The tax law is all about semantics. For instance, if you’re legitimately trying to make a profit in an endeavor, it may be classified as a “business” by the IRS. In that case, you can deduct the full amount of expenses relating to the business operation. Typically, you might show losses in the early years of ownership. These losses can be used to offset other income such as investment earnings or wages from a full-time job (either yours, your spouse’s, or both).
How the Tax Court Has Ruled
Despite the success of the equestrian interior designer detailed in this article, many taxpayers who engage in horse-related activities lose in Tax Court. A few examples:
- The Tax Court ruled that a North Dakota physician’s Arabian horse breeding activity was not carried on with a profit objective. One reason:The taxpayer “did not operate in a businesslike manner.” She failed to keep track of expenses on a per-horse basis and did not prepare financial projections to aid in evaluating the economic performance of her activity. In addition, the taxpayer engaged in limited advertising, had an inadequate business plan and did not keep a separate bank account for her horse breeding. Instead, she paid horse-related and personal expenses out of several personal accounts. (Keating, TC Memo 2007-309)
- The Tax Court held that a Texas plastic surgeon’s horse ranch activities and his medical practice were not interrelated business activities. Therefore, he could not deduct the losses from the ranch. The taxpayer claimed that the publicity he derived from playing polo and hosting social gatherings helped him get patients for his cosmetic surgery practice. (Wilkinson, TC Memo 1996-39)
- In another case, the Court refused to aggregate a taxpayer’s farming/polo activity and his real estate law practice, despite the taxpayer’s position that one reason he began playing polo was to meet clients for his law firm. The Court concluded that the farm was formed and operated as a separate business, and the Court was not convinced that the taxpayer began the polo activity to generate legal business or that the activity materially benefited his law practice. (De Mendoza, TC Memo 1994-314)
On the other hand, if the IRS treats the activity as a “hobby,” the tax benefits are more limited. Expenses can be deducted only up to the amount of the income received from the activity. Thus, you can’t claim an overall tax loss for the year.
To make matters worse, hobby expenses must be deducted as miscellaneous expenses. Miscellaneous expenses are deductible only to the extent the annual total exceeds 2 percent of your adjusted gross income. So you may derive little or no tax benefit from your losses.
How can you tell a “business” from a “hobby?” A number of factors must be considered. But in general, an activity is treated as a business only if you’re operating it with the actual intention of turning a profit. The IRS and taxpayers regularly argue this issue in the courts (see right-hand box) and the tax agency frequently wins.
However, one case involving a horsing enthusiast illustrates how taxpayers can be victorious.
Facts of the case: The taxpayer, a skilled equestrian from Florida, developed an interior design business for horse barns, homes and other structures. She relied on her reputation and exposure as a rider to promote the business. Virtually all of the taxpayer’s clients were equestrian-related contacts who depended on her knowledge and expertise to provide design services related to horses.
Citing the fact that the taxpayer’s clients were affluent individuals who were also involved in horse activities, the Tax Court found that activities as an equestrian rider materially benefited her interior design business. In other words, the two activities could be treated as one integrated business. Her “success as an equestrian competitor creates goodwill that benefits her design business,” the Tax Court noted.
The court acknowledged that “keeping and maintaining horses is expensive” but added that the taxpayer “does what is necessary to maintain her reputation in the equestrian world” but “does not do so in an extravagant manner.”
In addition, the court emphasized that the combined horse-design business was profitable in each of the years at issue. The IRS argument that the activity was not engaged in for profit neglected the fact that the “business was a success from the beginning…”
Result: The Court determined that the equestrian expenses were “ordinary and necessary” for the operation, as well as reasonable in amount, so they could be deducted as business expenses. (Topping, TC Memo 2007-92)
What About Your Situation? Weighing the Tax Factors
Determining whether a particular activity is a business or a hobby is an art, not a science. Although there is no absolute test, the courts have traditionally relied on the following factors:
- The manner in which the taxpayer carries on the activity.
- The expertise possessed by the taxpayer and any advisers.
- The time and effort spent on the activity.
- Any expectations the taxpayer has that assets used in the activity will appreciate in value.
- Prior success in carrying on other activities.
- The history of income or losses with respect to the activity.
- The amount of profits, if any, that are earned.
- The financial status of the taxpayer.
- Any elements of personal pleasure or recreation.
No single factor by itself is conclusive, but a preponderance of factors can tip the scales in your favor or against you.
Showing a Profit
If you would like to turn an activity into a business, be aware that a tax presumption may be on your side: If you show a profit in any three out of the last five consecutive years, the IRS will generally presume that you’re carrying on a business. This tax presumption is enhanced for an activity involving the breeding, training, showing or racing of horses. In those cases, the activities are presumed to be a business if you show a profit in two out of the last seven consecutive years.
The IRS can rebut the tax law presumption by providing evidence that the activity is actually a hobby.
Caution: You may fight an uphill battle if an activity involves entertainment or recreation. The IRS tends to give less leeway to these types of endeavors. But keep in mind that the Tax Court makes this point in many cases: A business will not be turned into a hobby merely because the owner enjoys the activity.
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