Before 1986, ingenious tax attorneys and financial advisors created investments for their clients that were purposefully designed to create tax losses that could offset other income. In its attempt to curb the use of these abusive tax shelters, Congress enacted The Tax Reform Act of 1986 (TRA), which included the “passive activity loss rules.” Since then, the law has clearly stated that you can offset your business losses against your other income, but your passive losses may only be deducted from your passive income (any excess losses must be carried forward to the following year).
To avoid the passive activity loss rules, you need to prove that your activities are not passive. There are a number of way of accomplishing this.
Seven material participation tests
To prove that you participate in your horse-related business enough to avoid the passive activity loss rules, you must meet one of the following material participation tests:
- You participated in the activity for more than 500 hours during the tax year;
- Your participation constituted substantially all of the participation of all those who participated in the activity during the tax year;
- You participated in the activity for over 100 hours during the tax year, which was more than any other person during that time;
- You spent more than 500 hours participating in significant participation activities (a “significant participation activity” is an activity that you participated in for more than 100 hours that doesn’t qualify under the other material participation tests);
- You materially participated in the activity for any 5 of the 10 preceding years (need not be consecutive);
- Your activity is a “personal service activity” (this may include veterinary and consulting services), and you participated in it for any three of the preceding tax years;
- During the tax year, you participated in the activity on a regular, continuous, and substantial basis, as determined by an analysis of all the facts and circumstances.
To ensure that the IRS will believe that you materially participated in your activity during the tax year, you should keep accurate and complete records of your activities.
How to prove that you “materially participated”
Maintaining appointment books, calendars, and narrative summaries provide an estimation of time spent on your activity during the tax year and will help you satisfy the material participation tests noted above. Note that if your numbers appear to be unreasonable, you may be asked to produce contemporaneous daily records.
You can expect the IRS to ask questions similar to these when evaluating your tax return:
- Do you live so far from your horse farm that it would be difficult to commit significant time to it?
- Is the time you claimed you spent in your stables reasonable as compared to your other commitments?
- Does the time you claimed otherwise make sense?
- Are you compensated for your horse-related work or is your work voluntary?
- Does your work at the farm have a material impact on the business?
- Do you hold a full-time salaried position elsewhere that would make it difficult for you to materially participate in your horse-related activities?
- Do you work at the farm on a regular, continuous basis?
- Do you conduct other business activities or have other hobbies that take up a significant amount of your time?
- Are you healthy enough to handle the additional work?
- Do you have paid staff who provide daily oversight of your operations, so that you need not be there on a regular and continuous basis?
- How often are you present at the stable?
If you are involved in a horse-related business as more than a passive investor, consider documenting all your activities to ensure that the IRS acknowledges your active, material participation in the endeavor.
In our next post in this series, we will cover taxation of horse-related businesses, including deducting and expensing your activities.
* The information contained in this blog should not be used as a substitute for a consultation with equine tax accountant and/or attorney.