakfast meetings, lunch meetings,

and dinner meetings--including the one with a Hawaiian theme; touring
                                       - 33 -

[*33] ClassicStar’s facilities; watching the Kentucky Derby; and talking to other

ClassicStar clients. The remaining hours in their log show initial research,

viewing ClassicStar materials, or reviewing contracts.

      None of these activities are the day-to-day management or operation of a

horse-breeding business. While Scott and Debra were doing them, other people

far away were supposedly taking care of the horses they’d purportedly leased and

making the day-to-day decisions about their care. See Lapid v. Commissioner,

T.C. Memo. 2004-222, 

, at *4 (owner of hotel rooms didn’t

materially participate where someone else cleaned and checked people in).

      What’s more, we’ve previously said that the types of activities Scott and

Debra logged are not material participation. In Syed, at *5, a putative rancher

logged hours for “reading magazines about animal husbandry, talking with other

ranchers, and thinking about ranch matters.” There we explained that “reading,

talking, and thinking” don’t count as material participation if other people are

doing the actual work. See id. at *22. They don’t count here, either. At best, the

activities which the Householders logged were things investors might do to

monitor an investment.
                                         - 34 -

[*34]         3.     Management

        Scott and Debra nevertheless argue that these activities should count as

material participation. They say they alone managed their horse-breeding

operation because they decided how much to spend, selected pairings, and

authorized veterinary care for Phoenix Heat. But Phoenix Heat wasn’t born until

2004, and Debra didn’t see her until 2005, so any involvement they had with her

wasn’t material participation in 2002 and 2003. Plus we aren’t convinced that

they actually selected thoroughbred pairings--they signed contracts that didn’t list

any horses, signed a schedule A that listed nonthoroughbreds and a gelding, and

their “Outline of Facts” and Debra’s late-produced notebook aren’t consistent

about which pairings she purportedly requested orally. And deciding how much to

spend sounds a lot like an investment activity.

        Even if we counted all these things, it still wouldn’t help Scott and Debra.

Section 1.469-5T(k), Example (8), Temporary Income Tax Regs., 53 Fed. Reg.

5728 (Feb. 25, 1988), says that someone who owns an interest in a cattle business

and periodically makes unilateral decisions about feeding and selling the cattle

doesn’t satisfy the test in section 1.469-5T(a)(7), Temporary Income Tax Regs., 53

Fed. Reg. 5725 (Feb. 25, 1988), where someone else receives income for

managing the cattle’s day-to-day care. Changing “cattle” to “mares” in this
                                       - 35 -

[*35] example gives us something very close to Scott and Debra’s version of

events--even if we assume they made the financial and breeding decisions,

ClassicStar still managed the day-to-day care. Scott and Debra’s decisionmaking,

we find, doesn’t count as material participation.

      C.     Principal Purpose

      We note as well that the regulations say that hours spent on an activity don’t

count toward material participation if “[o]ne of the principal purposes for the

performance of such work is to avoid the disallowance, under section 469 and the

regulations thereunder, of any loss or credit from such activity.” Sec. 1.469-

5T(f)(2)(i)(B), Temporary Income Tax Regs., 53 Fed. Reg. 5726-5727 (Feb. 25,

1988). The evidence here shows ClassicStar repeatedly told the Householders to

read magazines and emails, listen to talks, and take trips. We agree that the

Householders followed those instructions and did all these things--but only

because they wanted the losses ClassicStar sold them. Virtually every hour they

spent was done to show material participation so they could avoid disallowance of

losses, which means those hours don’t count toward material participation.

      The Householders didn’t spend 500 hours a year breeding horses, they

didn’t handle any day-to-day operations or management, and they did what they

did just to avoid disallowance of their deductions. That means their involvement
                                       - 36 -

[*36] with ClassicStar’s mare-leasing program was a passive activity, and their

passive losses are allowable only to the extent that they have passive income.

III.   Trade or Business

       Even if Scott and Debra did materially participate in a horse-breeding

operation, we have another reason for disallowing their horse-breeding

deductions. Section 162(a) permits deductions for ordinary and necessary

expenses paid or incurred “in carrying on any trade or business,” but an activity is

a trade or business only if a taxpayer does it continuously and regularly with the

honest intent of making a profit. Commissioner v. Groetzinger, 

, 35

(1987); see also sec. 183(a), (c). Section 212 allows a taxpayer to deduct expenses

incurred in the production of income generally, but again only if he actually

intends to make a profit. See Bolaris v. Commissioner, 

, 1432 (9th

Cir. 1985), aff’g in part, rev’g in part 

 (1983); Allen v. Commissioner,

, 33 (1979); see also sec. 183(a), (c). A taxpayer’s profit expectation

doesn’t have to be reasonable, but it does have to be genuine. See Dreicer v.

Commissioner, 

, 645 (1982), aff’d without published opinion, 

 (D.C. Cir. 1983); Metz v. Commissioner, T.C. Memo. 2015-54, at *3;

sec. 1.183-2(a), Income Tax Regs.
                                        - 37 -

[*37] Taxpayers bear the burden of showing they had a profit motive. Wolf v.

Commissioner, 

, 713 (9th Cir. 1993), aff’g T.C. Memo. 1991-212. And

“profit” means economic profit--not tax savings. Id.; Surloff v. Commissioner, 

, 233 (1983). Did the Householders intend to make a profit breeding

horses?

      The regulations tell us to determine taxpayers’ subjective intent to make a

profit “by reference to objective standards, taking into account all of the facts and

circumstances.” Sec. 1.183-2(a), Income Tax Regs. They give us nine factors to

consider, but tell us that “[n]o one factor is determinative,” that we can consider

factors not on the list, and that we shouldn’t simply compare the number of factors

that suggest a profit motive to the number of factors that don’t. Sec. 1.183-2(b),

Income Tax Regs. The Seventh Circuit has called this “a goofy regulation” and

has said we’d be better off if, instead of “wading through the nine factors,” we

took a more holistic approach to determining whether a taxpayer intended to turn a

profit. Roberts v. Commissioner, 

, 250, 254 (7th Cir. 2016), rev’g

T.C. Memo. 2014-74. It did something like that in a recent opinion in a horse-

breeding case. See Estate of Stuller v. United States, 

, 896-98 (7th

Cir. 2016). But the cases before us are appealable to the Ninth Circuit, so we’ll

screw in our calks and into the mud we go.
                                        - 38 -

[*38] A.      Manner in Which the Activity Is Conducted

      The first factor tells us to look at how the taxpayer conducts the activity. It

says: “The fact that the taxpayer carries on the activity in a businesslike manner

and maintains complete and accurate books and records may indicate that the

activity is engaged in for profit.” Sec. 1.183-2(b)(1), Income Tax Regs. Scott and

Debra say they were businesslike because they researched ClassicStar, formed an

LLC and got it a bank account, maintained an activity log, and had a business

plan--not a written one, but one whose existence we should infer from their

actions. They also rely on a participation log that simply lists activities

ClassicStar told them to list and handwritten notes they say they’d misfiled for

nine years and fortuitously discovered only on the eve of trial. Their

administration of the LLC was hardly businesslike--they kept few records for it,

and they used its bank account to pay personal bills such as payments on their

Land Rover.

      Also unbusinesslike for people engaged in horse breeding was Scott’s and

Debra’s apparent uninterest in whether their horses got pregnant. Least

businesslike of all is their signing up for thoroughbred horse breeding purportedly

worth $802,000 in 2002 and $500,000 in 2003 without knowing what horses they

were paying to breed. For the 2002 program they signed contracts that referred to
                                       - 39 -

[*39] but didn’t actually contain a schedule of horses, and for the 2003 program

they signed a schedule that listed quarter horses and a gelding. And even if there

was a “verbal schedule A” or an oral agreement about placeholders or tradeouts--

which we doubt--the contracts themselves said any prior agreements were invalid

and said subsequent agreements were valid only if written. Signing such contracts

was, under the circumstances, decidedly unbusinesslike.

      This factor weighs against Scott and Debra.

      B.    Expertise of Taxpayers or Advisers

      Consulting with experts when preparing for an activity can suggest a profit

motive. Sec. 1.183-2(b)(2), Income Tax Regs. Scott and Debra say they consulted

extensively with two experts--themselves. They point out that Scott was a

successful businessman and that Debra spent time with horses in her youth. But

neither Scott nor Debra had any experience breeding thoroughbreds. Scott’s

background was in finance; and although a young Debra bred her show horse

Brandy Susie Bar twice, she managed to sell only one foal, and only for the

amount of the stud fee. These experiences did not turn them into thoroughbred-

breeding experts. And they can’t claim reliance on Holt or ClassicStar because

they were the ones selling them the program. See Romanowski, at *34-*35;

Pederson, at *42. This factor weighs against them.
                                        - 40 -

[*40] C.     Time and Effort Expended on the Activity

      “The fact that the taxpayer devotes much of his personal time and effort to

carrying on an activity, particularly if the activity does not have substantial

personal or recreational aspects, may indicate an intention to derive a profit.” Sec.

1.183-2(b)(3), Income Tax Regs. Scott and Debra argue that in addition to the

activities they recorded on their material participation log Debra spent “countless

hours * * * researching yearling sales information” for ClassicStar’s horses. But

that argument relies on the nanny’s unpersuasive testimony. See supra p. 30.

      Even the material-participation log fails to show devotion of much personal

time and effort. Close to half of the hours were logged for reading emails, articles,

and magazines, and these were the only activities for about half the months in the

log. Reading magazines doesn’t show time and effort spent managing a horse-

breeding business, and we have our doubts about how much time Debra actually

spent reading them--nothing about the log suggests that entries in it were made

contemporaneously with the activities recorded; and although Debra started

logging magazine hours in March 2002, she didn’t get information about the

magazines from ClassicStar until December of that year. Most of the rest of the

time was spent on trips to the Breeders’ Cup, the Kentucky Derby, Yellowstone,
                                        - 41 -

[*41] and the Virgin Islands--each of which included large dollops of recreation.

This factor also weighs against them.

      D.     Expectation That Assets Used in Activity May Appreciate

      An expectation that assets will appreciate can suggest a profit motive. Sec.

1.183-2(b)(4), Income Tax Regs. The Householders claim they expected to

receive and sell several foals, but the documents they reviewed and signed tell a

different story. The initial reports from ClassicStar show only losses, not profits.

Based on those reports, Scott and Debra decided to participate, signed the 2002

contracts not knowing what horses they were supposedly breeding, and signed a

schedule A for 2003 that included quarter horses and a gelding. And they knew

all along that they’d be able to exchange their mare-leasing interest for

participation in FEEP and Gastar, which also suggests that they weren’t really

interested in making money from horses. Deductible losses, not profitable foals,

are what they expected. This factor weighs against them.

      E.     Taxpayers’ Success in Similar Activities

      “The fact that the taxpayer has engaged in similar activities in the past and

converted them from unprofitable to profitable enterprises may indicate that he is

engaged in the present activity for profit.” Sec. 1.183-2(b)(5), Income Tax Regs.

The Householders point out that Scott ran an extremely successful financial
                                       - 42 -

[*42] advisory business and that Debra had experience with horses. But Scott had

no experience with thoroughbred breeding--although he testified that he did “due

diligence” on ClassicStar, he said Debra was the horse expert. See Annuzzi v.

Commissioner, T.C. Memo. 2014-233, at *26 (taxpayer’s success in concrete

business doesn’t show profit motive for thoroughbred activities). Debra also

lacked any experience as a manager of a breeding business--her horse experience

was hands-on and during her youth. And her two attempts at breeding her own

horse were commercial failures. This factor weighs against them.

      F.    History of Income or Losses With Respect to the Activity

      Long periods of losses following the initial startup phase can indicate the

lack of a profit motive. Sec. 1.183-2(b)(6), Income Tax Regs. The Householders

argue that their 2002 and 2003 losses were basically startup costs because they

expected to receive the 2002 program’s foals in 2004 and sell them in 2005. They

also say we shouldn’t count their continued losses against them because they

would’ve made money if ClassicStar had been on the level.

      It’s true that many businesses are unprofitable at first, and many also fail

without ever making money. But as we’ve already pointed out, the documents

Scott and Debra based their participation on show that they didn’t expect

economic profits--they expected only losses, and in amounts that would entirely
                                        - 43 -

[*43] offset their income. See supra p. 41. They can’t now argue that they

would’ve made money but for ClassicStar’s criminality when they never planned

to make money to begin with. This factor counts against them.

      G.     Amount of Occasional Profits, If Any

      Occasional profits can show a profit motive, but the size and frequency of

profits relative to losses are what matter. Sec. 1.183-2(b)(7), Income Tax Regs.

“[S]ubstantial profit, though only occasional” is therefore a better indicator of a

profit motive than “occasional small profit from an activity generating large

losses.” Id. Scott and Debra say this factor should count in their favor because

there was a small chance they’d make big money breeding horses. Once again, we

reject this argument because the record shows that losses, not profits, motivated

their involvement with ClassicStar. And the only horse-breeding revenue they

received was the $180,000 they got from the 2005 sale of Phoenix Heat, which

was occasional and small compared to the $1.3 million they claim to have spent in

2002 and 2003. This factor also weighs against them.

      H.     The Taxpayers’ Financial Status

      “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.” Sec. 1.183-2(b)(8), Income Tax Regs. In
                                         - 44 -

[*44] 2002 Scott and Debra reported $445,000 of income from the Householder

Group and $196,000 of COI income, and in 2003 they reported $420,000 of

business income. But thanks to the losses they reported from their involvement

with ClassicStar, they reported zero taxable income for each of those years--and

realized substantial tax benefits as a result.

      Scott and Debra say that horse breeding was Debra’s business and that we

should consider only her portion of their income when weighing this factor. But

by filing jointly they enjoyed the tax losses together. And their log credits Scott

with 121.5 of the hours, and only he went to the ClassicStar event in the U.S.

Virgin Islands. Scott and Debra together offset huge joint income with purported

joint losses from their joint involvement with ClassicStar. This factor weighs very

heavily against them.

      I.     Elements of Personal Pleasure or Recreation

      “The presence of personal motives in carrying on of an activity may indicate

that the activity is not engaged in for profit, especially where there are recreational

or personal elements involved.” Sec. 1.183-2(b)(9), Income Tax Regs. Scott and

Debra admit that Debra loved horses, yet they argue that personal pleasure wasn’t

a motive here because Debra didn’t spend time with them--after all, she was in

Arizona, and the horses were in Kentucky. Pointing out that Debra was thousands
                                       - 45 -

[*45] of miles from her horses is a curious way to argue that she was engaged in a

real horse-breeding business. More to the point, 160 of the hours in Scott and

Debra’s participation log are from trips--to the Breeders’ Cup, the Kentucky

Derby, Yellowstone, and the U.S. Virgin Islands. And the activities listed on these

trips are almost all recreational--tours, lunches, and dinners. Recreation was a

large part of Scott and Debra’s involvement with ClassicStar, so this factor counts

against them.

      This is not a case where slogging through the “goofy” regulation would ever

lead to a result different from taking a “holistic” approach. The regulatory factors

together show that the Householders got involved with ClassicStar with the intent

to generate losses, not profits. The documents ClassicStar sent them before each

breeding season showed them how to offset the income they expected from other

sources. They signed a 2002 contract not knowing what horses they were leasing,

and they signed a 2003 schedule of horse pairings that included quarter horses and

a gelding. The activities they logged were largely recreational. And from the

beginning they knew they’d be able to convert their mare-leasing interests into

stakes in related entities--some of which they later used to satisfy their NELC

loans. Looked at all together, we find that what they wanted from their horse-

breeding activity was tax savings to offset their large income from other sources.
                                        - 46 -

[*46] They lacked a subjective intent of making a profit. See Wolf, 4 F.3d at 713;

Surloff, 81 T.C. at 233. Scott and Debra’s purported horse-breeding activity was

not a trade or business.

IV.   Theft Loss

      The Householders argue that even if they didn’t materially participate in a

horse-breeding business they can still deduct as a theft loss any amounts they gave

to ClassicStar but didn’t get back. See sec. 165(a), (c)(3). To deduct a theft loss, a

taxpayer has to show by a preponderance of the evidence that theft or something

similar under state law caused the loss. See, e.g., Monteleone v. Commissioner,

, 692-93 (1960); see also sec. 1.165-8(d), Income Tax Regs. (“theft”

includes larceny, embezzlement, and robbery). The taxpayer also has to show the

year in which he discovered the loss, which becomes the year he can claim the

deduction as long as there’s no reasonable chance of recovery. See sec. 165(e);

sec. 1.165-8(a)(2), Income Tax Regs. And of course he has to show the amount of

the loss. See sec. 1.165-8(c), Income Tax Regs.; see also, e.g., Elliot v.

Commissioner, 

, 313 (1963).

      The Householders say that the federal criminal convictions of David

Plummer, Spencer Plummer, and Terry Green show that ClassicStar committed

theft by deception under Kentucky law. They also say they discovered the loss in
                                        - 47 -

[*47] 2006, when ClassicStar was raided, and in the same year determined that

there was no hope of recovery. In their opening brief they argue that they paid

$700,000--an amount that includes what they gave ClassicStar directly, the

principal and interest they paid on the short-term loans, and the interest they paid

on the long-term loans, but not the long-term loan principal they satisfied through

FEEP--but got back only $180,000 from selling Phoenix Heat, leaving them with a

$520,000 loss.

      The Commissioner doesn’t contest the amount the Householders paid, but

he says there was no loss. He points out that in addition to the $180,000 for

Phoenix Heat, the Householders received 75,000 shares of Gastar stock. They

exchanged part of their mare-leasing interest for these shares on the same day they

traded for their FEEP units--December 31, 2004. The parties stipulated that

Gastar stock traded at $16 at the end of 2004, which made these shares worth $1.2

million. And at the end of 2006--the year for which the Householders claimed a

theft loss--Gastar still traded at $10.75 a share, which made their shares worth

$803,000. ClassicStar didn’t steal from Scott and Debra--it gave them assets

worth more than they’d paid.

      Scott and Debra acknowledge that they received the Gastar stock. They

point out, however, that they weren’t allowed to sell it for one year without
                                        - 48 -

[*48] Gastar’s permission, and they say that even though they signed the purchase

agreements in December 2004, this restriction was still in effect at the end of 2006

because they didn’t actually receive the shares until “[s]ometime after” April of

that year.10 They now ask us to find a marketability discount for this restriction

and determine that they still had a loss.

      Scott and Debra didn’t present any expert testimony or other evidence that

would enable us to accurately determine a marketability discount for restricted

Gastar shares. They instead ask us to make a finding based on questionable

inferences. First, they say that because the 2004 purchase agreements allocated $3

to each Gastar share, we should find that $3 was the fair market value of a

restricted share at that time. Gastar was trading at $16 then, meaning the

marketability discount they want is over 80%. Next they say that because the


      10
         The purchase agreements had boilerplate clauses stating that the shares
weren’t registered, that Scott and Debra received them only under the accredited-
investor exemption, see Small Business Investment Incentive Act of 1980, Pub. L.
No. 96-477, sec. 602, 94 Stat. at 2294 (codified as amended at 15 U.S.C. sec.
77d(a)(5) (2016)); see generally Wright v. Nat’l Warranty Co., 

, 259-
60 (6th Cir. 1992), and that they cannot sell them unless the shares got registered
or an exception to registration applies. But the record also shows that Gastar was
publicly traded--the parties stipulated to Gastar’s share-price history and
introduced Gastar’s 2005 annual report, which says that its shares were listed on
the American and the Toronto Stock Exchanges. These facts overcome the
boilerplate clauses and lead us to find that they do not affect the value of the
shares.
                                         - 49 -

[*49] value of unrestricted Gastar stock dropped about 33% from the end of 2004

to the end of 2006, the value of restricted shares would’ve fallen by the same

percentage, making them worth just $2.11

      To make this finding we’d have to assume that the allocation on the

purchase agreement between the Householders and ClassicStar accurately valued

the stock. We won’t make that assumption. Scott and Debra entered into

agreements with ClassicStar that arbitrarily valued mare leases and related

expenses, and there’s no reason to think the allocation here is any more reliable.

We’d also have to assume that the marketability discount rate didn’t fluctuate over

time, and we’d have to ignore the fact that on their November 29, 2007,

bankruptcy proof of claim Scott and Debra valued the stock--which they said on

the claim they still hadn’t received--at $4.84 a share, only 9% less than the $5.30 it

was trading for that day. We won’t do that, either.

      More importantly, the Householders raised the issue of the Gastar stock’s

marketability for the first time in their reply brief, and we don’t let parties raise

new issues or theories on brief when doing so would surprise and prejudice the

other side. See Smalley v. Commissioner, 

, 456 (2001); Seligman v.

      11
        They didn’t do the calculation, but this would make their purported loss
only $370,000--the $520,000 they claim minus the $150,000 they now say their
shares were worth.
                                        - 50 -

[*50] Commissioner, 

, 198-99 (1985), aff’d, 

 (5th Cir.

1986). A party is prejudiced if it would need to present additional evidence to

respond to the new issue or theory. See Pagel, Inc. v. Commissioner, 

,

212 (1988), aff’d, 

 (8th Cir. 1990). To respond to the marketability-

discount theory, the Commissioner would have to amass evidence of what

restricted Gastar shares were worth. His lack of opportunity to do so would

prejudice him. We therefore won’t consider it.

       Scott and Debra didn’t lose the money they paid ClassicStar, so they didn’t

suffer a theft loss.

V.     Penalties

       The Commissioner determined section 6662 penalties against Scott and

Debra for 2001, 2002, and 2003. That section imposes a 20% penalty on

understatements that are substantial, see sec. 6662(b)(2), (d), or that are due to

negligence or disregard of rules and regulations, see sec. 6662(b)(1), (c). When

the taxpayers are individuals, the Commissioner has the initial burden of

production for penalties. Sec. 7491(c). He meets part of his burden for

substantial-understatement penalties here because Scott and Debra’s

understatements are more than $5,000 and more than 10% of the tax they

should’ve reported each year. See sec. 6662(d)(1)(A). He meets the initial part of
                                        - 51 -

[*51] his burden for negligence too because he showed, and we so find, that Scott

and Debra should’ve known that their return position--which offset all of their

income with horse-leasing expenses prepaid with sham loans--was too good to be

true, and they made no real effort to ascertain the correctness of that position. See

sec. 1.6662-3(b)(1)(ii), Income Tax Regs.

      A.     Reasonable Cause and Good Faith

      Scott and Debra say they’re not liable for penalties because they had

reasonable cause for their return position and acted in good faith when they took

it. See sec. 6664(c)(1); sec. 1.6664-4(b)(1), Income Tax Regs. They argue that

three things show their reasonable cause and good faith: They relied on a CPA,

they relied on Holt and PCG’s materials, and they conducted their horse-breeding

endeavor in a businesslike manner. We’ve already held that their conduct was not

businesslike, see supra pp. 38-39, so we address only the first two contentions.

      Reasonable reliance on an adviser such as a CPA can excuse a taxpayer

from an accuracy-related penalty. Neonatology Assocs., P.A. v. Commissioner,

, 98 (2000), aff’d, 

 (3d Cir. 2002). Reliance is reasonable

if:

      !      the adviser was a competent professional with sufficient
             expertise to justify reliance;
                                         - 52 -

[*52] !      the taxpayer provided necessary and accurate information to
             the adviser; and

      !      the taxpayer actually relied on the adviser’s judgment in good
             faith.

Id. at 99. Scott and Debra point out that they discussed their ClassicStar

participation with Stallworthy, their CPA, and the Commissioner doesn’t dispute

that she was a competent professional. But Stallworthy refused to give them an

opinion. She also didn’t come up with Scott and Debra’s return position--she

merely filled out their returns using numbers Scott gave her, and only after he

assured her that he and Debra materially participated. Far from relying on their

CPA’s advice, Scott and Debra told her what to do. That doesn’t protect them.

See, e.g., Bronson v. Commissioner, T.C. Memo. 2012-17, 

, at

*12-*13, aff’d, 591 F. App’x 625 (9th Cir. 2015); Kaplan v. Commissioner, T.C.

Memo. 2006-16, 

, at *23.

      Next they say that they reasonably relied on the opinion letter in the PCG

materials that Holt gave Scott. But the Householders can’t claim reliance on Holt

because commissions he received for placing people with ClassicStar make him a

promoter--someone “who participated in structuring the transaction or is otherwise

related to, has an interest in, or profits from the transaction.” 106 Ltd. v.

Commissioner, 

, 79 (2011) (quoting Tigers Eye Trading, LLC v.
                                        - 53 -

[*53] Commissioner, T.C. Memo. 2009-121, 

, at *19), aff’d,

 (D.C. Cir. 2012). Scott knew Holt was getting commissions for

placements with ClassicStar, and he knew Holt was placing multiple people in the

same program--another hallmark of a promoter. See id. at 80. No reasonable

reliance there, either.

      B.     Substantial Authority

      Scott and Debra also say they shouldn’t have to pay penalties because they

had substantial authority for their return position. Substantial authority is not a

defense to negligence; it’s a defense only to substantial understatements. See sec.

1.6662-4(d)(3)(iii), Income Tax Regs. And the tax opinion they got from Holt--

which is the only thing they say they relied on--doesn’t excuse their

understatement because “opinions rendered by tax professionals are not authority.”

Id. This argument also fails.

      C.     Section 6751

      Part of the Commissioner’s burden of production on penalties is showing

that they were “personally approved (in writing) by the immediate supervisor of

the individual making such determination.” See sec. 6751(b)(1); Graev III, 

at ___ (slip op. at 14). The Commissioner didn’t introduce any evidence of

such approval at trial, but we recently granted his motion to reopen the trial record
                                        - 54 -

[*54] and added to it penalty-approval forms for the 2002 and 2003 negligence

penalties. These are enough for the Commissioner to meet this part of his burden

of production for the 2002 and 2003 negligence penalties, and he’s conceded any

others.12 So, we sustain the section 6662 penalties for Scott and Debra’s 2002 and

2003 tax years and, despite their lack of reasonable cause or good faith, we don’t

sustain the section 6662(a) penalties for their 2001 tax year.


                                                      Decisions will be entered under

                                                 Rule 155.




      12
         More specifically, the Commissioner’s conceded the 2001 negligence
penalty and the 2001, 2002, and 2003 substantial-understatement penalties.