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 you’ve 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, you’ve
got a couple more foals on the ground, and once again it’s 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 you’re spending could be tax deductible, after all
this is a business, isn’t
it?
I’m 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 doesn’t
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 taxpayer’s 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
taxpayer’s 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.
Let’s 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 that’s 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 1099’s. 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? Don’t despair,
this doesn’t mean you can’t 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
doesn’t 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 taxpayer’s
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. Let’s 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, you’re 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 strategy’s worked, which ones
didn’t? 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:
I’m 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 vehicle’s
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.
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