it’s tax season right now, and most of us are looking for deductions to offset income from last year. Once you file your 2009 tax forms, it would be the perfect time to look forward to Spring 2011 and consider what you can do during the rest of 2010 to reduce your tax burden a year from now. Here are guidelines from Elizabeth Clarke, who’s a lawyer and business consultant specializing in equestrian businesses, to help you assess whether you have horse-related deductions that can be used to offset your 2010 income.
HJ: Who should be able to deduct horse-related expenses from their taxes’ THere’s the person with one horse; or a person with a clearly legitimate business of boarding, teaching, training, etc.; or a breeder; or infinite variations of them all. it’s hard to generalize.
EC: The IRS definitions are pretty simple. You can have a business. You can have a hobby that happens to produce income. Or you can have capital assets ? you buy one horse and sell him later for a lot more or a lot less money ? that’s treated like an investment.
The people who tend to get into trouble with the IRS are the people who don’t meet the IRS definition of a for-profit business. They never make any money. But they try to use their horse-related expenses to reduce their taxes against income generated from other activities.
A legitimate business can lose money sometimes, but there is a set of criteria that the IRS uses to determine whether you have a business that’s going through a bad stretch or whether you don’t have a business at all. It has to do with the intention to generate a profit and, when you don’t have a profit, the changes you make to move that way. So, if you lose money year after year, and you change nothing, you’re in trouble. If you try something, and it doesn’t really work, you’re sort of on the borderline.
The difficult mix, and it’s pretty common, is the professional who really has a business and generates income and also has some horses that don’t contribute toward the generation of that income. The people with sort of a hybrid, where some of the horses are personal and some horses are really revenue-generating, those people need good help from a tax professional.
HJ: What about the person who generates income for years but never really matches his expenses’
EC: What were the expenses’ For instance, if you want to teach, your competition expenses ? that’s getting you out there on a horse in front of people who could see you as a trainer ? are probably legitimate. But to the extent that the horse is your personal pet and He’s not for sale at any price and He’s not going breed and He’s not going to generate any other revenue, probably his expenses aren?t legitimate. Your competition horse’s expenses may be deductible, but your retired horse’s expenses aren?t.
HJ: What if you teach riding but board a horse and take lessons yourself’ Are those expenses deductible’
EC: If you’re actively an instructor, that’s fine. Riding lessons are along the line of education, and that’s not even a question mark. Boarding expenses for your horse, if you’re not teaching on the horse, may be a gray area. Some activities don’t make the horse deductible in its entirety.
The rule is that you can deduct what contributes toward generating income. If the expenses are incurred for a reason that will help you generate revenue, tHere’s no question. If the expense doesn’t have a whiff of generating revenue, that’s not deductible. The gray area is in between. How much does competition promote your equine-related business’ One horse, no question. If you keep seven of your own horses, and they’re not school horses, and you show them all once a year, does that make all seven deductible’ Some people try to stretch it a bit.
HJ: In general, if someone is going to deduct horse-related expenses, should they have tax help from a specialist in equine businesses.
EC: It certainly helps, in two ways. One is that they understand your activities better and, two, is that if you do get audited, they add a credibility level that will get you out of the audit faster. An accountant with no horse experience might be fine, but you’re going to spend a lot more time and, if he bills by the hour, you’re going to spend a lot more money helping that person learn things about your business that a horse specialist already knows.
HJ: When is it legitimate to deduct horse expenses on your taxes from the overall family income, rather than from just horse-related income’
EC: If you’re a sole proprietor in business, the revenue and expense are reported on Schedule C to your personal income tax return. The bottom line from the Schedule C goes onto your 1040 along with the net income or net loss from other ?income producing? activities.
For example, you have your horse-related business and your husband has a W-2 from employment, or maybe he has an LLC that operates a car-repair shop, and the two of you have some investments. Each activity has its own income/expense report, and they are combined on the return itself. it’s the combined total of all business income and losses that determines your Adjusted Gross Income for tax purposes.
The IRS web site (www.irs.gov) has a wonderful list of publications, and tHere’s one called ?Business Expenses? that’s simple to read and tells you how to determine what is deductible as business expense and what might be at least partially deductible for other reasons, such as hobby expenses, which can be deducted but in a more restricted fashion. The publications are general, not specifically for horse people, but the rules are the rules. They don’t make different rules for horse people if you go into an audit.
Knowing the rules will also will help you know whether your accountant is on the right track or not. There are a lot of accountants who either get way too aggressive and include personal expenses in the business or who don’t go far enough because they don’t understand things like competition of a personal horse serving an advertising purpose. it’s not a black-and-white line, so you have to be able to justify how the expense goes toward generating revenue. As long as you can show that the expense serves to generate revenue, and that you do intend to generate more revenue than expense, then it’s a deductible expense.
HJ: Are there particular red flags that tend to trigger an audit’
EC: There used to be. It used to be that cattle as a ?business? was the number-one red flag, with grapes number two, and horses number three. The likelihood went up if your income came from being a doctor, because tax shelters were very actively marketed to members of the medical profession. Now, there are two criteria, and one of them is random computer selection, so anyone can be audited. There also can be something on your returns, like repeated losses on a Schedule C, or a significant difference between the income you report on your return and the amount reported to the IRS by sources on W-2s, 1099s and K-1s, that can be a trigger.
HJ:Does breeding tend to be a particularly dangerous area’
EC:No. In general, if you make profits in any two years out of five for an ordinary business, the presumption is that you are in that business to try to make money and that you had some bad years or maybe got a slow start. For horse breeding, racing or training as a primary business activity, that rule changes to three years out of seven because of the lead time required to produce profitable results.
If you buy a broodmare and try to get her pregnant right away, it’s 11 months before a foal hits the ground and most horses are not sold as foals. It takes another two or three years for them to be marketable. This favorable treatment came from the racing industry arguing successfully that it takes three or four years to generate any real revenue, so the two-years-out-of-five presumption isn?t an accurate picture. Horses are the only business that gets this consideration, but note that it’s only breeding, racing and training. For boarding operations, the two-years-out-of-five presumption still applies.
Even if you meet the test, it doesn’t mean that all of your deductions will be allowed. It means the burden shifts to the IRS to prove you’re not in business instead of the burden being on you to prove that you are. Some people think that if you make that profit three years out of seven you’re immune to increased tax liability, but that’s not necessarily true.
HJ: What kind of paperwork should people be keeping’
EC: If you’re running a horse-related business, and you want to sail through a tax audit if one should happen, you want that business to look as professional as possible. You keep your receipts well-categorized. You save your invoices. You use a financial software package that prints out reports and you use the results to improve your business. You have a written business plan regarding where you’re going, how you’re going to offset losses.
So, the more business-like you make a business look, the more willing the IRS is to believe the losses are for some casualty reason and not that you’re trying to finance a hobby on the back of the IRS.
The real aspects of running a business are so much more complicated than the bookkeeping that the IRS is looking for. it’s not that hard. it’s that people are intimidated by a very complicated tax code and maybe are a bit math-phobic. You have to understand the numbers of your business, or you’re not a business. If you want to make money, you need to be evaluating where things are going and how to fix them if necessary.
If you are generating taxable income through your horse business, and especially if it’s your primary source of income, the IRS will much more readily believe that you are in business. it’s the generation of losses that raises their eyebrows.
HJ: Is there anything new in tax legislation for 2010 that should help out horse-related businesses’
EC: Make sure that you and/or your tax advisor are not letting any stimulus credits pass you by if you qualify and can use them.
Article by Margaret Freeman, our Associate Editor.