So you want to deduct some or all of your horse hobby expenses. Before taking those horse hobby expenses as deductions, you may want to consider the following factors, (since the Internal Revenue Service does) to determine whether your deductions will withstand scrutiny later.
Merely incurring expenses of an horse hobby as a “hobby”, even a hobby that you are passionate about and spend considerable amount of money and even run in a very business-like way, does not mean you can claim the deduction. Section 183(a) of the Internal Revenue Code (the “Code”) provides that if an activity is not engaged in for profit, “no deduction to such activity shall be allowed” except for interest and State and local taxes. Therefore, if you want to take deductions for your horse hobby expenses, you must satisfy the IRS that you have an “actual and honest objective” (in the words of the Tax Court) to engage in an horse hobby to make a profit.
Now, that does not mean that at first, you need make a profit. There a many business endeavors that sustain losses, particularly at start-up, which losses are not attributable to any fault of the tax payer. The IRS (and then the Tax Court if you litigate) will consider losses, but will not determine merely because you sustained losses that your horse hobby activities were not engaged for a profit motive. Rather, the courts have focused on whether there is a “good faith objective of making a profit.”
To determine if there was a good faith profit objective by the tax payer, the tax courts have examined a variety of objective facts, a non-exclusive list of which is also contained in the Code, and which includes:
– The expertise of the taxpayers or their advisors;
– The time and effort expended by the taxpayers in carrying on the activity;
– The expectation that the assets used in the activity will appreciate in value;
– The taxpayer history of income or losses with respect to the activity;
– The amount of occasional profit;
– The financial status of the taxpayer; and
– Elements of personal pleasure derived from the activity.
No single factor is controlling or dispositive, and the courts have also considered the relationship between the taxpayer’s horse hobby activities and his other businesses when the taxpayer claims that the horse hobby activity confers a benefit (i.e.: brings in clients or customers) for his other, non-horse hobby related business. However, the courts will give greater weight to these factors than to the taxpayer’s own statement of his or her intent.
Finally, it is the taxpayer that bears the burden of showing that she had a for-profit objective, and not the IRS who must prove that she did not have that intent. In other words, if you take the deductions for horse hobby activities, you better be able to prove you are entitled to them.
Looking at each of these statutory factors, consider the following before taking your deductions:
1.What was the manner in which you carried on your horse hobby activity?
First and foremost, you must maintain separate, complete and accurate records of your horse hobby activities. If you commingle your accounts, funds and transactions with non-horse hobby matters, you run the risk that there will arise a presumption, which you will be unable to rebut, that you were not serious enough about your horse hobby as a for profit enterprise to keep separate books. Therefore, a horse hobby would presumed to be a hobby for you.
Additionally, changing operating methods or training techniques or hiring qualified professionals to increase profits is an indicia of for-profit motive. In the case of a horse training business, this might mean changing where you buy your green horses, or who trains them, or where you market them. Drafting a business plan, and hiring expert advisors, discussed below, are particularly persuasive, and may help you avoid the issue of operating losses incurred beyond the start-up years.
2.Your expertise or those of your advisors.
Not everyone, and in fact most horse business owners, do not have the resources to formally hire a stable of advisors. However, you can demonstrate a profit motive by establishing that you have either studied the business, economic and equine scientific practices of horse hobby activities or have consulted those with that knowledge. If you are buying and selling ponies, keep records of who trained them, who entered them as a result of seeing them in which competition, who provided veterinary or other assistance to you in your horse hobby sales endeavors.
Now obviously you cannot justify every action, and should not try if you are enjoying your horse hobby truly as a hobby – without a profit motive – but taking the time to learn the business and having competent barn mangers and professionals assisting in the horse hobby business will support your claim of a profit motive. Indeed, hiring legal and tax professionals to structure your business may be an indicator of for-profit motive.
3.How much time and effort do you spend with your horse hobby?
I don’t just mean playing with the horses. Do you personally work on a plan to exhibit your horses at certain horse shows if you are trying to sell them? Do you engage in the physical labor involved in an horse hobby, e.g. mucking out, grooming, training, even though you can afford some one else to do it? Do you maintain another business that significantly detracts from your time spent with the horse hobby enterprise? If you have a limited amount of time to spend on your horse hobby, do you employ qualified employees to carry it on in your absence? Did you withdraw from some other occupation to devote your time to your horse hobby activities?
In one case, a court found that a woman who clearly had the means to hire help, yet nevertheless mucked stalls and worked at the barn and on horseback every day, clearly demonstrated that she had a profit motive in mind in running her stable.
4.Do you have a reasonable expectation of appreciation in value of your horse hobby assets?
Your horse hobby assets include not only your horses, but your real estate, equipment and the like. Obviously the equipment is unlikely to appreciate, so that leaves the ponies and the real estate. Purchasing real estate may in fact involve expectation of appreciation. To demonstrate this, you should develop a business plan which articulates your expectation of appreciation of the real estate you purchase for your horse hobby operation. Getting a hold of similar property appraisals, studying and appraising the property you do purchase, and adding value to the land may demonstrate that appreciation expectancy.
With respect to the horses, developing and implementing a scheme, no matter how simple, to realize the appreciation in value of your horses is critical. For a small operation, do you buy young, train and show them to make them, and then sell them for more than you put into them, or at least try to? For the more complex operation, do you breed, raise, train, board and show your horses with an intent to realize the appreciation in value of the horses from the training you or your hired trainers put into them? Do you have a plan that accounts for the costs associated with this endeavor? What is the actual relationship between your profits and your losses?
5.Have you been successful in other similar or even dissimilar activities?
If you have made money in successful horse hobby or horse ventures in the past, or are even doing so presently, this is strongly persuasive of an intent to do so with an horse hobby. An example would be the former professional horse shower who now is training and selling horses as his source of income. Compare this to the former or present investor in a thoroughbred syndicate who plays polo on the weekends. The former would be able to make a good case for his expenses as a trainer while the latter could not seek to recover his polo hobby expenses.
However, lack of experience does not mean that you do not have a profit motive in an horse hobby. Nor will diversion of income from one venture to your horse hobby or use of losses in an horse hobby to offset your other income. The courts have been somewhat unclear on this area in the horse hobby context, but I would suggest that there has to be a rational relationship between either the activities or the skills you utilized for each activity for the court to find a profit-motive. If that sounds fuzzy, remember, none of these factors alone determines for-profit intent.
6.What is your history of profit or loss in a horse hobby?
For example, in one case, it took 3 years for a horse owner and breeder to determine that a fungus growing in his pastures was the cause of low birth weight and other breeding problems. A later drought further compounded his ability to board ponies and prevented successful replanting of the pastures. Significant losses occurred many years after start-up. Even though the owner could afford to operate the farm at a loss, the court determined that these events were beyond the owner’s control, and that merely experiencing these losses did not create the presumption that there was no profit motive.
7.Have you made any occasional profit?
If you have, then you must still demonstrate that profit was as a direct result of for-profit intent. Using your horses for fun for 5 years and merely selling off your older horses does not demonstrate such intent. Training and selling horses consistently for 5 years at break even levels or worse, but then selling a few for significant profit would tend to support a for-profit motive. Also, again the court will look at the relationship between your losses and your profits.
8.What is your financial status?
The court may consider whether you have other activities that provide substantial income, and whether losses from an horse hobby produce tax benefits. However, the facts that you lose money in an horse hobby or can afford to operate your horse hobby operation at a loss does not mean you have no profit motive, because, as one court put it, “as long as tax rates are less than 100 %, there is no benefit in losing money.” Remember the woman who could afford all the help she needed, but still mucked and trained horses herself? Your conduct in running and participating in your horse hobby is significant in many ways.
9.Do you derive personal pleasure or recreation from a horse hobby?
We all do. But tax law does not prohibit a person from enjoying his or her work. The issue is whether these enjoyments are your sole motivation for conducting the horse hobby. Once again, your conduct, and the business-like manner in which you conduct your horse hobby operation, will be significant.
Some, after reviewing these factors, might conclude that they are too small or too unique in their horse hobby activities to satisfy all of these tests. That may be true. To those folks, I would suggest that you not abandon common sense altogether. If you plan to take a tax position that your horse hobby expenses are deductible, be sure to run your horse hobby as a business, develop a plan or be sure to keep evidence of a plan (e.g. copies of print advertisements for horse sales), and be able to trace profits made and losses incurred directly to that business.
To the others among you who say that you do not know if you meet these tests, it is time to take a look.
In the case of Frimml v. Commissioner of Internal Revenue, Tax Court Opinion 2010-176, (December 28, 2010) the Tax Court decided in favor of the taxpayers, reversing the auditors’ conclusions, where it framed the issues as:
The Frimmls had been audited after they failed to generate a profit for 10 years. In reversing the conclusion of the auditors, which assessed penalties and interest after finding the enterprise only a hobby and without profit objective, the Tax Court applied the 9 factors (set forth above) of I.R. Code § 1.183-2(b), explaining that “No factor or set of factors is controlling, nor is the existence of a majority of factors favoring or disfavoring a profit objective controlling.”
After noting that although the taxpayers had other full time jobs and that they did not keep their business books in a formal manner, the Court nevertheless found in their favor. The Court discussed the factors and found that their “decade formulating a business plan”, though not reduced to writing, “businesslike descriptions of decisions regarding their Paint horses”, consultations with training and breeding experts, the amount of time spend in the activity (substantial), losses occurred within the startup-window of the business (which the Tax Court has already determined is 5-10 years for horse-breeding operations) was not a negative factor, that a substantial part of the taxpayers’ income from their other jobs was used towards the farm business and that the taxpayers did not ride or derive pleasure from the paint horses they bred militated in favor of the farm being run with a profit objective, concluded that “After considering all the facts and circumstances, we find that petitioners have shown that they engaged in their horse activity for profit.”