Q: My husband has always wanted to have horses so recently we purchased a six-acre property that we will be moving to shortly. My husband is now talking about making horses a business even though he is not going to quit his current job. He is interested in boarding a horse or two, and/or raising a horse or two for sale. He is thinking this will help offset some of the costs of maintaining the property and the horses we will own. By his calculations we will probably lose money for a few years, but make a (modest) profit after that. Are we going to trigger lots of red flags with the IRS if we do this?
A: As is often the case my answer is a definite maybe. The answer really depends on your intent and your actions in running the new business. I have many clients that have turned their hobby or their recreation into a very legitimate business and passed the IRS smell test under audit. But, of course, there are those that are really just trying to find a way to get a tax break for doing something they like to do in their spare time.
The IRS loves businesses that make a profit and pay lots of tax, but they are more suspect if the business loses money year after year and seems to serve only to reduce the owner’s tax bill. The IRS will often consider these activities hobbies and disallow the deductions.
Generally the Tax Code limits deductions of “activities not engaged in for profit.” This is all rather vague and subject to the facts and circumstances of the particular situation. The Tax Code does however offer some guidance which is helpful. According to the Code, if a business is profitable in at least three of the last five years, there is a presumption that the business is carried on for a profit. In the case of an activity which consists mainly of breeding, training, showing, or racing horses, the test is to show a profit in at least two of the last seven years. This is not to say that either you or the IRS can’t argue to the contrary, but it does provide some guidelines.
So ask yourself the following questions (based on the IRS regulations that govern this issue):
• Am I carrying on this activity in a businesslike manner?
• Is the time and effort I am putting into this activity clearly showing an intention to make a profit?
• Do I depend on the income from this activity for my livelihood?
• Are any losses I incur due to circumstances beyond my control (or are they normal in the startup phase of my type of business)?
• Will I change my methods of operation to improve profitability?
• Do I have, or do my advisors have, the knowledge needed to carry on the activity as a successful business?
• Have I been successful in making a profit in similar activities in the past?
• In years the activity makes a profit, how much profit does it make compared with loss years?
• Can I expect to make a future profit from the appreciation of the assets used in the business?
• How significant is the element of personal pleasure or recreation in the business?
These are some of the questions the IRS will ask if challenging the business versus hobby status of your horse related activities. Keep in mind that no one factor is decisive, but viewed in total the answers can reveal much about your intent. And by the way, it is certainly okay to love your work!
Assuming you are truly running a business, you should identify your expenditures related to the business and deduct them accordingly. Obviously having good accounting records, a separate bank account, marketing materials and a web site, and all the other attributes of a well run business will lend further evidence that you have a profit motive.
So good luck with the new business!
The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation. Peter Robbins is a principal in the Boise office of CliftonLarsonAllen LLP, specializing in tax matters for small businesses, individuals, and trusts and estates. Have a question for Robbins? Email your question to firstname.lastname@example.org. Enter “Talking Tax” in the subject line.