Business owners can reduce their taxable income by deducting "ordinary and necessary" expenses.
Having trouble interpreting taxspeak as it applies to the horse industry? Read on.
The United States’ tax code is written in a special dialect—call it “taxspeak”—that is nearly incomprehensible for most people. One way to make sense of taxspeak is to study the subject until you master it, but that takes substantial time and effort. A more practical approach is to find someone who already knows the language and can decipher it for you. B. Paul Husband is a Burbank, California, attorney with a rare talent: He knows the tax code and, more importantly, he can explain what it means without resorting to taxspeak. In this article he will help us interpret some of the important tax provisions affecting the horse industry.
“Depreciation” is taxspeak for “cost recovery.” It’s a common accounting practice that allows a business owner to use federal tax deductions to recoup the purchase price of a horse or other property used in the business. That’s a good thing, says Husband, because cost recovery puts money back in a business owner’s pocket to use for additional purchases. In the end, policy planners in Washington say, both individual business owners and the economy will benefit.
The IRS allows business owners to reduce their taxable income by deducting expenses that are both “ordinary and necessary.” As a general rule, if the qualifying purchase is for something that will be used up within 12 months, the entire purchase price can be deducted in the year during which the purchase was made. A bag of grain, a utility bill, veterinary charges, or employees’ wages are examples of expenses that generally can be deducted in full during the tax year in which the expenditures are made. There is no depreciation on these purchases.
If the purchase involves a business asset with a “useful life” of more than 12 months, however, the IRS requires a taxpayer to spread out the cost over several years. Farm vehicles, horse trailers, buildings, fencing, and horses all fall into the latter asset category. As Husband explains, cost recovery over a period of years (what the tax law is supposed to say) is called depreciation (what the tax law does say).
To provide some uniformity, and to avoid relying on fortune tellers to speculate how long a specific horse or other property might actually last, the tax code includes tables designating the official “useful life” of business assets.
“A taxpayer needs to know the age of the horse and how it will be used to determine the depreciation schedule,” Husband says. “Depending on those two factors, horses are depreciated over either three years or seven years.” Broodmares, stallions, horses older than 12 years of age, and racehorses depreciate over three years; broodmares, stallions, show horses, riding horses, or any other horse 12 years or younger depreciate over seven years.
How it works: The depreciation amount is called the animal’s “tax basis,” generally the purchase price. (Homebreds have a basis of $0 and cannot be depreciated.)
“Depreciation begins when the horse is ‘placed in service,’ ” Husband adds, “and that doesn’t always mean the year in which the horse is purchased.” A Thoroughbred yearling bought for racing might be considered “placed in service” when training starts in the fall of the yearling year or when the horse begins racing as a 2-year-old. The same yearling bought as a show hunter prospect might not be “placed in service” for tax purposes until much later.
The tax code from time to time also gives business owners an extra incentive to spend money on business assets by offering “bonus depreciation.” Actually calculating depreciation amounts is not for the faint of heart and probably best left to accountants and tax attorneys, but the idea behind “bonus depreciation” is to jump-start the economy. If the portion of an asset’s purchase price that can be deducted in the first year increases, legislative thinking goes, a business owner will pay less in taxes and will have more money to plow back into the economy.
Bonus depreciation was set at 50% through 2014, which allows a business owner to deduct a significant portion of an asset’s purchase price the first year. Depreciation is firmly entrenched in the federal tax system, and in one form or another is here to stay. Bonus depreciation can change, depending on Congress’ mood, but Husband expects that some amount of bonus depreciation will be renewed: “The economy still is recovering, and we’ll need continuing incentives to stimulate purchasing.”
In some situations a business owner can deduct the entire cost of a property in the year of purchase. It’s called “expensing,” and it bypasses one of the main drawbacks of bonus depreciation. Under current law, Husband says, only “original use” property is eligible for bonus depreciation. “ ‘Original use’ can be difficult to define,” he adds, “but, essentially, it means new property.”
An unraced, untrained Thoroughbred yearling is eligible for bonus depreciation because a buyer will be placing the horse in service for the first time. It’s a “new” horse for tax purposes. A Thoroughbred sold as a 2-year-old in training probably is not. Changing how the horse is used, buying a show hunter as a broodmare, for example, does not constitute a new “original use” for bonus depreciation purposes. The original use requirement applies to all business property being depreciated.
Expensing, on the other hand, “works with both new and used property,” Husband says. Depreciation and expensing deductions generally can be combined for maximum taxpayer benefit, using bonus depreciation for new property while expensing the cost of used property. There are expensing limits--$500,000 through 2014 in business property purchases each year. That limit, like bonus depreciation, is subject to congressional whim.
“The expensing limit was supposed to go down a few years ago, and it did,” Husband says. “But then the limit was retroactively increased again.” The fact that tax laws change frequently makes it important for business owners, or their accountants and attorneys, to stay abreast of shifts.
Business or Hobby?
Deciding whether an equine operation is a business or a hobby is an ongoing dilemma for taxpayers and the IRS. The answer determines the value of depreciation, expensing, and other deductions to the taxpayer. If the activity is a business, the owner can use deductions to generate a loss for the operation. Then the resulting loss can reduce taxable income from other sources. The result is a lower overall tax bill. If the activity is a hobby, however, the owner can deduct expenses only to the extent that the hobby generates income. While a business can show a loss, a hobby cannot—at least for tax purposes.
The business/hobby conundrum comes to the forefront when a taxpayer uses business losses from an equine operation to reduce other taxable income, paying less in taxes in the process. If the IRS disagrees and argues that the horse operation is a hobby, an audit ensues. The tax code goes into excruciating detail about the difference between a business and a hobby and identifies nine factors that can be used in making the distinction. Many disputes are resolved during informal negotiations between taxpayers and the IRS. If those negotiations fail, the business or hobby question is answered in federal tax court.
Husband doesn’t expect major law changes regarding the business/hobby question in the foreseeable future. The good news, he says, is there were relatively few audits of horse operations in three of the last five years. The bad news is the IRS might step up its enforcement efforts.
Related to the business/hobby question is the level of involvement a taxpayer has in a horse operation. “Material participation” is taxspeak for involvement sufficient to allow the taxpayer to use losses to reduce taxable income from other sources. Without material participation in the horse business, it is a “passive activity,” and losses can only be used to lower taxable income from other passive activities. The IRS is trying to avoid tax shelters by requiring that a taxpayer be actively involved in the business that is showing a loss.
Consider a professional with material participation in a business that produces significant income as well as a horse breeding operation that loses money. The taxpayer would benefit by using losses from the horse business to reduce the taxable income from his principal business. If the taxpayer also materially participates in the horse farm, the loss can be used to lower income from any other source. If there is no material participation in the horse business, however, the individual can only use losses to offset income from other passive activities, and not the main business.
The IRS is fond of using tests to establish or refute a horse operation’s business status and to confirm material participation. Husband identifies two tests as most common in the horse industry: the “500-hour test” and the “all facts and circumstances test.” A taxpayer can satisfy the first by documenting at least 500 hours of participation during the tax year. Satisfying the second requires what the name implies—an examination of all the relevant facts to evaluate material participation.
Husband says that only one recent tax court case addressed material participation in the horse industry. The taxpayers claimed more than 500 hours working on business related to their horse farm during the years in question, but documentation was scarce and the judge did not believe the allegations of time spent.
There are few guarantees in the tax world, but Husband offers some general suggestions to improve a taxpayer’s odds for success in a dispute with the IRS:
“Keep a calendar of all your activities relating to the horse business, and make the calendar entries contemporaneously.” Calendar entries made on an as-you-go basis have much greater credibility with the IRS or a tax court judge than a document created from memory in preparation for an audit or litigation. The activity calendar is important for two reasons, Husband says.
“In an audit, the IRS usually starts with a hobby loss challenge,” he says. “If the IRS wins with that argument, the deductions are lost. If the IRS loses and the court decides that the activity is a business, then the IRS can make a passive loss challenge. If the IRS wins with the second claim, the tax deductions may be delayed, but they are not lost and can be applied against passive income in the future.” Contemporaneous activity logs help prove the taxpayer operated in a businesslike manner, an important factor in resolving the business/hobby question, while also showing the level of taxpayer involvement in the activity to establish material participation.
“Keep business receipts and organize them,” Husband says. A receipt is proof that the expenditure actually was made, he says, and “any document prepared by a third party is good.”
Husband recommends opening separate banking and credit card accounts for an equine operation and suggests outsourcing bookkeeping to a professional. In addition to routine bookkeeping chores that busy taxpayers frequently push aside, professional accountants stay up-to-date on relevant changes in tax law and might be able to assist with an IRS audit. For do-it-yourself accountants, he advises having a professional review the books on a regular basis. It’s important to consult with experts in all areas related to operating a successful horse business, Husband adds, “not just trainers.”
Finally, Husband says every horse operation should have a business plan.
“The IRS loves business plans,” he says. “A plan only in the owner’s mind can work, but a written business plan always is better. The plan should be realistic, and that can be a problem for the horse business. A business owner can project future expenses fairly successfully, but it’s almost impossible to forecast income. There are too many variables.”
Owners should have a business plan in place and actually use it, as they would an activity log or calendar, rather than preparing one after the fact as a litigation exhibit. Business plans must be flexible and allow for changes in how the operation is run, based on information gathered from business records. A plan used to make changes in a business’ operation will be more persuasive evidence in a dispute than a plan that is not implemented.
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.
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