There is an old saying in Texas: "In the horse business, you can make a small fortune--out of a large one."
Many people who engage in various horse activities--racing, showing, boarding, breeding, training and rider instruction--regard themselves as being in the horse business. Accordingly, on income tax returns they report receipts from those activities as business income, deduct expenses as business expenses, and deduct depreciation of business assets. If they show a net loss from the horse activities for a tax year, they deduct that loss from other income, such as salary or investment income.
If the horse activities are a business, there is no problem with deducting losses from unrelated income. However, when a taxpayer incurs losses from horse activities year after year, and those losses are deducted from unrelated income, the Internal Revenue Service begins to question whether the horse activities are more a hobby than a business. The government takes the reasonable position that it should not subsidize the hobbies of taxpayers by permitting those expenses to be deducted from unrelated income. Hobby expenses are personal, not business. If the horse activities are a hobby, then receipts must be reported as income, and expenses can be deducted from that income, but only to the extent of the hobby income. The taxpayer cannot deduct any of the hobby activity expenses from unrelated income.
If the IRS is successful in declaring a horse activity to be a hobby, it can re-compute your tax liability for at least the past three years. You can be required to pay the additional taxes for those years, plus interest, plus possible penalties for the underpayment. The result can be financially quite devastating.
If your horse activities incur loses year after year and if you have substantial unrelated income that those losses offset in part, then the IRS begins to become curious. Professionals who engage part-time in horse activities--or whose spouses do so--are a prime target, but the risk of being declared a hobby is not restricted to doctors, lawyers, and accountants.
The ultimate question is not whether you turned a profit or incurred a loss, but whether your horse activities were engaged in for the purpose of turning a profit. So long as you in good faith intend a profit, your losses are business loses, not hobby loses. However, even the most stoutly asserted good faith will not overcome year after year of substantial loses: If you really intended to make a profit, then why did you persist in engaging in losing activities for all those years?
Here is what the IRS regulations say about this ultimate question:
The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit. In determining whether such an objective exists, it may be sufficient that there is a small chance of making a large profit. Thus it may be found that an investor in a wildcat oil well who incurs very substantial expenditures is in the venture for profit even though the expectation of a profit might be considered unreasonable. In determining whether an activity is engaged in for profit, greater weight is given to objective facts than to the taxpayer's mere statement of his intent.
26 CFR § 1.183-2(a).
If your horse activities show a profit for at least two of seven consecutive years, then the law presumes that you intended to make a profit. However, that presumption can be overcome by evidence that shows lack of a profit motive. All the presumption does is to place the burden upon the IRS to show the activity was merely a hobby.
So, how does the law decide whether your horse activities are a hobby or a business? Tax regulations set out nine factors to be taken into account. No one of those factors is decisive. You are not required to pass muster on a majority of the factors. Different weights are assigned to different factors in different situations. The nine factors are also not exclusive--the government can look at other factors that are not on the list of nine.
The nine factors are (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, that are earned; (8) the financial status of the taxpayer; and (9) the elements of personal pleasure or recreation involved in the activity. 26 CFR § 1.183-1(b).
1. Operation of activity in business-like manner. Does the taxpayer keep complete and accurate books? Simple matters as having a checking account for the business that is separate from the personal account can be important. Has the taxpayer abandoned demonstrated unprofitable business pursuits? In one case, it counted for the taxpayer that he abandoned an Arabian horse breeding activity for a more profitable enterprise of breeding paint horses. If the taxpayer knew of more profitable uses to which the activity's assets could be put but fails to do so, that may suggest a lack of profit motive.
2. Expertise. Did the taxpayer take the time and effort to become an expert in the field of activity in which he is engaging or to employ experts to advise him? In one case, it was important that the taxpayer engaged in a new business of breeding Percheron horses without expertise in that activity and without consulting experts.
3. Time and effort devoted to the activity. The fact that the taxpayer devotes substantial personal time and effort to the activity may indicate an intention to derive a profit. Devoting only a limited time does not mean the taxpayer did not intend to turn a profit if he employs other competent and qualified persons to carry on the activity.
4. Expectation that assets may appreciate. The expectation of appreciation of assets, such as a breeding stallion or a horse facility, is considered in determining whether the taxpayer intended a profit. The expectation must be that the operating income and capital gains from selling the asset would more than cover the expenses involved in the activity.
5. Past successes in similar or dissimilar activities. The taxpayer's past success in similar or dissimilar activities can be indicative of a profit objective. The fact that he has not engaged in past successful business activities counts against the taxpayer, but can be outweighed by other factors.
6. History of income and losses. A taxpayer's history of income, losses, and occasional profits with respect to an activity may indicate the presence or absence of a profit objective. Losses are the norm during the startup phase of a business and are therefore not weighed heavily against the taxpayer.
7. Amounts of occasional profits. The amount of profits earned in the activity, when compared to the amount of losses incurred, the amount of the investment, and the value of the assets in use, may indicate a profit objective. The opportunity to earn substantial profits in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even through only losses are produced.
8. Taxpayer's financial status. The fact that the taxpayer does not have substantial income unrelated to the horse activities may indicate that the activity is engaged in for a profit. The cases in which the IRS challenges deductions under the hobby rule are cases in which the taxpayer has a very substantial income from sources unrelated to the horse activity.
9. Personal pleasure or recreation. The presence of personal pleasure or recreation may indicate the lack of a profit objective. No one would claim that a person engaged in the hog business for pleasure rather than profit, but horses are different. They do bring pleasure as well as requiring a great deal of work. However, the mere fact that the taxpayer enjoyed engaging in the activity does not mean it wasn't engaged in for profit. It's okay to love your work!
You can find out more about this subject from other locations on this AAHS web site. Go to Law Cases for Horsemen; Horse Business/Taxes. There, you will find cases from the Tax Court and United States Courts of Appeal in which the IRS has challenged horse activities under the hobby rule. You may find a case that is close to the facts of your horse activity and which might enable you better to predict what would happen should your horse deductions be challenged.