Brian C. Bernhardt
for Virginia Business
The May cover story of Virginia Business explores the growing horse industry in the commonwealth. As the industry has grown over the years, however, it has also attracted the attention of the IRS. As with all businesses, the IRS is not only concerned with whether owners of horse-related businesses are including all of their revenue on their tax returns, but also whether they are truthfully accounting for their expenses. The IRS is also concerned with a deeper, more theoretical issue — whether the horse-related activity is “really” a business or simply a hobby.
This theoretical question has very practical consequences: If the horse-related activity is “only” a hobby, then you can only deduct expenses up to the amount of revenue received. On the other hand, if the horse-related activity is a business, then you can deduct all expenses, even if they exceed revenue. The real-world difference is whether you can receive a tax benefit for these “additional” expenses in a future year or not. And since the IRS audits past years, if the IRS determines that your horse-related business is a hobby, this issue can often result in millions of dollars of back taxes, penalties and interest.
The key is showing that the horse-related business is operated with an “actual and honest profit objective.” Interestingly, this does not mean that you need to have a “reasonable” expectation of profit. Instead, there only needs to be a “bona fide” expectation of profit. Thus, if you subjectively believe that the business will be profitable, there should be an “actual and honest profit objective,” even if your subjective belief is not objectively reasonable.
Proving this type of subjective belief, however, is complicated. The IRS will not simply accept your word. Instead, it will examine all the surrounding facts and circumstances. As a result, although the question of profit objective is subjective, the IRS looks at objective criteria to establish the true intent.
The IRS has established a list of nine factors it considers when determining whether horse-related activities have an “actual and honest profit objective.” The nine factors are:
(1) The manner in which you carry on the activity. For instance, whether you have a business plan, whether the business plan has changed as circumstances have changed, and whether there are books and records which can help identify methods to increase revenue and decrease expenses.
(2) The expertise of you and your advisers. The IRS examines whether you have expertise in the horse-related activity and whether you have consulted with both experts in the industry as well business/financial experts.
(3) The time and effort you have spent carrying on the activity. In general, the more time you spend on the horse-related activity, the more the activity looks like a business rather than a hobby, especially if you have left your job or other profitable business.
(4) The expectation that the assets used in the activity may appreciate in value. Asset appreciation, including appreciation in land values, can help show a profit motive, especially when the cumulative asset appreciation is greater than the cumulative losses incurred while operating the horse-related activity.
(5) Your success in carrying on other activities. If you have been involved in other unprofitable business activities in the past and turned them around, this will help establish that you are doing the same here, even if this activity is currently not profitable.
(6) Your history of income or losses with respect to the activity. Losses during the seven year start-up phase for horse-related activities do not mean the activity is not a for-profit business. However, if the activities continue, the IRS may treat those losses as evidence that you are not engaged in the activity for profit. Notably, if the losses are the result of unforeseen circumstance, such as the unexpected death of a horse, the IRS will take that into account.
(7) The amount of occasional profits, if any. The IRS evaluates the activity’s level of profits and losses, the investment in the activity, and the value of the assets used in the activity. You can also satisfy this factor when there is an opportunity to earn a substantial ultimate profit in a speculative venture — such as horseracing.
(8) Your financial status. The IRS believes that when you have substantial income from sources other than the horse-related activity, you are more likely to be engaged in the activity as a hobby, not because you want to make a profit. However, some courts have rejected this factor, ruling that your financial status should not matter.
(9) The amount of personal pleasure or recreation involved in the activity. When all else fails, or when the other factors are inconclusive, the IRS will examine how much you enjoy the activity. Although many courts have ruled that it is perfectly acceptable to enjoy your job, the IRS apparently believes that if you like your job too much, then maybe it is not, actually, a job — it is just a hobby!
No one factor is determinative. Generally, it is highly unlikely that a single factor in a case will outweigh all the other facts and circumstances, but some factors may stand out to the IRS. For instance, most of these audits do not take place unless the horse-related activity has generated a history of losses. But there is a difference between annual losses of $20,000 for six out of seven years with the seventh year showing a profit, and 20 consecutive years of losses in the hundreds of thousands of dollars annually.
So what does this all mean? If you are just starting out in the horse business, a little planning can go a long way. By taking a little extra time, and spending a little extra money, you can help ensure that your activity has the indicia of a business rather than a hobby. And if you are already engaged in a horse-related activity, take some time, step back, and take a critical look at the operation. Can you meet these factors? Does your activity look like a business? If not, spending the time and money to talk to the right people, get their opinions, and implement their recommendations, may save you time, energy and money in the long run.
Brian Bernhardt is a partner in the Richmond office of McGuireWoods LLP. He practices in the areas of Federal tax controversies, Federal tax litigation, and nonprofit and tax-exempt organizations, focusing on their administrative relationships with the Internal Revenue Service.Tweet
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