In recent years, the Internal Revenue Service (IRS) has been cracking down on both full- and part-time business operators to prevent them from deducting illegitimate losses. If your operation is targeted by the IRS because you fail to show a profit for a couple of years, the agency will likely try to label your operation a hobby rather than a business. Your ability to claim deductions may be taken away. Even established commercial stable owners are facing the problem.
When the IRS brands an activity a hobby, losses cannot be used to offset income from other sources, including income from another job, investments or another activity. On the other hand, if your horse barn really is a hobby, you have to report and often pay taxes on all net income generated by it. That means the horse professional (full- or part-time) who owns the business must add all of the net income produced by the activity to his or her personal taxable income. As a business, though, the activity’s expenses may be used to offset all or part of the activity’s income, but that often means there’s no activity income to make the numerous expenses count in your favor.
In order for these costs to count toward reducing taxable income, no matter the source, they must qualify as so-called business losses. For that to happen, the stable activity needs to qualify as a “tax” business. And it’s surprisingly easy to qualify as a tax business, even though legitimate expenses often exceed the income a horse barn produces.
Every horse professional who operates a barn is familiar with the rule that an activity must show a profit in at least three out of five consecutive years (when draft, breeding or racing horses are involved, the rule is three out of seven years) for the IRS to accept it as a business. That profitable-years test means that the burden is on the IRS to prove a profitable operation is not a business and on the taxpayer to prove an unprofitable one actually is a business—especially difficult for a start-up operation.
But another section of the same tax law allows some operations to avoid using the profitable-years test if they can satisfy a separate set of criteria to prove that a legitimate tax business exists. It’s referred to as the nine-point test and it’s used to demonstrate that there is an “intent to show a profit.” That intent indicates the existence of a real business regardless of profits and losses, securing the right to claim some losses to reduce taxable income from other sources.
The nine-point test was created by the courts and adopted by Congress to avoid confrontations between the IRS and taxpayers arising from the fact that U.S. tax law doesn’t differentiate between hobbies and businesses. Rather, the tax rules refer only to activities “not engaged in for profit.” To determine whether a given activity is engaged in for profit, the tax law clearly states that all facts and circumstances must be taken into account.
Proving intent to earn a profit
Along those lines, Congress outlined the nine factors it felt the IRS should consider when determining whether an activity is engaged in for, or with the intent of showing, a profit. Each is listed below, followed by questions barn operators should ask themselves to determine whether they have a valid argument for claiming tax-business status.
- The manner in which the horse barn is operated. What types of books and records are kept for the operation? What changes have been made to eliminate losses? What types of marketing/PR are being undertaken to increase customers and income?
- The expertise of the operator or taxpayer. What are your reasons for engaging in a stable-related activity? Do you have any prior experience in this area? What preparation did you do prior to entering this field?
- The time and effort expended carrying on the activity. How much time do you spend engaged in running the barn, giving lessons, training horses? How much assistance do you get from others or do you pay for help?
- The expectation that assets used in the activity may appreciate in value. Is your barn located in an area where real estate prices are increasing? Do you have a marketable stud or brood mare?
- Success in other activities. Have you demonstrated success in related or unrelated businesses?
- The activity’s income/loss history. How many years have losses been shown? Are the losses increasing or decreasing?
- The amount of occasional profits, if any, earned by the activity. Has this activity ever produced a profit? How does the amount of profit compare to the amount of losses or capital invested in the activity?
- The financial status of the taxpayer. Do you have other sources of income? Is the activity being used to shelter other income?
- The elements of personal pleasure or recreation. Is this simply a fun weekend pursuit? Just because something is enjoyable doesn’t make it a hobby, even to a jaded IRS. However, the personal pleasure or recreational aspects of any activity must be weighed when attempting to qualify it as a tax business.
No one of these factors will be enough to convince a skeptical IRS auditor that a “for-profit” or a “not-for-profit” exists. However, taken as a whole, both you and the IRS can establish a rapport and come to a good conclusion as to if your horse operation is a business that will allow you to shelter other income to reduce your tax bill while you continue working on making that elusive profit. [sm]