By Len Green
The Thoroughbred industry is one of the ways to own a piece of sports. For those of us who enjoy competition but cannot afford the “billion-dollar price tag” associated with the New York Yankees or Dallas Cowboys, “the sport of kings” provides an opportunity to participate in sports at the highest levels.
Due to a multiple number of variables, it is considered to be a challenging and arduous business. Even the IRS considers this activity as an “uphill battle” and, therefore, regulates it under a unique set of rules and codes.
One example is the way the IRS extends the time horizon for profitability. The unique rule variations for our industry provide a more lenient landscape to prove that a) your racing and/or breeding operations are “for profit” and b) that you are taking the required steps to provide yourself with the opportunity to accomplish a profit motive.
There are two safe-harbor rules for determining if you have a for-profit business.
Normal Rule. An activity is presumed to be a for-profit business if it produces positive taxable income (revenues in excess of deductions) for at least three out of every five years. Losses from the other years can be deducted because they are considered to be business losses as opposed to hobby losses.
Special Rule. Specifically for the horse industry includes that horse racing, breeding, training or showing activities are presumed to be for-profit business if they produce positive taxable income in two out of every seven years.
Taxpayers who can plan ahead to qualify for these safe-harbor rules earn the right to deduct their losses against their earned income from outside sources during unprofitable years.
Intent To Make Profit
Even if you cannot qualify for one of the aforementioned safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses. Basically, you must demonstrate an honest intent to make a profit.
Factors that can prove (or disprove) such intent include:
- Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies. Having a business plan in place would reinforce the profit-making objective.
- Spending enough time at your craft to prove that the activity is a business, and not a hobby. This includes the “500-hour test,” which represents the minimum amount of time devoted to the business during the course of one calendar year. Some items which qualify toward the test and have historically passed IRS scrutiny include:
1. Discussions with trainers, jockeys and other industry-related professionals (i.e. phone calls, texts, emails and meetings).
2. Attendance at races and other industry-related activities.
3. Attendance at horse sales.
4. Licensing and regulatory requirements.
5. Reading trade publications.
6. All other work done in connection with the business (this is a “catch-all” item that basically equates to any other items not previously listed).
In order to best provide evidence of the above, we recommend that you annually provide your tax preparer with your horse-related electronic calendars. This should include attended races, meetings, sales, etc.
- The expectation of asset appreciation (this is why the IRS will almost never claim that owning rental real estate is a hobby even when tax losses are incurred for many years).
- Providing the IRS with proof of expertise and/or hiring a third-party service (i.e. attorney, accountant, bookkeeper, etc.) with years of experience working within the equine field. Evidence of such will add tremendous weight in circumstances such as an audit.
- Testament of success in other ventures will aid in indicating business acumen.
- The history and magnitude of income and losses from the activity. Occasional large profits hold more weight than frequent small profits. Losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
- Your financial status–the higher your net worth, the more likely you can afford to absorb ongoing losses (which may indicate a hobby).
- Elements of personal pleasure–attending stakes races is usually more fun than digging post holes for fences. However, the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.
As an active member in the Thoroughbred industry, you are well aware of how difficult it is to be profitable. Thankfully the IRS also understands the difficulty of normal profitability standards.
When you invest in the stock market, you rarely have to worry if General Mills had a bout with colic the night before a big event. However, when investing in delicate athletes, like Thoroughbreds, you are constantly worried about a plethora of factors. This can include their overall health, the track conditions, if they break from the gate alertly, if your yearling vetted out before a sale, if your mare carried her pregnancy full-term and countless other variables completely out of your control. Nonetheless, what is in your control, are following some of the above-mentioned guidelines to prove your intention for profit.
It is in your best interest to attend sales, meet with your trainer regularly, talk sale strategy with your consignor and most importantly surround yourself with experts in the industry who have successful racing and breeding operations.
We hope you enjoyed this month's article and, as always, please feel free to call The Green Group and speak to one of our equine tax experts. Remember to mention TDN and receive your first one-hour consultation for free!