“Proven Strategies” is a new regular series in the TDN, presented by Keeneland. It is written by Len Green of The Green Group and DJ Stables, who won the 2018 GI Breeders' Cup Juvenile Fillies with Jaywalk (Cross Traffic).
by Leonard C. Green, CPA, MBA, and Frank R. Palino, EA, CDFA, ATA
An IRS examination notice not only creates extreme anxiety, but also may trigger possible tax assessments, interest and even penalties.
Let's face it, the horse industry, whether you are a horse/farm owner, trainer, veterinarian or buy and sell horses, can be a very difficult business in which to make money.
When you deduct horse-related losses against your other income, you become the potential target for the IRS to examine your tax returns.
What is the Best Way to be Successful in Case of an Examination?
Based on over 30 years of experience in the Thoroughbred industry, we believe there are steps you should be taking in the event of an audit.
1. Start by having a team of experts who are involved in the industry and who know the tax law.
2. Let them review your tax returns and look for possible “red flags” as well as areas you could have generated additional deductions.
3. Be aware of what the IRS considers in its pre-audit analysis. These include:
–Are there activities with large expenses with little to no income?
–Are losses offsetting other income on the tax returns?
–Does the activity result in a large tax benefit to the taxpayer?
–Does the taxpayer have a business plan?
The IRS is looking for taxpayers who significantly reduce their taxable income by reporting losses from activities that may or may not be engaged in for profit. It is up to the IRS to make a factual determination whether an activity is engaged in for profit.
The Internal Revenue Code allows individuals to deduct expenses which are incurred: (i) In a trade or business (ii) For the production or collection of income, (iii) For the management of property whose activities are operated for the objective of generating a profit.
Defining Such Activities
An activity that is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual profit motive typically involves nine non-exclusive factors, which are as follows:
1. The manner in which the taxpayer carried out the activity.
2. The expertise of the taxpayer or his/her advisors.
3. The time and effort expended by the taxpayer in carrying out the activity.
4. The expectation that the assets used in the activity may appreciate in value.
5. The success of the taxpayer in carrying on other similar or dissimilar activities.
6. The taxpayer's history of income or loss with respect to the horse activity.
7. The amount of profits, if any, which are earned.
8. The financial status of the taxpayer.
9. Elements of personal pleasure or recreation.
Important Fact: If the number of factors indicating the lack of profit exceeds the number indicating the presence of a profit objective (or vice versa), it is considered not conclusive. For example, if five factors say the activity is not for profit, but four are on the profit side, the activity still could be determined to be engaged as a for profit.
“Plus Factors” that Assist the Taxpayer in Case of Audit
It is the responsibility of the taxpayer to prove that he/she is in a 'trade or business.” Here are some recommendations:
1. Have segregated business bank accounts.
2. Avoid having personal expenses being commingled with business expenses.
3. Have separate books and records.
4. Be profitable at least two out of every seven years but also understanding this is not the controlling factor.
5. Be knowledgeable about the industry.
6. Be in constant contact with trainers, advisors or people involved with the care of the horses.
7. If you buy or sell horses, spend time with people involved in the process and learn the criteria they use to make their decisions.
8. Have a profit motive and a business strategy that changes as operations change.
9. Implement a specific business plan – it may be deemed as a benefit to have an outside party (i.e. lawyer, accountant, specialist, etc.) co-author the plan.
Taxpayers should have a business plan which reflects their financial economic forecast for the activity. It should be both a short- and long-range forecast for the activity allowing changes in the event of potential unforeseen and fortuitous circumstances.
A stumbling block that must be overcome is whether the taxpayer materially participates in the horse industry.
The best way to prove this would be to participate in some of the following six rules.
1. Spend more than 500 hours in qualifying activities.
2. Your participation constitutes substantially all of the participation in the activity or shows losses for a number of years, then the IRS may classify the losses as nondeductible passive losses.
3. You participate for more than 100 hours and this participation is not less than the participation of any other individual.
4. You materially participated in the activity for any five years of the 10 years that preceded the year in question.
5. You materially participated in the activity for any three years preceding the tax year in question.
6. You satisfy a facts and circumstances test that requires you to show that you participated on a regular, continuous and substantial basis.
Potential Problem Areas to Consider
1. The taxpayer has an unrelated W-2 wage job he or she devotes significant amount of time.
2. The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
3. The taxpayer is rarely involved in the horse activity.
Preparation for the possibility of an IRS Audit, such as record keeping for all of your activities will give you a better chance of winning these issues.
Having an advisor and tax preparer who knows the horse operation and is familiar with all the specific horse tax laws and operations is very helpful.
Frank Palino, who heads up our audit division, is a former IRS Agent and has a successful record in over 1,000 IRS audits. He is also very familiar with what the IRS is looking for in audits.
For more information on anything in this article, contact our offices. Also take advantage of the one-hour complimentary consultation that is available to those who read this column.
The Green Group
Phone: (732) 634-5100