It’s true that successful people love their work but truly successful people work at what they love. The tax law recognizes that people can mix profit and pleasure. Even where the prospect of profit may be deferred for years and ultimately never arrive, the intervening losses are deductible so long as the taxpayer is genuinely trying to reap an overall profit. Yes, the stodgy old tax law recognizes that people can still be profit motivated in activities they enjoy even though they may be incurring losses on the front-end of a start-up business and even when there may only be a small chance at a great profit. Of course, the IRS and the courts expect every taxpayer deducting losses from something he or she enjoys to say they were profit motivated.
When IRS agents examine Schedule C returns that report activities involving the breeding, training, showing, or racing of horses, they look for the way certain specific items are handled on the return. Thus, it's important that we appropriately document your treatment of these items should your return be chosen for an audit. Doing so ahead of time will save time and money should an audit arise. It's also important to identify issues that could result in your return being picked for an audit so we can resolve those issues before your return is chosen for an audit.
If your horse [breeding/training/showing/racing] activity has a history of losses, the IRS may assert that the activity is an activity not engaged in for profit (i.e., that it is a hobby). In this case, your losses will be limited. In addition, the argument that your horse-related activity is a hobby can have implications beyond just losing losses to offset your other income. Many other areas on your tax return can be affected, including, but not limited to, self-employment tax, deductions for health insurance premiums, alternative minimum tax, itemized deductions, adjusted gross income (AGI), and Roth IRA contributions. The determination of the proper amount of AGI can affect other items on your return including, but not limited to, rental losses, medical expenses, casualty losses, miscellaneous deductions, and interest on education loans.
Determining whether or not an activity is engaged in for profit, and thus is not a hobby, is a factual determination. Generally, that means that it's up to you to prove that you are engaged in your activity with an actual and honest objective of realizing a profit. However, in the case of an activity that consists mainly of the breeding, training, showing, or racing of horses, the activity is presumed to be engaged in for profit if you can establish that your gross income from the activity exceeded your deductions attributable to that activity in two out of seven consecutive tax years. This special treatment for horse-related activities is in recognition of the fact that individuals engaged in such activities are engaged in a long-cycle operation of uncertainty, often requiring investment over several years of funds from other sources. If the relevant number of profit years is met, an activity is presumed to be engaged in for profit, unless the IRS establishes to the contrary.
Among the factors the IRS takes into account in determining whether you are engaged in a horse [breeding/training/showing/racing] activity for profit are:
(1) the manner in which you carry on the activity (for example, whether you keep the records of your horse [breeding/training/showing/racing] activity separately from your personal records);
(2) your expertise in the [training/breeding/showing/racing] of horses, and whether you consult experts and professional periodicals when making decisions with respect to the activity;
(3) the time and effort you put into carrying on the [training/breeding/showing/racing] activity;
(4) your expectation that the assets used in the [training/breeding/showing/racing] activity (generally, the farm property) may appreciate in value;
(5) your success in carrying on other similar or dissimilar activities;
(6) your history of income or losses from the [training/breeding/showing/racing] activity;
(7) the amount of profits (if any) earned from the [training/breeding/showing/racing] activity;
(8) your financial status; and:
(9) the presence of personal motives in carrying on the activity (for example, whether you or your family members ride the horses used in your [training/breeding/showing/racing] activity for pleasure).
If you have questions about your particular situation, you should contact your CPA. If you are in need of a recommendation for a CPA, call Devon.