What to Claim: Tax Rules Differentiate Business & Hobby In The Horse World
TAX RULES DIFFERENTIATE BUSINESS & HOBBY IN THE HORSE WORLD
The IRS conducted a three-year study completed at the end of 2012, called the IRS Employment Tax National Research Project (NRP), to address the belief that non-compliance with employment tax regulations accounts for a multi-billion-dollar tax gap. The NRP was a process of rigorous random audits of businesses of all sizes and types, the most comprehensive in twenty years. Its focus was on five primary areas: worker classification; fringe benefits; reimbursed expenses; compensation of officers and owner-employees; and non-filers.
The findings from this study provided updated statistics that will enable the IRS to audit more efficiently and improve the detection of underreported income and overstated deductions and credits, placing taxpayers under closer scrutiny.
Historically the IRS has examined equine activities and determined whether they constituted a trade or business by looking at whether they were operated with a profit motive. If unable to show a profit motive, the activity is considered a hobby. An activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses).
This distinction is important because if an activity can be considered a trade or business, it qualifies for deductions under the tax code that are not available if it is considered a hobby. If an activity is not for profit, losses from that activity may not be used to offset other income. These limits are often referred to as the “hobby loss rule.”
There are nine “hobby loss” factors, which the IRS applies in determining whether an activity is a business or a hobby. These factors include:
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- The elements of personal recreation or pleasure in carrying on the activity.
While there is no real algorithm to determine profit motive, some factors seem to be more thoroughly examined than others. For instance, auditors focus on the manner in which the taxpayer carries on the activity. Formal business plans, separate and distinct record-keeping, maintenance of financial records, and the abandoning of unprofitable methods can help show a profit motive. Other “hobby loss” factors often given more weight are the financial status of the taxpayer and whether the equine activity is engaged in for recreation and pleasure. The IRS is always in the process of adapting and refining its rules, and thus it is necessary to use a CPA and/or tax attorney who keeps up with these changes.
With the changes brought about by the NRP campaign, it is critical that those involved in the horse industry perform regular internal compliance reviews to assess potential areas of concern. This article should not be used as a substitute for conferring with your CPA and/or your tax attorney regarding compliance with the IRS rules. Those who wish to treat equine activities as a business should confer regularly with tax professionals. If unwilling or unable to do this, the activity should be considered a hobby.
One additional word of caution: anyone receiving a request for information from the IRS must immediately contact a CPA and/or tax attorney for help in gathering and preparing the requested information. The IRS treats information initially received from the taxpayer as an admission. Many times cases are won or lost based on the information gathered by the auditor during the initial interview.
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