By Joost van Adelsberg, C.P.A.
In case you have not yet discovered, the IRS has a special place in its heart for the racehorse owner. That place is called the “Hobby Loss” Rule.
At the risk of stating the obvious, the operation of a racing or breeding stable is a risky business, which often results in a “loss” in any one particular year. The Hobby Loss Rules of Internal Revenue Code Section 183, deny the deduction of expenses in excess of gross income for certain activities the IRS determines are “not engaged in for profit.” Those determinations are consistently litigated, creating a gold mine of litigation revenue for lawyers, and to some extent for accountants alike. How can an owner best protect oneself? The answer is a familiarity with the rules, and effective tax planning.
While horse racing is a sport, it may nevertheless, for tax reporting purposes, constitute a “trade or business.” The existence of a substantial financial risk in a racing or breeding operation should not necessarily characterize the activity as a “hobby” any more than it should in the case of other risky activities, such as mining, oil development, or securities trading. Clearly, all of these businesses involve a substantial risk factor and frequently lead to great loss, yet they are rarely deemed “hobbies” by the IRS.
The key to the Hobby Loss rule is the phrase “not engaged in for profit.” Generally, in order to determine if an activity is not engaged in for profit the facts and circumstances of the particular operation must be examined. In order to make this determination easier, Congress created “safe harbor” rules that if met, will prevent the activity form being classified as a “hobby.” Congress has established a special provision for the “breeding, training, showing, or racing of horses” which states that if the activity had net taxable income for 2 of the past 7 tax years, including the current year, the activity is presumed not to be a “hobby” and all losses may be currently deducted.
If a breeding or racing operation does not meet the safe harbor test, all is not lost. The activity may yet be deemed a “business” and entitled to all deductions. The burden of proving its status rests with the taxpayer however. The IRS is not going to take anyone’s word for it; you must prove it!
Fortunately, the risky nature of horse-related activities is reflected in the more liberal profit presumption extended to such endeavors. As in the case of other risky activities, the key element in the test of whether a racing or breeding operation is “business” or a “hobby” is the owner’s intention and expectation of profit. After all, substantial investment in valuable thoroughbred horses is arguably indicative of a good faith profit motive.
Treasury regulations provide nine factors the IRS must consider in determining if an activity is a hobby of legitimate business. Those factors are:
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 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 or losses with respect to the activity;
7. The amount of occasional profits, if any, which are earned;
8. The financial status of the taxpayer; and
9. The elements of personal pleasure and recreation.
The taxpayer must remember that this list is not necessarily exhaustive and that other factors may weigh more heavily than others. For example, two factors the courts have frequently relied upon are: 1) the conduct of the activity in a businesslike manner, and 2) continuous losses.
One factor, which will be scrutinized, is the manner in which the taxpayer carries on the breeding or racing operation. In the case where a stable is being actively managed by a person with experience, and who is prepared to abandon the enterprise or a component therein when it becomes obvious that the venture is definitely unsuccessful, the loss sustained will ordinarily be allowed. Likewise, a taxpayer is engaged in the breeding and racing of horses in a “businesslike manner” if he or she researches and plans horse purchases, advertises where appropriate, consults trainers or breeders, and becomes knowledgeable about the horse racing and breeding industry and its profitability
It has been held in a number of cases that the mere fact that the activity has shown continuous losses is not alone sufficient to establish that it is not operated for profit. In commenting on evidence of consistent “losses,” one court pointed out the fact that even though the taxpayers were wealthy enough to afford a hazardous occupation, in which they found pleasure in spite of discouraging losses, the losses did not destroy the essential “business” nature of the occupation. In that case the taxpayers sufficiently established that the only reasonable measure of success, in their opinion, was financial gain.
The pursuit of “financial gain” can be a double-edged sword. In cases in which it is shown that the activity was originally engaged in for the purpose of making a profit, taxpayers may be denied deductions in subsequent years if the operation has shown a consistent loss. This disallowance is based on the assumption that a person would not continue in a business, which has consistently shown losses unless motivated primarily by the pleasure involved. Although the assumption is reasonable, isn’t it also reasonable to assume that most taxpayers do not ordinarily indulge in extravagant “hobbies” involving substantial continuous losses? Obviously, there are additional factors, which will be considered in making the ultimate determination on permitted deductions.
In the case of horse racing and breeding activities, the standards by which ordinary business people determine whether a business is or is not a successful one are largely not applicable. In view of the character of the activity, an owner’s earnings or losses generally fluctuate. To moderate such fluctuation requires considerable experience and skill. While profits and losses must be computed on an annual basis for tax purposes, this is not necessarily true in determining whether there was a bona fide profit motive.
In California, a taxpayer’s marginal tax rate can reach as high as 50.6%. This means the taxpayer is losing deductions that could otherwise reduce his or her taxes by 50.6% of all disallowed “hobby losses.” For example, if a taxpayer had a $10,000 tax loss in one’s stable activities for the year, and $200,000 dollars of other income, he could offset $10,000 of the $200,000 income with the stable activity losses. This would result in a tax savings of $5,060. However, if the IRS deems the stable activity a “hobby, ” no deduction is allowed and the taxpayer’s bill is $5,060 more.
Whatever the taxpayer’s particular case is, early tax planning can mean the difference between the classification as a legitimate “business,” and as a “hobby.” The stakes are high. Be prepared.