AreYour Horses Tax Deductible?
By Carolyn Miller, CPA,
(written in 2000, some rates may have changed)
It starts off with a mare; you breed her to a top stallion, in hopes of getting a future champion. The foal arrives, you decide to keep him and put him into training, you think youve got a good one. Encouraged by your success so far, you purchase a couple of more mares, breeding them to a couple of up and coming stallions. They both yield you nice foals, one of which you sell successfully at a yearling prospect sale. The other, you think will bring more as a two year old, so you hold on to her. Meanwhile, youve got a couple more foals on the ground, and once again its time to decide which stallions to breed those mares to. And so it escalates. An innocent little venture has grown into a small-scale horse operation. You wonder if perhaps some of this money youre spending could be tax deductible, after all this is a business, isnt it?
Im often asked How many horses do I need to call this a business. The answer to this question is that there is no magical formula that if one has more than x horses, he is running a business, and if they have less than x horses, they are a hobby.
What is the difference between a hobby and a business? Businesses are operated with the objective of making a profit, hobbies are not. For income tax purposes, hobby expenses are personal, and are only deductible to the extent of hobby income. Business expenses on the other hand are fully deductible from unrelated income.
Well I want to make a profit, you say, then, that makes me a business doesnt it? The answer to this question is NO, not necessarily. The Internal Revenue Service considers all facts and circumstances with respect to the activity when determining whether an activity is engaged in for profit or not. 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. If the taxpayers horse activity has two profit years during a seven year period, the taxpayer will be presumed to have a profit motive. The IRS has listed nine factors which are normally taken into consideration when determining whether a profit motive exists. They are as follows:
1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or his advisors;
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 taxpayers history of income and losses with respect to the activity;
7. The amounts of occasional profits if any, that are earned;
8. The financial status of the taxpayer, and;
9. The amount of personal pleasure or recreation involved in the activity.
A taxpayer does not need to meet all of these requirements, nor does he have to meet the majority. No one factor weighs more than another, each factor is weighed as applicable to each different situation. This list is also not all inclusive, the government may look at other factors not on this list.
Lets examine in detail this list of nine factors.
1. The manner in which the taxpayer carries on the activity: If you want the IRS to consider your activity as a business, run it like a business! Good record keeping is essential to running a business. Maintain a business bank account separate from your own personal account, co-mingling of funds is frowned upon by the IRS. Keep your accounting records in a fashion that lets you monitor profit and losses. If you see that one segment of your business is unprofitable, change your operations so that the segment becomes profitable, or if that is not possible, abandon the unprofitable activity.
Develop a five-year business plan for your business. Put down in figures, how you intend to be a profitable business. Compare actual results with projected results. If expenses are running higher than projected, undertake cost cutting measures, if thats not possible, modify your remaining projections. Can you still show your business earning a profit?
The IRS requires businesses to file certain information returns periodically such as 1099s. If you hire contract labor (this includes unincorporated blacksmiths, veterinarians, trainers etc.) and you pay them over $600 in any one calendar year for services, you must issue them a form 1099-Misc.
2. The expertise of the taxpayer or his advisors: Are you an expert in the horse industry? No? Dont despair, this doesnt mean you cant run a horse business, but it does mean you should seek the advise of individuals who are experts. Obtain all the information you can about your respectful equine business including if possible expected financial returns. Read books, magazines, watch videos, go to seminars, talk to people in the business. These are all avenues you can follow to obtain professional expertise. Consult an accountant regarding setting up your books, and developing your business plan.
3. The time and effort expended by the taxpayer in carrying on the activity: Devoting a large amount of the time to the horse activity rather than hiring people to do everything may indicate that the taxpayer has a profit motive. This doesnt mean that if a person hires competent people to run the operation, and simply oversees the operation, that there is a lack of profit motive.
4. The expectation that the assets used in the activity may appreciate in value: The IRS regulations state that profit includes appreciation on assets, as well as operations. This means that though a taxpayer may not be able to show positive income from operations, that he may be able to prove that his business is profitable by considering the appreciation of assets. Assets that can appreciate are buildings, breeding stock, and of course land. Most taxpayers report their horse operations on a cash basis, this results in raised horses not being reported as income until it they are sold. There can be substantial appreciation in your inventory of raised animals.
5. The success of the taxpayer in carrying on other similar or dissimilar activities: Has the taxpayer ever run a business before? Was he successful? This can help support your ability to prove that you are indeed running a business. This factor is perhaps not considered as relevant as the other factors; in recent court cases there has not been a lot of discussion in this area.
6. The taxpayers history of income and losses with respect to the activity: It is recognized that when starting up a horse business, not unlike any start-up business, that there may be losses in the start-up years. What the IRS likes to see is progress towards a profitable state. Are revenues increasing fairly steadily? Now that the operation is underway, have expenses declined in relation to the revenues? Is there a reasonable expectation of profit in the forthcoming years?
Of course, several years of profit goes along way to proving that your operation is profitable!
7. The amounts of occasional profits if any, that are earned: The fact that your business has earned a profit of a couple hundred of dollars in a year, will not necessarily convince the IRS that you are operating with a profit motive, if your losses over the next several years are in the thousands. The IRS regulations state that an occasional small profit from an activity that generates large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is a business.
8. The financial status of the taxpayer: The fact that your horse business is your only source of income, may be considered a positive factor by the IRS. If on the other hand, you work full time and earn a substantial income from sources unrelated to your equine activity, you are more likely to be challenged on your profit motive.
9. The amount of personal pleasure or recreation involved in the activity: The IRS regulations state that personal motives may indicate that an activity is not engaged for profit, and is actually a hobby. Most of us derive some kind of pleasure from our horses, and that is okay even if you want your horse activity to be considered a business, so long as the other factors support your profit motive.
Some of the above nine factors are not factors that can be changed by our actions today or tomorrow, however, some of them can be influenced by our actions. Perhaps the most important factor is how you run your business activity. Lets examine in more detail what kind of documentation you should be keeping and what you should be doing to support your profit motive.
Bookkeeping: First of all, you need to keep some books. Simply totaling receipts and invoices at the end of the year is not a good business practice. You can use a handwritten worksheet to enter your monthly receipts and purchases or perhaps you would prefer to use a simple accounting program, the choice is yours. You should separate your income and expenses in a fashion that will permit you to see what portion of your business is profitable and what portion is not. Take a look at the Schedule F to see the categories that will be used to prepare your income taxes, and keep in mind, youre not limited to the categories that are listed on the Schedule F, expand the categories to suit your needs.
At the end of each year, prepare an income statement. Compare this to your original budget, or financial plan. Can you isolate any unprofitable areas? Are costs in one particular category running over budget? If so, can they be controlled next year? What marketing strategys worked, which ones didnt? This is the kind of analysis a well-run business will utilize to try to maximize profits.
Maintain a bank account solely for your business operations. Do not pay personal expenses from this account, and conversely, do not pay business expenses from your personal account. If your business account needs replenishing, write a check on your personal account and deposit it to the business account. If you pay for a business expense with personal cash, reimburse yourself with a check from the business account. As stated before, commingling of funds suggests that an activity is a hobby, not a business.
Keep all your accounting records including receipts, invoices and bank statements for at least three years from the later of:
1. The date you filed your tax return or the date it was due; or
2. 2 years after the date the tax is paid.
Try to obtain a receipt for every purchase, a cancelled check may be accepted as proof of payment, but it alone does not establish your entitlement to a tax deduction. Likewise, complete a sales invoice for every sale you make, including a sales date, the name of the purchaser, a description of the item sold or service provided and the date payment was received.
How to Distinguish a Business Expense from a Personal Expense: Im often asked is this expense deductible? How about that one? How do I determine if an expense is deductible or not? Per the IRS regulations, an expense is deductible if it is ordinary in your business, and necessary for its operation. An ordinary expense is one that is common and accepted in your field of business, trade or profession. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary. If you have an expense that is partly for business and partly personal, you must separate the personal part from the business part. Only the business part is deductible.
Business owners have the choice of reporting income and expenses on the accrual or cash method. The accrual method reports income and expenses as they are incurred, not necessarily paid, and the cash method reports income when it is received, and expenses when they are paid. Most small business owners choose to report their income on the cash basis. Expenses paid by credit card, are considered expenses when they are purchased, not when the credit card is paid.
Property and equipment purchases with useful lives in excess of one year are called capital assets. Capital assets are depreciated rather than being deducted as an expense all in one year. Section 179 of the income tax allows you to elect to expense all or part of qualifying property in the year you place it in service, up to a limit of $19,000 in 1999 and $20,000 for 2000.
Can you claim your vehicle expenses? You can claim that portion of your vehicle expenses that pertains to business usage. You should keep a logbook to support your business mileage claimed, as well as note your vehicles odometer reading at the beginning and end of the year. If you do not operate more than one vehicle in your business at once, you may choose to calculate your deduction based on actual vehicle operating expenses (gas, oil, license tags, insurance, repairs, and depreciation) or on a standard mileage rate. The rate for 1999 is 32.5 cents a mile before April 1st, and 31 cents a mile thereafter. If you operate more than one vehicle in the business at one time, you must use the actual expense method. Note that if you want to use the standard mileage rate, you must do so the first year you use the vehicle in the business. Parking fees, tolls and interest on the vehicle may be claimed under either method.
Seven Year Election: A taxpayer in the horse business, can elect to have a special presumption apply to his horse operation. This special presumption allows the taxpayer to postpone any IRS finding as to whether his activity is engaged in as a business until after the first seven years of operation. If the horse business has two profitable years in the seven, it will be presumed to be a business for profit. The downside of this election is that it leaves the taxpayers income tax returns for all seven years open for reassessment of the horse activity, not just the normal three years.