The Tax Cuts and Jobs Act of 2017 pretty much eliminated the tax benefits of hobby activities – as noted in Part I of this blog series, any taxpayer whose venture is classified as a hobby is no longer able to claim expenses related to that hobby, but must still pay tax on any income generated from it (the “hobby loss rule”).
For-profit businesses, however, may deduct expenses relating to their activities under 26 U.S. Code § 162 and 26 U.S. Code § 212 . For this reason, taxpayers should ensure that their activities can be classified as for-profit so that they can deduct their expenses and offset any losses from their other income during the tax year.
There have been many cases on the issue of whether a venture should be classified as a hobby or a for-profit business. In this post, we will explain how the tax court makes its determination and the best ways to demonstrate that your horse expenses are in fact tax deductible.
A presumption that may work in your favor
Through proper advance planning, you may be able to deduct your losses in years that are unprofitable.
Under 26 U.S. Code § 183(d) , the “safe-harbor rules”, if a taxpayer’s activities are profitable for three out of five consecutive years, the activity will be presumed to be an activity engaged in for profit. The taxpayer will be able to deduct business losses incurred during all those years. This “safe harbor presumption” period begins during the first year that the business makes a profit.
A nice tax break for horse owners: The rules are slightly different if the activity “consists in major part of the breeding, training, showing, or racing of horses.” These activities need only make a profit during two out of seven consecutive years to qualify.
Keep in mind, however, that the IRS may still rebut the presumption and demonstrate that your activity is a hobby. For example, if you experience substantial losses in some years and only minor profits in others, the IRS may subject you to increased scrutiny and claim that you are manipulating the hobby loss rules.
Nine factors to prove profit motive
If you don’t qualify for the safe harbor presumption, you still have an opportunity to deduct your losses if you can demonstrate a profit motive. Nine factors – as listed in Treasury Regulation 1.183-2(b) – are typically used to make this determination:
- You conduct your activities in a business-like manner. Here are just a few ways of proving that you expect to make a profit: (1) You maintain accurate and complete books and records, (2) you create a business plan with both short-range and long-range projections, (3) you keep your business and personal funds separate, and (4) you hire a bookkeeper to maintain your financial records.
- You or your advisors have expertise in the activity. You should be able to demonstrate your extensive knowledge of best practices in your chosen activity (e.g., teaching riding lessons, breeding Andalusians), or that you hired people who have that expertise.
- You spend sufficient time and effort engaged in the activity to justify it being classified as a business, and not just a hobby. This may include time spent by people that you hire to carry on the activity on your behalf.
- You expect your assets to appreciate. You may also show how you otherwise expect to profit from the activity.
- You have had success in other ventures.Your previous activities may have been similar or dissimilar, but in any case showed that you turned an unsuccessful venture into a profitable one.
- Your history of income or losses from the activity. If you have losses that continue for a long period time – and beyond the usual period that businesses need to become profitable – the IRS may assume that you are not concerned about your profit and that you are engaged in a hobby.
- The amount of any occasional profits you may earn. Even if you only make a profit from time to time, if the amount is substantial this is indicative that you are engaged in the activity for profit.
- Your financial status. In this case, it helps if you are not wealthy, since the IRS assumes that rich people don’t mind losing money to a hobby while average people are more concerned about making sure that their sideline activities bring in additional income.
- Elements of personal pleasure. You can certainly enjoy your pastime, but the more enjoyable it is, the more likely the IRS will deny your attempt to deduct losses from that activity.
This list is not exhaustive, and none these nine factors alone (nor a majority of them) will determine whether or not your activity is deemed a hobby or for-profit. Regulation 1.183-2(b) clearly states that all facts and circumstances with respect to the activity must be taken into account in making that determination.
Another option – make it a business!
There is nothing wrong with getting pleasure out of having horses, so long as the IRS doesn’t conclude you’re your business is purely recreational. Many tax experts anticipate increased IRS scrutiny over any attempt to deduct losses on a money-losing venture. For this reason, a growing number of taxpayers have been turning their side activities into business entities.
In our next post, we will discuss the benefits of establishing a business entity, the most common structure utilized by individuals in the horse industry, and equine tax planning.
* The information contained in this blog should not be used as a substitute for a consultation with equine tax accountant and/or attorney.