He
was a feared NFL football player. He played in the league for 16 seasons,
winning 4 Super Bowls. He was ... volatile, at best. In 1997 he broke the jaw
of Carolina Panthers quarterback Kerry Collins. He spat in the face of San
Francisco 49ers wide receiver J.J. Stokes during a Monday night game. In 2003 he confronted a player on his own team,
ripping off that player’s helmet and crushing his eye socket with a punch.
His
name is Bill Romanowski (BR). And he now has entered the tax literature.
BR
decided to get into horse breeding – sort of. There is a Code section that
disallows losses incurred in what the IRS considers a “hobby.” The IRS
understands that one can try and fail in a business venture, but it wants the
venture to truly be profit-driven. It is not interested in allowing losses from
a weekend racecar hobby, or Tennessee walking horse competitions for one’s
teenage child, or (more recently) owning an Amway distributorship. There are
numerous factors to consider: one’s past experience and familiarity with the
business or industry, development of a business plan, reaction to and modification
of that plan when confronted with losses, and so on.
Horse
breeding is a likely area for hobby-loss challenge by the IRS. It is also (or
at least used to be) a popular tax shelter area. BR got involved and combined
the two, to a financially detonative extent.
BR
and his wife for many years used a financial planner by the name of Kathy
Lintz. It sounds like she did a good job, including managing their portfolio and
providing them a monthly stipend. Ms. Lintz also collected financial
information for their tax returns and engaged a CPA. She would review the
completed tax returns before sending them to the Romanowski’s.
During
2003 BR had tax issues with a real estate investment in Colorado. Ms. Lintz put
BR in touch with Rodney Atherton (Atherton), a partner at Greenberg Traurig in
Denver. BR went to Denver to discuss real estate, at which time Atherton told
BR about a horse-breeding business, ClassicStar, which had retained his firm. It
sounds like the meeting went well, as BR retained Greenberg Traurig. BR also
wanted more information about the horse breeding deal.
BR
received documents frequently associated with a tax shelter:
- a 53-page opinion letter from the law firm Handler, Thayer& Duggan, LLC regarding tax aspects of horse-breeding;
- a 22-page opinion letter from the accounting firm Karren, Hendrix & Associates regarding tax aspects of the horse-breeding business, and
- a 6-page opinion letter from Karren Hendrix & Associates regarding tax aspects of NOLs generated from a horse-breeding business.
OBSERVATION: Folks, I am a career tax
CPA. I have received and reviewed attorney opinion letters over the years.
Allow me to assure you that such letters are not normal business practice. It
is however normal tax shelter business practice. And your first clue that you
are leaning a bit far over the ledge.
How
did the deal work? It was relatively simple: BR would lease mares owned by
ClassicStar, which in turn would provide boarding and care for the mares and
breed the mares to stallions. Any foals produced from the breeding would belong
to the Romanowski’s.
How
much would this cost BR? Karren Hendrix, who did accounting work for
ClassicStar, sent an “NOL illustration” regarding BR to Atherton. In the NOL illustration,
Karren Hendrix estimated that BR needed an NOL of over $13 million to offset his
taxable income from 1998 to 2003.
In
2003 Atherton and BR again traveled to Kentucky. This time Mrs. Romanowski
reviewed the materials and made the trip to Kentucky. They toured the
ClassicStar operation, saw the horses, visited auction houses, and met with
ClassicStar personnel.
The
Romanowski’s decided to invest approximately $13 million.
OBSERVATION: Wow! I wonder how they came
up with that amount?
Ms.
Lintz, the financial advisor, was adamantly opposed. She believed it a tax
scheme and a threat to the Romanowski’s financial health.
BR
blew her off.
The
Romanowski’s created Romanowski Thoroughbreds, LLC, through which they would
operate the horse activities.
In
December 2003, the Romanowski’s wrote a $300,000 check to ClassicStar as a
deposit. They then signed a mare lease and board agreement with ClassicStar. Pursuant
to the agreement, Romanowski Thoroughbreds agreed to spend $13,092,072 on the breeding
program to produce foals.
Mind
you, when the Romanowski’s signed this agreement, they had not negotiated or seen
any list of horse pairings. Rather, they relied on ClassicStar to pick the
horse pairings and to set the fees and expenses they would pay.
Right....
They
later received a list of the horse pairings they would receive. They would
receive 68 pairings, but only 4 of the 68 pairings were to thoroughbreds. The remainder
were to quarter horses.
NOTE: What?? Sounds to me like a good
time to call the attorney and back out of this deal, right?
The
Romanowski’s were assured by ClassicStar that they would substitute an unknown
number of thoroughbred pairings for quarter horse pairings. Of course, nothing
was written down.
Right....
Meanwhile,
Ms Lintz became aware that Atherton was receiving a “due diligence fee” from
ClassicStar. She was concerned, as she considered it a conflict of interest. Why?
Because Atherton was the Romanowski’s attorney, and he was suppose to have
their best interest at heart.
In
February 2004, Ms. Lintz resigned as the Romanowski’s financial adviser,
partially because of their investment in the horse program. Her resignation
letter states that the Romanowski’s choose to “enter into an aggressive tax
shelter.”
Later
that month Ms. Lintz sent the Romanowski’s another letter identifying two
independent horse and tax experts whom they could contact if they “need[ed]
further assistance”. The letter stated that one of the experts told Ms. Lintz
that ClassicStar had “come on strong in
the last couple of years” and that there had been “No scandals thus far” even
though “some of the principals were involved in bad prior deals.”
OBSERVATION: Ms. Lintz sounds like a
very attentive financial advisor for her clients.
Atherton
of course denied receiving any improper payments from ClassicStar. What
happened is – if Atheron referred a client to ClassicStar - ClassicStar would
pay Atherton a percentage of the deal. Atherton
would escrow the funds and bill against them at a much higher hourly rate than
his normal rate. For example, in an email to another client, Atherton wrote:
“Here is what I propose, I simply bill my time
on your clients at a premium--I usually bill 365 an hour. Are [sic] okay if I
bill 1000 an hour and just charge an
hourly rate?
He
of course never told the Romanowski’s about any arrangement.
NOTE: Nice guy. We will probably hear
his name again when he runs for Congress.
In
a completely unexpected development, ClassicStar filed for chapter 11
bankruptcy protection in 2007. The Romanowski’s filed claim in the bankruptcy court
and also filed separate claims against ClassicStar and against Greenberg
Traurig.
Fast
forwarding, the IRS challenged the whole deal as a hobby, wanting back over
$4.7 million dollars of tax refunds. Oh, they also levied an accuracy penalty
of over $950,000 to boot.
They
go to court. The experts trot out onto the field. The IRS expert asserts that
the activity “had absolutely no chance of making a profit”.
The
Romanowski’s expert counters:
“that
there was absolutely no chance that any of the non-Thoroughbred horses listed
on * * * would produce profitable foals.”
The expert argued that the quarter
horses “were obviously placeholders” and that if ClassicStar “had honored their
contract and provided Thoroughbred mares of at least the same quality as
those * * * [eventually bred for petitioners] then there was definitely profit
potential.”
Wow!
And this is the taxpayers’ expert?
The
Tax Court decided against the Romanowski's. They now owed well north of $4
million in taxes. The Court did however let them off the hook for the accuracy
penalties, though. The Court felt that their reliance on an attorney was
sufficient to avoid the penalty. Small victory, I suppose.
MY
TAKE: The IRS took a risk, as they have lost their share of horse-related
litigation. The courts have been receptive to the “long shot” argument: someone
could legitimately keep funding a losing business if the payday would be
outsized. Why would the IRS pursue the case? There is one feature here the IRS
likes: the recognizable taxpayer name. No one would note or remember if you or
I lost a tax case. Substitute Brad Pitt, however, and you have something.
But
quarter horses ...? What was Romanowski thinking? The only way Romanowski could have
made money off this deal is if he bought a lottery ticket while he was visiting
Lexington.
