Exam I
Test your knowledge of equine law. by Attorney Krysia Nelson
Hobby vs. Business: Understand the “Taxable” Difference
s your horse activity a business, or just an expensive hobby? The real test comes if you claim your horses as business expenses, and then the IRS audits your federal income tax return and challenges the deductions under what is known as the “hobby loss” rule. The hobby loss rule, as its name suggests, prohibits a taxpayer from claiming the expenses of a hobby as busi- ness expense deductions. Whether you run your horse activities through
a “company” of any sort doesn’t matter to the IRS. In order for your horse expenses to be deductible as business ex- penses, your company must meet IRS business standards. This means the company must be engaged in its business with an actual and honest profit objective. Whether or not this objective exists is, for all practical purposes, evaluated by the IRS from a profit-loss stand- point: if the business is showing a profit and paying taxes, the IRS will happily accept the money and probably leave the taxpayer alone. If the business is operating at a loss, thus causing the taxpayer to pay less in taxes, the IRS is more likely to get inquisitive. Since most horse businesses operate at a loss,
deducting horse-related expenses as business ex- penses is a red flag for the IRS and can lead to the very unpleasant experience of an audit. These au- dits are commonly referred to as “hobby loss” au- dits, as the IRS will contend that the horseperson/ taxpayer is merely trying to get the government to partially subsidize an expensive hobby. And, of course, expenses incurred in the pursuit of a hobby cannot be deducted as business expenses. An IRS audit is not your only worst nightmare. Your state revenue department can audit you as
78 March/April 2016
well, as most states have similar rules and enforce them in the same way as the IRS. Thus, you can be audited by either or both the IRS and your state revenue department.
WHAT DO YOU HAVE TO PROVE? According to the Internal Revenue Code, if an “activity is not engaged in for profit, no deduction attributable to such activity shall be allowed . . . . except to the extent of the gross income derived from such activity.”
The Treasury Regulations set out nine factors
for courts to consider in determining whether a taxpayer had the requisite profit motive to claim deductions in excess of gross income:
the manner in which the taxpayer carries on the activity the expertise of the taxpayer or his advisors the time and effort expended by the taxpayer in carry- ing on the activity
the expectation that assets used in the activity may ap- preciate in value
the success of the taxpayer in carrying on other similar or dissimilar activities
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