Equine Accounting: Hobby vs Business...What the IRS says

To you, it's a way to combine your passion with the need to eat and have a roof over your head. It's a business. But the IRS might have an alternative view. How do they decide and what difference does it make to you?
The IRS has created the Hobby Loss Rule for unincorporated businesses that it determines to be created mainly for recreation, sport or personal enjoyment. In addition to horses, examples of other activities that might qualify under this heading would be coin/stamp collecting or dog/cat breeding. For the IRS to classify your activity as a business, there must be a presence of a profit objective. The owner must have entered into or continued with the activity with the objective of making a profit.
The profit motive can be inferred by the IRS by examining the following factors (commonly known as the 9 Factors Test):
1. Is the activity carried on in a business-like manner - business records are separate from personal records, the business has a long-range business plan (preferrably written) and complete and accurate books are kept?
2. Does the owner invest a significant amount of time in the business?
3. Does the owner depend on the income from the activity for his/her livelihood?
4. What is the amount of occasional profits, if any?
5. Has the activity been profitable in some years and how much profit is realized?
6. Does the owner have the expertise to carry on the business? Do they solicit the advice of experts?
7. Are there elements of personal pleasure or recreation involved?
8. Is there an expectation that the assets used in the activity will appreciate in value?
9. Has the owner had success in other similar ventures?

The burden of proof is on the taxpayer. IRS regulations state that in determining whether an activity is enaged in with a profit motive, the IRS will look to "objective standards, taking into account all the facts and circumstances of each case."
What can you do to avoid having your business classified as a hobby activity? As a business owner, you need to operate in a way which conforms to the factors that indicate a profit motive. Available on the IRS website is the Audit Techniques Guide for Farm Hobby Losses with Cattle and Horse Activities. This guide is available to auditors, prior to visiting a horse/cattle activity. Read it and familiarize yourself with the areas are important to the IRS regarding this issue.
Another factor for you to consider is the possibility of timing the profit and loss years. In IRS terms, this situation is known as the "General Presumption" or more commonly as the "Two out of Seven Rule". This is a lengthy subject and will be discussed in a later issue of this newsletter.
If you think that your business is too big, has been in business too long, etc. to be determined to be a hobby by the IRS, consider this; in 1958, Tempel Smith decided to build a herd of Lipizzan horses and create an organization in the U.S. similar to the Spanish Riding School. Tempel Farms showed consecutive losses over the period from 1958-1976, totalling approximately $5.9 million dollars. By 1976, the herd size was approximately 400 horses. In Smith v Commissioner 1979, the IRS challenged the profit presumption and tried to establish that Tempel Farms was a hobby activity. Fortunately for Tempel Farms, the U.S. Tax Court disagreed with the IRS position.
If your activity IS determined to be a hobby, income is reported as other income on Form 1040 and deductions are reported as miscellaneous itemized deductions on Schedule A. However, any expenses your business sustains may not be deductible in excess of business income and the unused losses cannot be carried over to another year.
In these tough times, your business may not be able to show a profit. But you can operate your business with consideration for the eight factors listed above. Plan ahead.

Equine Accounting: Tax Records - What, what, where, when and how (long to keep it)...

The IRS requires that you keep permanent records that are "sufficient to establish the amount of gross income and deductions, credits and other matters shown on your tax return." To accomplish that goal, tax law requires that your business maintain an accurate and complete set of books. J.K. Lasser Publications estimates that the average small business owner spends ten hours each week working on their company's financial records.
Examples of deductible expenses for a horse business could include costs for wages, training, supplies, feed, breeding fees, veterinary visits, donations, trailering, interest, taxes, repairs, auto, travel, advertising and insurance.
Documentation for most types of expenses require that you maintain basic information for each expense - date of purchase, amount, description and business purpose. But some categories of expenses have specific requirements for documentation:
Auto - Keep a log of all business-related travel including destination, purpose of trip, name of party visited and start and end odometer readings.
Charitable Contributions - For cash contributions, you need either the bank record or written communication from the donee with the date, amount and donee name. For cash contributions of $250 or more, a contemporaneous, written acknowledgement from the donee indicating the amount of donation is required.
Gift - The amount, date given, description of the gift, business reason for giving the gift, name and occupation of person receiving the gift and their business relationship to you must be documented.
Travel & Entertainment - Records must show the amount, time, place and business purpose of the expense. The written proof must be recorded "contemporaneously" with the expense. In other words, you can't spend the money one day and document the expense in writing six months later.

How long do you need to keep this documentation?
The IRS has three years from the date the return is due or filed OR two years from the date the tax was paid (whichever is later) to assess the tax. There are also longer statutes of limitation for unreported income, filing a credit or claim for refund and losses from worthless securities. However, if the taxpayer files a fraudulent return or doesn't file a return, there is NO statute of limitations for the IRS to assess tax. Also, for any property, supporting documentation for the cost and any improvements should be kept until the property is sold. Since each situation is different, business owners should consult with their financial advisor before deciding to throw away any documentation that support their tax return.
For more information, visit the IRS website.

Equine Accounting: General Guidelines for Tax Deductible Expenses

We'll be covering specific expenses such as depreciation, meals and entertainment and auto/travel expenses in future issues of the newsletter.
Here are general guidelines as to the deductibility of an expense. The expense has to be part of the cost of carrying on a trade or business and the business is operated with the goal of making a profit. The expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your business. For example, limo service may be an ordinary expense to a literary agent but not to a plumber. A necessary expense is one that is helpful and appropriate to your business, but need not be indispensable. For a riding school, a bridle for each school horse would be an example of a necessary expense.
When deciding whether an expense is both ordinary and necessary, examine industry guidelines, speak with others in your field and check related literature. But keep in mind that the IRS tends to be conservative in its interpretation of this topic.

For more information, visit the IRS website.

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