In hobby loss audits, the IRS sometimes views horse activities as a means of generating tax losses, rather than as a profit-oriented venture. The IRS gives the greatest problems to individuals who have had a significant history of losses that they use to write off other income.
In addition, the IRS will argue, particularly in such cases, that the activity has all the hallmarks of a hobby, so that the costs of operation are nondeductible, personal expenses of the taxpayer.
In a recent case, the taxpayer convinced the Tax Court that his breeding activity was a business, not a hobby, despite 23 years of losses. [Mullins v. United States, 334 F.Supp.2d 1042 (E.D. Tenn. 2004).] The case involved primarily cattle–however, the same hobby loss principles are applicable to the horse industry as well.
The court said:
“If losses, or even repeated losses, were the only criterion by which farming is to be judged a business, then a large proportion of the farms of the country would be outside the pale. It is the expectation of gain, and not gain itself which is one of the factors which enter into the determination of the question.”
The taxpayer in the Mullins case maintained from 70 to 100 head of cattle during his years of farming. After retiring from his company, he devoted about 50 hours per week working on the farm. He and Mrs. Mullins lived on a modest house on the farm.
The court said that Mr. Mullins pursued his farm operations with the same dedication and devotion that he applied to his successful toolmaking business. He did not enter the farming venture blindly, but consulted with people who had extensive experience in the cattle business. The court said that Mr. Mullins acquired a certain amount of expertise on his own, and that he also relied upon the expertise of others through regular consultations.
Although the cumulative losses were substantial, the court concluded that he engaged in the venture as a business, not as a hobby.
Also, at the trial a real estate expert testified that the fair market value of the farm had significantly appreciated as a result of farm improvements. This evidence, according to the court, made the losses less significant because an overall profit could result if the land were sold.
It is important in a horse or livestock venture, if there is a history of losses, to seek expert advice on whether you are operating in a businesslike manner. Of course, “businesslike manner” varies from individual to individual–because every venture is a unique operation. What might count as businesslike for one type of activity might seem amateurish in another case.
In this regard, I find that it is important to have a tax opinion letter or other formal analysis to have as documentary evidence of your overall businesslike approach.
A tax opinion letter is something that I utilize to help clients analyze the details of their operations, with a view towards complying, as best as possible, with the criteria set forth in the hobby loss rule. A tax opinion letter helps show that you sought expert advice and that, hopefully, you followed some or all of it.
In hobby loss audits the IRS will view this document, among others, in deciding whether you are operating in a businesslike manner.
The IRS does not expect an impossible level of formality or excellence in your farm records. But usually in audits where there is a fairly long history of losses–the IRS will heavily scrutinize your operations in order to decide whether it is a business or a hobby. The lack of good business records, in such cases, will incline the IRS to rule that the venture is a hobby.
In the above case, the taxpayer had helpful evidence that his farm property had appreciated in value. This was by way of a formal appraisal (as well as testimony of a realtor). A formal appraisal is a helpful item of documentary evidence, for if your property has appreciated in value (or is expected to appreciate in value) as a result of your stewardship, this is is an element in your favor. It shows that you have a profit motive because if the property were sold you might then make a profit, overall.
In addition to a tax opinion letter, appraisals are important items of evidence to show your businesslike intentions. Keep in mind that appraisals are important not only for land, but for assets used in the venture, such as bloodstock.
Contributed By: John Alan Cohan, Attorney at Law