Horses and the Law
Horses, Expenses & the IRS?

Disclaimer - This article is intended as general discussion and information on the topic covered, and is not to be construed as rendering legal advice. If legal advice is needed, you should contact an attorney. This article may not be reprinted or reproduced in any manner without prior written permission of the author.

“...In this world nothing is certain but death and taxes.” Benjamin Franklin, 1789.

April 15th is just around the corner and we all know what that means–tax time. Grain cost, hay cost, bedding cost, vet cost, farrier cost, truck cost, trailer cost, harness cost, carriage cost, repair cost, fence cost, insurance cost, barn cost, and on and on and on–all of these expenses are deductible–right? Not so fast!

Internal Revenue Code section 183 states that expenses which are greater than income cannot be deducted against other income unless the business is “engaged in for profit.” This is the so-called “hobby loss” section of the Internal Revenue Code. If your horse activity is a hobby, then you cannot deduct losses greater than income as hobby losses are considered personal expenses as opposed to business expenses. On the other hand, if your horse activity is a business and your losses are greater than income, you can take those losses against other income. Since many horse owners do have other sources of income, this distinction takes on critical importance.

However, nothing is simple when dealing with the IRS. Section 183 of the Code states that if a horse business shows a profit in 2 out of 7 years, it is presumed to be for profit. (Special rules apply to new businesses which is a topic for a later time.) Now it becomes complicated. Even if you do not show a profit in 2 out of 7 years, you can still be considered a business as opposed to a hobby if you can prove to the IRS that your objective is to make profit.

In order to be successful in such a situation, the IRS analyzes nine factors which are set forth at IRS Regs. Sec. 1.183-2. A review of these factors will follow.

Factor 1 – The manner in which the taxpayer carries on the activity.

This factor essentially boils down to maintaining complete and accurate records of the horse activity. The IRS is looking to see that you in fact carry on your business in a legitimate business-like manner by keeping separate and accurate books and records including bank accounts. Tax Court decisions analyzing this factor look to such things as changing unprofitable methods in an effort to cut losses, advertising expenses and having sound business practices including a plan for the business to become a profitable operation. In short, keep all of the records pertaining to the horse business separate and distinct from your personal records and do not commingle funds with your personal bank accounts.

Factor 2 – The expertise of the tax payer or his advisors.

The owners knowledge about horses becomes important in analyzing this section. The owners background, experience and efforts to manage the horse operation including retaining experts in the field have been considered important in viewing this section. Good record keeping of horse blood lines, registry certificates and performance records also point to the expertise of the owner and are important records to be kept on file in the event of an audit.

Factor 3 – The time and effort expended by the taxpayer in carrying on the activity.

The more time you spend in your horse activity the better chance you will have in favorably complying with Factor 3. Court decisions have held that keeping the business and financial records, supervising the operation including hired help, cleaning the barn, bathing and grooming horses and other physical work around the farm are all factors weighing in favor of the taxpayer and indicating a profit motive.

Factor 4 – Expectation that the assets used in activity will increase in value.

The IRS regulations include in the definition of appreciation, real estate used in the activity. (IRS Regs. Sec. 1.183-2 (b) (4)). The Tax Court has been inconsistent in considering this section, especially as it relates to appreciation of land value. As such, this factor has not been one of the major factors looked at by the IRS on the issue of business versus hobby.

Factor 5 – The success of the taxpayer and other similar or dissimilar activities.

The IRS regulations state that if a taxpayer has engaged in other activities which were profitable, this is an indicating factor that the taxpayer is engaged in the present activity for profit. However, this factor has not been an important factor on the issue of hobby versus business cases.

Factor 6 – The taxpayers history of income or losses with respect to the activity.

If your loss years far exceed your profit years, or if you have no profitable years, this is a factor which indicates that the horse activity is not engaged in for profit. However, if the taxpayer can show that unusual business risks or losses have caused the problem, the taxpayer can still be successful. If the taxpayer can show that losses were occasioned as a result of circumstances beyond his control such as weather, fire, depressed market, unforeseen loss of a horse or horses, the IRS should still permit the deductions under the circumstances.

Factor 7 – The amount of occasional profits, if any, which are earned.

The IRS will look at the amount of profits in relation to the amount of losses in the operation. This would include occasional small profits even though the business in general has large losses. Although the regulations seem to down play the importance of a small profit year the courts and an auditing IRS agent are far more easily convinced if a profit year is present in the financial history of the business. One factor the courts must keep in mind when dealing with the horse business is that loss of money is far easier to achieve than making money. For example, the Jockey Club in a study commissioned in 1995 concluded that more money was spent by owners and breeders in the Thoroughbred industry than they made through winnings or sales of horses. (“The Future of the Thoroughbred Industry,” 1995 study by Pugh Roberts, Cambridge, Massachusetts.) Further, a study conducted in 1996 for the American Horse Council concluded that the horse industry, which included all breeds, is a loss industry in terms of financial success. (“The Economic Impact of the Horse Industry in the U.S.,”prepared for the American Horse Council, December 1996). Theses studies are important evidence to present to the IRS in an audit situation.

Factor 8 – The financial status of the taxpayer.

The more income you have from other sources, the less favorable this factor becomes to the taxpayer. Obviously a lack of income from other sources will be held in favor of the taxpayer in determining whether the horse activity is a business or hobby. The IRS takes a strict position in these cases but, fortunately, the Courts do not always agree. For example, in Mary v. Commissioner, T.C. Memo 1989-118, the taxpayer was a doctor who had substantial income from his medical practice. The Tax Court rejected the IRS position that Dr. Mary’s horse farm was a hobby instead of a business and concluded that expenditures by Dr. Mary reduced his “spendable income by more than they provide any benefit from reductions of taxable income.”

Factor 9 – Elements of personal pleasure or recreation.

Obviously, if personal pleasure and recreation are the objectives of the horse activity, the enterprise will not be considered for profit. The key factor is to review the prior eight and if a profit motive exists, the fact that a taxpayer has personal pleasure or recreation from the horses will not weigh negatively in his favor.

It should be noted that there is no mathematical formula which the IRS uses in adding up the number of positive and negative points based on the nine factors. There is an amount of subjectivity which the IRS and the Courts have in reviewing these factors and some factors appear to have greater emphasis then others. However, it appears one of the most crucial factors is the first factor concerning the treatment of the business activity. Failure to maintain separate books and records for the horse activity including bank records have been important elements in ruling that the activity is a hobby as opposed to a business. Good record keeping is perhaps the key in establishing that your horse activity is for profit.

As with all tax issues, you should consult with your attorney and accountant who can best advise you on these matters.

Enough legal talk–it’s time to hitch horses.

Ken is a practicing attorney in Myerstown, Pennsylvania, where a good bit of his practice involves negligence cases. Ken and his wife, Karen, own Sunny Hill Farm Belgians, and they have been exhibiting their six horse hitch for the past few years at most major shows in the East. needed, you should contact an attorney. This article may not be reprinted or reproduced in any manner without prior written permission of the author.

“...In this world nothing is certain but death and taxes.” Benjamin Franklin, 1789.

April 15th is just around the corner and we all know what that means–tax time. Grain cost, hay cost, bedding cost, vet cost, farrier cost, truck cost, trailer cost, harness cost, carriage cost, repair cost, fence cost, insurance cost, barn cost, and on and on and on–all of these expenses are deductible–right? Not so fast!

Internal Revenue Code section 183 states that expenses which are greater than income cannot be deducted against other income unless the business is “engaged in for profit.” This is the so-called “hobby loss” section of the Internal Revenue Code. If your horse activity is a hobby, then you cannot deduct losses greater than income as hobby losses are considered personal expenses as opposed to business expenses. On the other hand, if your horse activity is a business and your losses are greater than income, you can take those losses against other income. Since many horse owners do have other sources of income, this distinction takes on critical importance.

However, nothing is simple when dealing with the IRS. Section 183 of the Code states that if a horse business shows a profit in 2 out of 7 years, it is presumed to be for profit. (Special rules apply to new businesses which is a topic for a later time.) Now it becomes complicated. Even if you do not show a profit in 2 out of 7 years, you can still be considered a business as opposed to a hobby if you can prove to the IRS that your objective is to make profit.

In order to be successful in such a situation, the IRS analyzes nine factors which are set forth at IRS Regs. Sec. 1.183-2. A review of these factors will follow.

Factor 1 – The manner in which the taxpayer carries on the activity.

This factor essentially boils down to maintaining complete and accurate records of the horse activity. The IRS is looking to see that you in fact carry on your business in a legitimate business-like manner by keeping separate and accurate books and records including bank accounts. Tax Court decisions analyzing this factor look to such things as changing unprofitable methods in an effort to cut losses, advertising expenses and having sound business practices including a plan for the business to become a profitable operation. In short, keep all of the records pertaining to the horse business separate and distinct from your personal records and do not commingle funds with your personal bank accounts.

Factor 2 – The expertise of the tax payer or his advisors.

The owners knowledge about horses becomes important in analyzing this section. The owners background, experience and efforts to manage the horse operation including retaining experts in the field have been considered important in viewing this section. Good record keeping of horse blood lines, registry certificates and performance records also point to the expertise of the owner and are important records to be kept on file in the event of an audit.

Factor 3 – The time and effort expended by the taxpayer in carrying on the activity.

The more time you spend in your horse activity the better chance you will have in favorably complying with Factor 3. Court decisions have held that keeping the business and financial records, supervising the operation including hired help, cleaning the barn, bathing and grooming horses and other physical work around the farm are all factors weighing in favor of the taxpayer and indicating a profit motive.

Factor 4 – Expectation that the assets used in activity will increase in value.

The IRS regulations include in the definition of appreciation, real estate used in the activity. (IRS Regs. Sec. 1.183-2 (b) (4)). The Tax Court has been inconsistent in considering this section, especially as it relates to appreciation of land value. As such, this factor has not been one of the major factors looked at by the IRS on the issue of business versus hobby.

Factor 5 – The success of the taxpayer and other similar or dissimilar activities.

The IRS regulations state that if a taxpayer has engaged in other activities which were profitable, this is an indicating factor that the taxpayer is engaged in the present activity for profit. However, this factor has not been an important factor on the issue of hobby versus business cases.

Factor 6 – The taxpayers history of income or losses with respect to the activity.

If your loss years far exceed your profit years, or if you have no profitable years, this is a factor which indicates that the horse activity is not engaged in for profit. However, if the taxpayer can show that unusual business risks or losses have caused the problem, the taxpayer can still be successful. If the taxpayer can show that losses were occasioned as a result of circumstances beyond his control such as weather, fire, depressed market, unforeseen loss of a horse or horses, the IRS should still permit the deductions under the circumstances.

Factor 7 – The amount of occasional profits, if any, which are earned.

The IRS will look at the amount of profits in relation to the amount of losses in the operation. This would include occasional small profits even though the business in general has large losses. Although the regulations seem to down play the importance of a small profit year the courts and an auditing IRS agent are far more easily convinced if a profit year is present in the financial history of the business. One factor the courts must keep in mind when dealing with the horse business is that loss of money is far easier to achieve than making money. For example, the Jockey Club in a study commissioned in 1995 concluded that more money was spent by owners and breeders in the Thoroughbred industry than they made through winnings or sales of horses. (“The Future of the Thoroughbred Industry,” 1995 study by Pugh Roberts, Cambridge, Massachusetts.) Further, a study conducted in 1996 for the American Horse Council concluded that the horse industry, which included all breeds, is a loss industry in terms of financial success. (“The Economic Impact of the Horse Industry in the U.S.,”prepared for the American Horse Council, December 1996). Theses studies are important evidence to present to the IRS in an audit situation.

Factor 8 – The financial status of the taxpayer.

The more income you have from other sources, the less favorable this factor becomes to the taxpayer. Obviously a lack of income from other sources will be held in favor of the taxpayer in determining whether the horse activity is a business or hobby. The IRS takes a strict position in these cases but, fortunately, the Courts do not always agree. For example, in Mary v. Commissioner, T.C. Memo 1989-118, the taxpayer was a doctor who had substantial income from his medical practice. The Tax Court rejected the IRS position that Dr. Mary’s horse farm was a hobby instead of a business and concluded that expenditures by Dr. Mary reduced his “spendable income by more than they provide any benefit from reductions of taxable income.”

Factor 9 – Elements of personal pleasure or recreation.

Obviously, if personal pleasure and recreation are the objectives of the horse activity, the enterprise will not be considered for profit. The key factor is to review the prior eight and if a profit motive exists, the fact that a taxpayer has personal pleasure or recreation from the horses will not weigh negatively in his favor.

It should be noted that there is no mathematical formula which the IRS uses in adding up the number of positive and negative points based on the nine factors. There is an amount of subjectivity which the IRS and the Courts have in reviewing these factors and some factors appear to have greater emphasis then others. However, it appears one of the most crucial factors is the first factor concerning the treatment of the business activity. Failure to maintain separate books and records for the horse activity including bank records have been important elements in ruling that the activity is a hobby as opposed to a business. Good record keeping is perhaps the key in establishing that your horse activity is for profit.

As with all tax issues, you should consult with your attorney and accountant who can best advise you on these matters.

Enough legal talk–it’s time to hitch horses.

Ken is a practicing attorney in Myerstown, Pennsylvania, where a good bit of his practice involves negligence cases. Ken and his wife, Karen, own Sunny Hill Farm Belgians, and they have been exhibiting their six horse hitch for the past few years at most major shows in the east.