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.
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.