Plaintiffs lived in Illinois, where they owned several restaurant franchises, and also bred horses. In 1985, they purchased a horse farm in Tennessee, where they entered into an oral agreement with a horse trainer to train their Tennessee Walking Horses and manage their farm.

Plaintiffs founded LSA, an S-corporation, as a horse-breeding operation. By 1999, they had purchased a house and adjoining 332 acres for around $800,000. The property was owned by each Plaintiff individually as trustees of a revocable trust, with each other as a beneficiary. However, Plaintiffs continued to live at their home in Illinois.

Following an audit, the IRS determined that the horse-breeding was not an activity engaged in for profit under 26 U.S.C. § 183. As such, Plaintiffs couldn’t claim deductions for the S-corporation’s losses. Plaintiffs paid the assessments but filed suit in the district court for a refund.

Before trial, citing Daubert, the government moved to preclude the horse trainer from testifying as an expert on whether Plaintiffs’ horse-breeding was carried on with the intent to earn a profit. The district court allowed the horse trainer to testify, reserving its ruling on the Daubert motion. After trial, the judge granted the motion, holding that the trainer’s expertise didn’t extend to the financial or business aspects of a horse-breeding operation, and he lacked a reliable methodology to opine on Plaintiffs’ intent.

The district court held that LSA was not operated with a good faith intent to profit, and therefore its losses weren’t deductible as business expenses, citing the unbusinesslike manner in which Plaintiffs operated LSA, their history of steady losses with only one barely profitable year, and the substantial tax benefit LSA provided to Plaintiffs, in light of their income from other business ventures. Plaintiffs argued that the district court’s exclusion of the horse trainer’s expert testimony didn’t adhere to the Daubert framework and ignored the record.

The Court of Appeals, Manish S. Shah, District Judge of the United States District Court for the Northern District of Illinois, sitting by designation, explained that the district court followed Daubert. It considered whether the horse trainer was qualified in the relevant field (i.e., the business and financial aspects of horse-breeding) based on his education, training, or experience, as is required by Federal Rule of Evidence 702. The district court examined whether the trainer used a reliable methodology and analyzed the bases for his conclusions, the materials that he did or didn’t review and whether he considered any factors outlined in Treasury Regulation § 1.183–2(b) or any other relevant factors. In making its determination, the district court didn’t ignore Plaintiffs’ arguments and evidence in the record. The judge recognized that he was a horse trainer and that he was testifying based on his observations from day-to-day operations of the farm—but there was an insufficient foundation for expert testimony. The issue for which the horse trainer was offered as an expert was whether the S-Corp’s horse-breeding activity was run with the intent to profit.

Judge Shah wrote that a witness may be qualified as an expert through “knowledge, skill, experience, training, or education,” citing Rule 702, and the trial judge acknowledged that the trainer had over 50 years of experience in training and breeding horses. However, the district court found that the horse trainer’s expertise didn’t extend to the financial and business aspects of running a horse-breeding operation. Judge Shah said this was quite clear, as the horse trainer testified that he didn’t breed horses to make money and that it had been years since he sold a horse that he had bred. His income was largely derived from training horses.

The district court also didn’t abuse its discretion in finding that the trainer lacked a reliable methodology. Plaintiffs admitted that the trainer was unaware of and didn’t consider the nine, non-exhaustive factors relevant to determining whether an activity is engaged in for profit, as listed in § 1.183–2(b). He was also unfamiliar with LSA’s finances and didn’t review its business or financial records. Instead, his method was to draw a conclusion based on his observations of the farm over the years and his oral agreement with Plaintiffs. Citing Kumho Tire, Judge Shah explained that Rule 702 requires an expert’s testimony to have “a reliable basis in the knowledge and experience of [the relevant] discipline.” Given the trainer’s failure to consider the financial records of LSA and his unfamiliarity with the relevant factors outlined in § 1.183–2(b), Judge Shah held that the district court was well within its discretion to exclude the horse trainer’s expert testimony as unreliable.

The trainer didn’t have any specialized experience or reliable method to draw upon when opining on the intent of the Plaintiffs to turn a profit. In fact, Judge Shah held that he was at most a lay witness to the operations on the farm. The trial court properly considered some of his testimony in that proper context, but correctly disregarded the horse trainer’s opinion about the Plaintiffs’ intent.

Plaintiffs had substantial business experience operating their restaurant franchises, but horse-breeding was a very different kind of activity, and there was no evidence that Plaintiffs consulted with any experts regarding methods for running a profitable horse-breeding enterprise. Plaintiffs argued that they received advice from their accountant and the horse trainer, but neither had expertise in the financial or business aspects of horse-breeding. Judge Shah said that a taxpayer’s failure to acquire expertise or consult relevant experts indicates a lack of a profit motive.

The Plaintiffs never came close to turning a meaningful profit through LSA, and there wasn’t any evidence that LSA’s operations were like horse-breeding operations that generated substantial profits. From 1994 to 2009, it lost money every year except 1997, when its annual profit was $1,500. As a result, the Plaintiffs’ belief that one or more of their horses might achieve great success was at the most a “mere expectation” that was “utterly lacking in ‘any probative foundation.’”

The judgment of the district court was affirmed.


Estate of Stuller v. United States, 811 F.3d 890 (Cir. 7 Jan. 26, 2016).