(used by permission from author)
By Kathleen A. Reagan, Esq.
Congress recognized a long time ago that taxpayers will try to claim federal income tax losses for activities at which the taxpayer has no genuine intent to create profit. The so called Hobby Loss provisions are found at section 183 of the Internal Revenue Code. Horse owners are a prime target of IRS “hobby loss” challenges, reflecting, of course, the fact that it is very difficult to actually make money in horses, yet many engage in the pursuit for the sheer enjoyment of it anyway. Here are seven tips that will make it easier to survive a so called “Hobby Loss” audit.
1. In the planning stages, consult with experts, self educate, and hire professionals in the area of financial acumen and in helping the business to become profitable.
Tax courts are concerned with the steps that the taxpayer took to make the business profitable. So, along with the education about the horses themselves, the taxpayer needs to engage experts in the field of making that particular equine business a profitable one.
Even if the taxpayer hired experts, if they were the kind of experts that advised the taxpayer about what kind of horses were best and how to become proficient at breeding them, and not necessarily how to make money at that business, then the court may not count that. That is, at least one court has ruled against the taxpayer overall, noting that the professionals hired were the same kind that the taxpayer would have hired if she was just engaged in a hobby (e.g. trainers.)
Self education is an important aspect of this; going to seminars, buying books and periodicals, attending shows, and engaging professionals for advice on particular issues, all of which will show a profit motive for the court. Also, get involved in the trade organizations, as this is usually a positive factor mentioned by the court. Using a trade organization to retain an expert that will help demonstrably change behavior in order to generate profits, is one way to help produce the profit motive ruling.
2. Use written business plans and other aspects of commercial behavior.
Business plans are a difficult issue, because horse values are difficult to measure. If a taxpayer produces a business plan that has unrealistic values plugged in, then the court will hold that against the taxpayer. One way out is to use the cash basis of accounting, and then to make major modifications, one or more to the operation, in an effort to make the business profitable. Or, create a business plan, and then work hard on documenting the values involved, with independent appraisals and regular updating of values, and regular efforts to change course in an effort to obtain profits.
A taxpayer can also help himself by engaging in the all of the aspects available for commercial behavior: incorporation, using letterhead, and so forth, that will demonstrate business like behavior.
– Use separate books and accounting.
Keeping good and separate records are an important aspect of business behavior. That is, the commingling of personal funds and business funds lends the appearance of a hobby. Keeping separate books will also help in keeping records of the expectation of appreciation. In any case where the taxpayer has not kept separate records and lost, this is mentioned as a substantial factor influencing the court’s decision. However, the mere keeping of books and a record of expenditures is not enough. The point of keeping books is not the mere recording of financial activity. Many cases have pointed out that the point of the recordkeeping is to allow the taxpayer to cut expenses, and to implement cost savings measures and improve profitability. One thing that will be very important in the record keeping effort, is to keep separate financial records showing the income and expenses associated with each horse, on a horse by horse basis. That is, start a file for that horse and keep the purchase records, sale documents, birth and registration documents, racing or showing and performance records, insurance records and veterinary records in it. The failure to keep such records has been held to show a lack of profit motive.
Documenting the tragedies and setbacks that occur both to the business and to each individual horse will help the court find that there may have been unusual factors that prevented a profit in any one year or for a series of years. So, keep a good record of these “profit busters” and document them fully. That way, if there are explained losses, the Tax court will be more likely to find a profit motive even in the face of sustained losses.
– Running the business: engage in substantial effort and time.
A good rule of thumb here is that the more time the taxpayer devotes, the better. If the taxpayer owns a farm, then the manual labor the owner expends does help show that the taxpayer is doing his best to create a profit. In this context, if the taxpayer has another job from which the taxpayer derives substantial income, which he then uses to offset with horse losses, then that is a factor which weighs heavily against the taxpayer. Conversely, if the taxpayer has no other source of income, then that is a factor which helps the taxpayer.
– Devote substantial resources in terms of adjusted gross income.
Some courts have looked at the percentage of available income the taxpayer is willing to devote to the activity. A taxpayer who devotes roughly over 30% of annual adjusted gross income will likely be seen as having a profit motive, whereas, a commitment of less than 10 percent is usually found to be consistent with a hobby.
– Avoid the appearance of pleasure or recreation.
This goes to the heart of the appearance of “hobby” for a court. That is, if the taxpayer would do this activity anyway regardless of any profit obtained, the court will be much more likely to find that the business is not being engaged in for profit. If the taxpayer or their children do like to ride for recreation, then there is a huge problem if the horses they are riding are the ones utilized in the operation. This can be overcome, but only with diligent attention to the other business attributes available.
– Generate sufficient revenues to offset significant losses.
If there is no income generated or there is a wide disparity of income generated, then the court will have a hard time finding profit motive if this disparity continues for a long time. Though there is a grace period typically during which a start up operation can suffer losses, this start up phase will be abbreviated by the court if the court finds that the taxpayer conducted the very same activity at a loss, and not as a business, in years previous. It is possible to help create a profit year, especially using a cash basis of accounting, if the horses are sold and expenses are taken outside the year in question. Keep in mind that failure to “cull” a herd is also mentioned in several cases as showing a hobby motive and not a business motive. Finally, again, get yourself armed with a good accountant in the equine field. That person can be of material help, and will help with specific details regarding individual taxpayers.
Kathleen A. Reagan, Esq. is an equine attorney practicing in Braintree, MA, available at www.kathleenreaganlaw.com. She has developed a course in equine law at www.concordlawschool.com and is co-founder and vice president of QueryHorse, the largest horse information resource on the Internet.