Jittery taxpayers have read about plans of the IRS to conduct more random audits. In an effort to do a better job of conducting audits, the Internal Revenue Service plans a random check of about 50,000 individual tax returns this year. Since that news, I have received a greater volume of requests for tax opinion letters from horse owners who want to insure that they will be able to withstand face-to-face questioning by the IRS should they be selected for audit.
Perhaps the IRS announcement to conduct random audits is nothing to fear for most horse owners who are conducting their activity for profit, but a random check of tax returns can be worrisome for the taxpaying population that earns above $100,000 and fails to show a profit in their horse activity.
There are many considerations in conducting a horse activity for profit. As with all other areas of farming and ranching, the horse industry is understood to require a startup phase–often a period of at least seven years but often more than that–before the activity turns a profit. After a certain point some people decide they had best not take any more tax writeoffs because they are afraid the IRS will contest the authenticity of their intentions. Others, believing in earnest that they are moving closer and closer to a profit year, continue to conduct the activity as a business, and it is those situations that are likely candidates for audits.
A tax opinion letter is something that involves assessing the overall operations of the activity and then applying various legal principles and Tax Court cases to analyzing the venture, making recommendations, and expressing an opinion as to whether the activity is, on balance, conducted in accordance with IRS Regulations. My tax opinion letters are considered as evidence of compliance with Factor No. 2 of IRS Regulations pertaining to the importance of taxpayers in the horse industry to consult experts.
Most of my clients do very well in audits, and I am proud of my record in the Tax Court arena. At the audit stage, the IRS is primarily concerned with raising revenue, and in many instances a bad result at that stage may seem utterly perplexing to a taxpayer. Often, however, once a case is brought into the different Tax Court, the chances of settling the case are much better than at the audit phase, although this will depend on how good your facts are and on the skill of your legal counsel. In one client?s case, there were good facts:
Ellwood Jones had consistently promoted and advertised his horse activity by placing ads in the leading quarter horse journals. He had studied advertising layouts in college, and composed his own ads. He also had a concrete business plan that was established in consultation with his trainers and an accountant who had experience in rendering of advice to owners and breeders engaged in horse racing for profit. The accountant prepared detailed profit and loss analyses and discussed them with the taxpayer from a practical business perspective.
There are various cost-savings procedures Mr. Jones implemented in an effort to reduce expenses and therefore enhance the chances of making a profit: (1) culling from inventory those horses that were least productive, and making a decisive move to retain the best mares, thereby focusing expenditures on this smaller group; (2) acquiring and maintaining his principal stallion and selling a fractional interest in it to other investors (“syndication”); (3) farming of other products such as alfalfa, soy or other farm products, which reduced the amount spent on feed, and also raised revenue from the sale of surplus farm produce; (4) realizing cost savings by boarding of his horses on at his farm instead of paying outside establishments for boarding services; and (5) eliminating expensive annual mortality insurance premiums and becoming self-insured instead.
It is also important to demonstrate that you are assiduously at work in the years in issue to make your horse activity profitable. Mr. Jones had been successful in every other business venture he had ever established, and the string of losses he experienced was attributable in large part to depressed sales prices in the horse market. Mr. Jones had conducted a careful investigation of the horse racing and breeding business prior to buying his first mare. And the facts revealed that he had a genuine and forthright expectation that his venture would make a profit in the long run. He was therefore able, with the assistance of legal counsel, to withstand IRS scrutiny.
Careful planning means obtaining a tax opinion letter, which to many people is not only cost effective but provides considerable practical advice that helps to make a profit in this industry.
John Alan Cohan is a lawyer who has served the horse industry since 1981. He serves clients in all 50 states, and can be reached by telephone at (310) 557-9900 or via e-mail at [email protected].