TAX CONSIDERATIONS: IS YOUR HORSE RACING ACTIVITY A BUSINESS?
AMERICAN HORSE COUNCIL
By: B. Paul Husband
The overall question is whether your primary subjective intent is to make a profit?
If profit is your primary motive, then you have a business and business tax treatment, including the ability to offset losses in your horse business against other income is appropriate.
If profit is not your primary motive, then your horse racing activity is not a business, and business treatment for tax purposes is not appropriate.
If profit is your primary motive, then at a practical level, the question is: How do you prove your intent to the IRS or other taxing authority.
The IRS Regulations have a Nine factor test, that will be considered by the IRS in virtually every case.
PRESUMPTIONS
There are two “presumptions that can be involved.
A. General Presumption. If you have 2 profit years in a 7 year period, then from the end of the second profit year to the end of the 7th year after the first profit you, you will be presumed to be in business for a profit.
B. Special Presumption. During your first 7 years of business, you can file an “Election to defer determination”, and if you file that election, then if you have a profit during any 2 years of the first 7 years, then you will be presumed to be in business for profit for ALL 7 Years. But there is a price to be paid. If you file the election to defer determination, you must also extend the statute of limitations from the usual 3 years to 7 years. You are also assuring that you will be audited at the end of Year 7, with 7 years in issue.
The IRS, when examining a new horse business will sometimes offer to discontinue the audit IF the horse business owning taxpayer will make the election to defer determination. Some experience horse tax professionals recommend that the special presumption NEVER be elected because it opens up the statute of limitations.
POSSIBLE TAX BENEFITS FOR HORSE OWNERS
If your horse operation is a business, then consider available deductions:
A. 100 percent bonus depreciation – deduct the cost of a horse or certain other property in full during the year that it is placed in service.
B. Three-year depreciation for racehorses available through 2020.
C. Seven-year depreciation – broodmares and breeding stallion less than 144 months of age.
D. Deduction of “ordinary and necessary” expenses. In the tax world “ordinary and necessary” means “reasonable and helpful. And “ordinary and necessary” expenses are currently deductible in full in the year that they are incurred.
UNDER PRESENT LAW, HOBBIES CANNOT DEDUCT EXPENSES OR DEPRECIATION
Under the Tax Cuts and Jobs Act, Miscellaneous itemized deductions have been eliminated for 5 years (until 2022). Under prior law, a horseman with a hobby could take their expenses, including expenses first and them depreciation, up to the extent of the income that the hobby earns. But not under present law. Under present law, all of the income must be reported and tax paid upon it. But none of the expenses or depreciation may be taken. It is a good time to have a horse business.
The overall question is whether your primary subjective intent is to make a profit?
If profit is your primary motive, then you have a business and business tax treatment, including the ability to offset losses in your horse business against other income is appropriate.
If profit is not your primary motive, then your horse racing activity is not a business, and business treatment for tax purposes is not appropriate.
If profit is your primary motive, then at a practical level, the question is: How do you prove your intent to the IRS or other taxing authority.
The IRS Regulations have a Nine factor test, that will be considered by the IRS in virtually every case.
- Manner in which Taxpayer carries on activity. Does the owner maintain books and records? Under this factor, keep books and records like you use in your other business. Review them and use the to make changes to improve your business.
Also evaluated under this factor: Have there been any major changes in the operation to improve profitability or limit losses? - Is there an expectation that assets, including land, will increase in value? If so, this suggests a profit motive. This is factor No. 4 of the 9 in the regulations, but it is the second most important in helping the IRS understand that an horse activity is a business.
Have your horses appreciated? Written appraisals will help you prove appreciation of your horses.
Do you have a farm or ranch? If so, IF you purchased it for the purpose of operating a horse business on it, it is an asset of of the horse business and therefore the appreciation of the land counts in favor of your business. - Expertise of taxpayer of Advisors. Is the racehorse owner an expert in racing, or the care of equines? Does he or she regularly hire equine breeding, racing or business experts to advise the activity? The more expertise, the better.
- How much time does the racehorse owner spend engaging in racing? Again, the more the better. A contemporaneously kept daytimer or other written journal is the best way to prove the time that you have spent. But there are other ways as well, like credit card receipts or records.
- Does the horse owner conduct similar activities while turning a profit? Can you show that your operating methods, e.g., buying yearlings at Keeneland, similar to successful businesses? The more you operate like other businesses that are successful, the better.
- How many years have you operated without making a profit? Initial start-up losses are expected, especially in racing, but if they’re ongoing, unless there is a good excuse or other reason then it may not be a business.
- Do you derive substantial income from other sources? The more you make, the closer the IRS will look. The case law says that the presence of other income poses the question whether the owner is profit motivated, but it does not answer that question. One writer put his tongue in cheek and observed: “It is easier for a camel to pass through the eye of a needle than for the tax return of a rich man to enter into the kingdom of the ‘no change’ audit”.
- Be prepared to show the auditor that it is possible to make large profits in the horse business.
PRESUMPTIONS
There are two “presumptions that can be involved.
A. General Presumption. If you have 2 profit years in a 7 year period, then from the end of the second profit year to the end of the 7th year after the first profit you, you will be presumed to be in business for a profit.
B. Special Presumption. During your first 7 years of business, you can file an “Election to defer determination”, and if you file that election, then if you have a profit during any 2 years of the first 7 years, then you will be presumed to be in business for profit for ALL 7 Years. But there is a price to be paid. If you file the election to defer determination, you must also extend the statute of limitations from the usual 3 years to 7 years. You are also assuring that you will be audited at the end of Year 7, with 7 years in issue.
The IRS, when examining a new horse business will sometimes offer to discontinue the audit IF the horse business owning taxpayer will make the election to defer determination. Some experience horse tax professionals recommend that the special presumption NEVER be elected because it opens up the statute of limitations.
POSSIBLE TAX BENEFITS FOR HORSE OWNERS
If your horse operation is a business, then consider available deductions:
A. 100 percent bonus depreciation – deduct the cost of a horse or certain other property in full during the year that it is placed in service.
B. Three-year depreciation for racehorses available through 2020.
C. Seven-year depreciation – broodmares and breeding stallion less than 144 months of age.
D. Deduction of “ordinary and necessary” expenses. In the tax world “ordinary and necessary” means “reasonable and helpful. And “ordinary and necessary” expenses are currently deductible in full in the year that they are incurred.
UNDER PRESENT LAW, HOBBIES CANNOT DEDUCT EXPENSES OR DEPRECIATION
Under the Tax Cuts and Jobs Act, Miscellaneous itemized deductions have been eliminated for 5 years (until 2022). Under prior law, a horseman with a hobby could take their expenses, including expenses first and them depreciation, up to the extent of the income that the hobby earns. But not under present law. Under present law, all of the income must be reported and tax paid upon it. But none of the expenses or depreciation may be taken. It is a good time to have a horse business.