Business or Pleasure?
- Feb 1, 2002
If you think that you need help preparing federal income tax returns for your horse activity, then you should seek the assistance of a qualified accountant or tax attorney. If, on the other hand, you think that you can manage the task without professional guidance, you still probably need help. The Internal Revenue Code and its attendant Regulations comprise a virtually incomprehensible minefield, with numerous traps for the unwary or ill-informed. The goal of reducing the flow of money from your business to the government is best met with the aid of professionals who make taxes their business.
This is especially true in light of passage of the Economic Growth and Tax Relief Reconciliation Act of 2001. In addition to the tax rebate checks that almost everyone received, the Act makes several changes that can affect persons in the horse business. These include changes in the estate tax, tax treatment of limited liability companies and family limited partnerships, and retirement accounts.
In-depth treatment of any tax issue is beyond the scope of this article, which instead presents a broad outline of two issues of concern to nearly every horse owner. First, whether the Internal Revenue Service (IRS) will consider your operation a business; and second, whether the IRS will allow you to use losses incurred by your horse operation to reduce taxable income from any other businesses.
The "Hobby" Horse Problem
Apparently concerned that people were taking tax deductions for activities that they actually enjoyed, the IRS in 1969 enacted Section 183 of the tax code, severely restricting tax deductions for any activity (not just horse-related ones) that "is not engaged in for profit." In other words, if the IRS thinks your two-horse dressage stable is merely a pleasurable hobby, and not a business activity with a legitimate profit motive, your expenses for the stable will not be deductible on your federal income tax return. Any income you manage to earn through your "hobby" is, of course, taxable.
From a tax liability standpoint, it almost always will be to your advantage to have the IRS consider your horse operation a for-profit activity, even though running a business does require better and more extensive record keeping. Getting a "for-profit" designation often is easier said than done, however.
Because the IRS understands profits, the easiest way to establish that you are running a for-profit business is to make money with your horses, at least occasionally. If the major part of your business involves either the "breeding, training, showing, or racing of horses," and if you show a profit for two out of seven years, the IRS will presume that you are conducting a for-profit activity. This presumption shifts the burden to the IRS, which must prove that your horse activity is not really a for-profit business if your deductions are questioned.
The "two-of-seven" test often can be met simply by grouping sales of horses in one year rather than spreading those sales over two or three years, or by shifting major expenditures from one calendar year to another. There should be a legitimate business purpose other than tax avoidance for such income/expense scheduling, however. Check with an accountant or tax attorney.
A common misconception is that a horse activity is required to show a profit for two of seven years to be considered a legitimate business by the IRS, but this is not the case. Although passing the profitability test is the surest way to have your activity characterized as a business for tax purposes, there is another route. Even if you do not make a profit in two of seven years and do not have the for-profit presumption in your favor, you might well be able to convince the IRS that your horse activity is conducted with the goal of showing a profit, based on the way you conduct the activity.
The IRS will evaluate your horse activity by looking at all of the facts and circumstances of your activity. The most common factors considered, and the ones set out in the IRS regulations, are:
- The general manner in which the taxpayer carries on the activity. Among the things that might indicate a legitimate profit motive are accurate and separate books and records, whether your activity is conducted in a manner similar to other horse activities that are profitable, and whether you are willing to change your operating methods in a way intended to improve profitability.
- The expertise of the taxpayer or his or her advisors. The IRS expects a taxpayer with a profit motive either to be an expert in the business, become an expert through study, or have advisors who are experts. If you have expert advisors, but disregard their advice, it might indicate to the IRS that you are not serious about making money with your horse activity.
- The time and effort expended by the taxpayer in carrying on the activity. In a nutshell, the more time you spend with your horse activity, especially at the exclusion of other profitable enterprises, the more likely the IRS will decide you have a legitimate profit motive. If the activity lacks "substantial personal or recreational benefits," so much the better.
- An expectation that assets used in the activity might appreciate in value. The IRS recognizes that "profit" can be more than just money coming in to your business. Purchase of land, construction of buildings, or acquisition of breeding stock, all of which you expect to appreciate over time, can show a profit motive.
- The success of the taxpayer in carrying on other activities. The IRS also will look at your track record with other horse activities, and with other business ventures in general. If your current equine activity is the most recent in a series of successful ventures, you likely will have better luck with the IRS than if your present activity is one of many failures.
- The taxpayer's history of income or losses with respect to the activity. The IRS will look at your track record with the current activity to determine whether you generally lose money, whether you generally show a profit, or whether you come close to the profitability mark. Several losing years at the start, or losses due to factors beyond the control of the taxpayer, might not indicate the lack of a profit motive, but the IRS will be harder to convince the longer the string of losing years continues.
- The amount of occasional profits, if any, which are earned. Unless your profits and losses are timed to satisfy the two-of-seven test, a few tiny profits stacked up against a series of large losses might indicate to the IRS that your horse activity is not a legitimate business. These "occasional profits" will be compared to the losses generated by your horse activity and by the amount of your overall investment in the activity.
- The financial status of the taxpayer. If your horse activity generates a substantial portion of your overall income, the IRS is more likely to believe that you have profit motive, simply because you need the horse business to earn a living. Conversely, if you have substantial income from other sources, the IRS is more likely to decide that you do not have a genuine profit motive for your horse activity.
- Elements of personal pleasure or recreation. You do not have to hate what you are doing to have it qualify as a legitimate business for tax purposes, although IRS regulations certainly make it seem so. The more fun you derive from your horses, the more important it is to conduct your horse activity in the most businesslike manner possible. Done properly, a horse activity can be enjoyable and a legitimate business.
The IRS states that this list of factors is not all-inclusive, and that other relevant factors can be considered as well. In practice, however, tax courts seldom stray beyond these nine factors in deciding whether the IRS or the taxpayer wins. Even if you plan to prepare your own tax returns, you should retain a tax attorney if you decide to challenge the IRS in court. Although tax court decisions are very fact-dependent, a clear trend is that taxpayers who represent themselves nearly always lose. The consequences can be staggering, and devastating, to a small business.
Passive or Active?
Another potential limitation on your ability to deduct the expenses incurred by your horse activity involves the level of your participation in the activity. Simply put, the Tax Code characterizes certain activities as "passive," and defines those activities as ones in which the taxpayer does not "materially participate." A taxpayer will be presumed to be a material participant in an activity if he or she spends an average of at least 10 hours per week on the activity. This is a laughable minimum for horse owners who exercise and groom their own horses, do their own stable work, and participate in shows throughout the year.
The question of material participation becomes more problematic if the taxpayer's only involvement comes as a limited partner in a racehorse, for example, or if the taxpayer has employees who do most of the barn work. For these taxpayers, detailed record keeping that sets out the time spent on the activity is essential.
Losses generated by a passive activity are limited to the income produced by other passive activities, and such losses generally cannot be deducted from non-passive income.
Whether a particular activity will be characterized as passive depends heavily on the facts and circumstances of the situation. IRS regulations provide a few guidelines, however. If the taxpayer participates in the activity for more than 500 hours in a year, it will constitute material participation. If, on the other hand, the taxpayer participates 100 hours or less during a year, it will not constitute material participation sufficient to avoid the passive loss restriction. If a taxpayer's involvement falls somewhere between the two levels of participation, a fact-specific determination will be made.
The implications for many horse owners are troubling. Consider, for example, the owner/operator of a successful bakery, who also owns a small show hunter stable that is running in the red. That taxpayer can use the losses from his horse activity to reduce his overall tax liability only if he materially participates in the operation of the hunter stable. Without material participation in the show stable, the activity will be considered a passive activity, whose losses cannot be applied to the bakery, which is presumably a non-passive activity.
Considering the fact that dealing with the IRS is, at best, an unpleasant experience, it is understandable that many taxpayers think of taxes only as the filing date approaches. It should be clear, though, that nearly any business decision has potential tax implications, and that tax planning always should be a work in progress. Although you can go it alone, tax matters are dangerous waters. Safe passage requires accurate and comprehensive record keeping, realistic and flexible business planning, and probably some expert assistance from an accountant or tax attorney.
TAX RELIEF AND MARE REPRODUCTIVE LOSS SYNDROME
Although the final toll probably never will be known with certainty, it is clear that economic losses attributable to mare reproductive loss syndrome (MRLS) in Kentucky alone will total hundreds of millions of dollars. State aid for breeders is unlikely due to budget constraints, and proposed federal low-interest loans, if approved, will not be available to everyone. A logical question, then, is whether a breeder who suffered an economic loss either as a result of early fetal loss or late-term abortion is entitled to tax relief.
All legitimate expenses incurred in attempting to get a mare in foal, such as the stud fee, veterinary bills, and costs for board and upkeep, are deductible as ordinary business expenses, assuming the IRS recognizes your horse activity as a business. This is true regardless of whether the mare actually produces a live foal. If the mare was bred to a stallion with a live foal guarantee and the stud fee is returned to the breeder due to the loss of the foal, whether due to MRLS or some other cause, the stud fee will be counted as income in the year received. The stud fee presumably was deducted in the year paid.
More problematic is trying to deduct the potential value of the foal that was lost to MRLS, or to some other abortion-causing disease. Although such a deduction might make logical sense, the IRS does not authorize a tax deduction for the loss of anticipated, but unrealized, income. No matter how certain a breeder might be of the potential value of a foal, until the foal is actually sold, there has been no receipt of income by the breeder. The IRS does not allow a deduction for the loss of something the taxpayer never had in the first place.
About the Author
Milt Toby is an author and attorney who has been writing about horses and legal issues affecting the equine industry for more than 40 years. Former Chair of the Kentucky Bar Association's Equine Law Section, Milt has written eight nonfiction books, including national award winners Dancer’s Image and Noor. He teaches Equine Commercial Law in the University of Louisville's Equine Industry Program.
POLL: Who Eats Breakfast First?