Using Equine Activity Losses To Achieve Overall Tax Savings

Most performance horse owners begin their horse ownership and performance horse activities for purposes other than pecuniary (monetary) gain. Nevertheless, many hope eventually to turn a profit as their horse progresses in skill or as their equine business develops. If you treat your equine activities as a business, you might be able to use any losses incurred in those activities to offset other income. Early tax planning strategies can lead to an unexpected reward, an indirect subsidy by the federal government of your equine activities.

Assume the following situation: Mr. Smith, a performance horse owner, earns $500,000 from wages and non-equine related business activities in 1996. Due to the purchase of two new horses and other related expenses, Mr. Smith's equine-related business activities incur total losses in 1996 of $100,000. Assuming Mr. Smith has no other deductions and if the equine activity qualifies, he will be able to reduce his taxable income to $400,000 by deducting the $100,000 equine loss. At a combined federal and state marginal tax rate of 45%, the horse owner would save $45,000 in taxes from this deduction. Put another way, it will have cost Mr. Smith only $55,000 to invest $100,000 in his equine activities in 1996. The other $45,000 is effectively provided by the federal and state governments.

For equine activity losses to be deductible against other income, early tax planning is crucial. Two provisions of the Internal Revenue Code (the "Code") operate to deny this deduction if the taxpayer either engages in his equine activities as a hobby or fails to materially participate in the activity (a "passive activity"). Section 183 of the Code provides that expenses from a "hobby activity" can only offset income generated by that hobby activity. If hobby expenses exceed hobby income, those expenses must be carried over and can only be used to offset future hobby income in later years.

Section 469 of the Code provides that if a taxpayer does not materially participate in an activity that generates a loss, that loss can only be used to offset income from other activities in which the taxpayer does not materially participate. If a taxpayer's equine activity is not considered a hobby and the taxpayer materially participates in the activity, all net losses from the activity can be used to reduce the taxpayer's overall tax liability. This article considers the hobby loss restrictions.

An activity is treated as a hobby if it is not engaged in for profit. A taxpayer can avoid hobby characterization by either taking advantage of certain presumptions provided in the Code or by treating the activity as a business and showing, on a factual basis, that the taxpayer intends to treat the activity as a business and hopes to turn a profit.

Facts and circumstances: The IRS considers nine objective factors when making a determination of whether an activity is a business or a hobby:

1) The manner in which the taxpayer conducts his horse activity. This includes, among other things, an analysis of books, records, and business practices--accurate accounts of operations and expenses, use of professional accountants, advertising, and exhibiting at horse shows.

2) The expertise of the taxpayer or his advisors. Here, the IRS will look at the degree of research and study undertaken by the taxpayer or his advisors of the economics of conducting the horse activity and whether the taxpayer makes use of this information in the actual conduct of the horse activity.

3) The time and effort expended by the taxpayer in carrying on his horse activity. With this factor, IRS is concerned with whether the taxpayer merely obtains enjoyment from the activity or actually engages in all activities necessary to promote the activity as a business. Significant time spent by the taxpayer doing non-recreational horse-related activities such as "mucking out" stalls, breeding horses, delivering foals, attending to sick or injured horses, and grooming evidence that the activity has a business orientation. If a horse owner employs competent and qualified persons to carry on these various activities, the lack of time actually spent by the horse owner does not necessarily indicate a lack of profit motive.

4) The expectation of appreciation in value of assets used in the horse activity. Even if a horse owner shows no profit from current operations, he might be able to demonstrate an overall profit motive if the appreciation in the value of the land, horses, and other assets is taken into account, together with the current income from the equine activity.

5) Success of the taxpayer in carrying on other horse activities. If the taxpayer has had previous success in other equine-related activities, such as breeding or stabling, the taxpayer is more likely to be engaging in business in his new activity.

6) History of income or losses in the horse activity. Clearly a profit from the equine activity evidences a profit motive. However, a series of loss years indicates the activity is a hobby if these losses continue beyond the period normally required to make the equine activity profitable.

7) Amount of profits earned in the activity. A sizable profit in one year might offset a series of loss years.

8) Financial status of the taxpayer. If the taxpayer has significant income from sources other than the horse activity, IRS may determine that the horse activity is not a business. If, however, the taxpayer relies on the activity as his means of support, the activity appears more in the nature of a business.

9) Personal pleasure and recreation motives in carrying on the horse activity. Personal motives in carrying on an activity might indicate that an activity is not for profit, especially where there are recreational and personal elements involved.

Presumption

The Code provides a presumption in certain circumstances that an activity is engaged in for profit. A specific presumption is available to horse activities. A taxpayer is presumed to be engaged in breeding, training, showing, or racing of horses for profit if profits result in two out of seven years. An equine activity that shows two profitable years within a seven-year period is presumed to be a business endeavor entitling the taxpayer to deduct all ordinary and necessary business expenses incurred in connection with the activity against all income. A similar presumption applies to non-horse-related activities where profits are shown for three of five years. This presumption applies to the second profit year and the remaining years within the relevant seven-year period. Note, this is merely a presumption; IRS can still challenge the activity as not being engaged in for profit, but IRS bears the burden of making this showing based on the nine factors outlined above.

There are two ways that a taxpayer can take advantage of this presumption. A general presumption arises automatically with respect to loss years following two profit years. If the taxpayer has two profit years in a row, the activity is considered to be engaged in for profit even if the taxpayer experiences a loss in each of the remaining five years.

A special presumption is available if the taxpayer makes an affirmative election with his tax return. The taxpayer can elect to postpone a determination as to whether the profit presumption arises. This election raises a special presumption that allows the taxpayer to avoid a determination as to the profit character of his or her activity until the close of the sixth taxable year following the taxable year in which the taxpayer first engages in the activity. A taxpayer should elect this special presumption: 1) Where the activity suffers loss years before its profit years, and the taxpayer wishes to deduct these losses; or 2) Where one of the required profit years comes between two loss years, and the taxpayer wishes to deduct the losses for both years.

If you think you might want to elect this special presumption, keep in mind that the election must be filed within three years after the original due date of the return for the year in which the activity is initially engaged.

In sum, a taxpayer can use equine activity losses to offset other income if the activity appears to be an activity engaged in for profit. If the taxpayer has the requisite two profit years, a statutory presumption is available that the activity is engaged in for business. If the taxpayer expects to have at least two profit years in the next seven, he should seriously consider making an election to defer the determination until the end of the seven-year period and take advantage of the special presumption. Keep in mind that even if the taxpayer never experiences a profit in his equine activities, the activity might still be considered to be engaged in for profit.

There are a number of decisions in which courts have noted that while equine activities generally are unprofitable, there is a small chance that the taxpayer might train a successful horse and earn significant prize money from racing or horse shows and earn substantial profits from breeding rights. Because of this profit potential, the courts have in some instances allowed equine business to be treated as engaged in for profit despite the fact that those activities never actually generated a profit. Nevertheless, the courts analyze the equine operation under the nine factors to determine whether the taxpayer treats the activity as a business.

If you wish to take advantage of using your equine losses to offset other income, you should consult with a competent tax advisor. Further, you should keep accurate records of all of your equine-related income and expenses as well as a record of the activities you perform in the equine business and the amount of time you spend performing them. When beginning your equine activity, you should research the activity and develop a business plan that outlines how you plan to approach the activity, your estimated income and expenses, and a long range plan detailing how you expect to make the activity profitable. Even if you overcome the hobby restrictions of section 183, you must also materially participate in the activity to be entitled to offset equine losses against other income. A competent tax professional can assist you in explaining the level of participation necessary to be material and in preparing the necessary documentation to substantiate your participation.

About the Author

Timothy J. Eifler

Attorney Timothy J. Eifler is a member of the law firm of Stoll Keenon Ogden, PLLC in Louisville, Ky. His practice encompasses litigating tax issues in the federal and state courts as well as providing advice and planning assistance with tax-oriented transactions. Eifler graduated magna cum laude from the T.C. Williams School of Law at the University of Richmond.

Stay on top of the most recent Horse Health news with FREE weekly newsletters from TheHorse.com. Learn More

Free Newsletters

Sign up for the latest in:

From our partners