If you’re like many equine professionals, you might liken the pleasure of tax preparation to that of unsedated tooth extraction. Even if you work with an accountant for your annual tax-time deadline, the legwork of recordkeeping, receipt collecting and file organizing is probably not high on your to-do list.
Unfortunately, tax issues are a routine aspect to business ownership. In the equine industry, there are several tax areas that can be confusing. Here, tax attorney and “American Horse Council Tax Handbook” author Thomas A. (Tad) Davis of The Law Offices of Davis and Harman in Washington, D.C., guides you through the top four tax issues in the industry:
1. HOBBY VS. BUSINESS
While the horse business probably isn’t one that you entered to get rich quick, it is one from which you should expect to generate a reasonable profit.
The basic rule of thumb is that you need to show a profit two years out of seven to be presumed to be a business operation rather than a hobby farm. This does not mean that your horse-related activity is a hobby if it does not have two profitable years in seven. However, Davis says, “If you’re not making money, you have to be able to demonstrate to the IRS that you have intent to make a profit and be able to say, ‘Here is the way I am going to do it.’”
According to the IRS “Farmer’s Tax Guide,” in determining whether you’re in the horse business to make a profit, they’ll consider a range of factors, including whether:
• You operate your business in a businesslike manner.
• You put in the time and effort appropriate to making your equine business profitable.
• You depend on this income for your livelihood.
• Your losses are due to circumstances beyond your control or are normal in the startup phase of your business.
• You change your methods of operation in order to improve profitability.
• You and your advisors have the knowledge to carry on this type of business profitably.
• You were successful in making a profit at this activity in the past.
If your motive behind your equine business is called into question by the IRS, they might examine your business plan, income and expense records, and interview you for an explanation of your management methods. Because your tax returns from up to three years ago can be audited, it’s important to keep up with your financial records.
“People tend to leave details to later, but I think it’s important to keep up with your income and expenses as you go along and have a good handle on them,” Davis says. “Analyze the numbers, and if you are not making a profit, see where you can cut expenses and improve income.”
By letting things go, it’s easy to overlook expenses and items you could be deducting. Plus, if you were to get audited, Davis says, “it will be a real pain to try to find all those records, put them into shape and present them in a reasonable manner. If you have nothing but a shoebox full of receipts, they’re going to be skeptical about the expenses and skeptical about the income.”
Regular expenses that you can deduct against your income include stud fees, training fees, show entries, feed, bedding, office supplies, veterinary work, employee wages, property taxes and any other cost that is incurred during the normal course of doing business.
One category of costs, capital expenditures, is not immediately deductible in the year in which they were incurred. These items, including horses, tractors, horse trailers and computers, have a useful life of more than one year. These are depreciated over a period of time based on the IRS’s schedule of depreciation, which changes periodically.
You can start claiming the depreciation of the equipment or animal the year it is put in service. This is easy to do when you purchase a tractor, because you’re going to use it right away. With horses, though, you might purchase a weanling, and it might be too young to use for your intended purpose in that year.
Putting the horse into service is determined by when you begin training it for the intended purpose. Davis points out “training” doesn't begin when you start riding the horse, but when you begin working with the horse in preparation for its use in the business. Racehorse yearlings purchased at a bloodstock sale, for instance, are placed in service when you begin the initial training and conditioning to race.
In 2009, the depreciation rules change for racehorses. As of January 1, 2009, all racehorses will be depreciated over three years, regardless of their age when they’re placed in service. Currently, racehorses must be depreciated over seven years if they’re placed in service before they’re more than 24 months old.
Horses purchased and put into breeding service that are 12 years of age (144 months) or younger are depreciated over a seven-year period. Those purchased and put into service when they are older than 144 months are depreciated over three years.
The Economic Stimulus Act of 2008 included several perks for small businesses that equine business owners can take advantage of.
One is bonus depreciation. This new law allows a 50-percent first-year depreciation deduction for capital investments made in 2008. Applicable to most types of tangible property acquired and placed in service in 2008, this provision allows you to deduct 50 percent of the item’s cost before taking regular depreciation on the undepreciated balance. Bonus depreciation only applies to new property—property that is originally used by the purchaser—so many horses do not qualify because they’ve been used for some purpose before being purchased. Bonus depreciation expires at the end of 2008.
Another perk in the bill is the increased limit for expense allowance. The Stimulus Act increased the amount of business property purchased and placed in service in 2008 that you can claim as an expense to $250,000; the previous limit was $128,000. If you purchase machinery and equipment, furniture and fixtures or a single-purpose agricultural structure, you may be able to deduct the entire expense of the purchase this year rather than depreciate it over time. There is an investment limit on the total cost of property that can be purchased during the year. The amount that can be expensed goes down dollar for dollar as purchases exceed $800,000. Next year, the expense allowance returns to $128,000 with an investment limit of $510,000 (plus an inflation adjustment).
Depending on your situation, it’s possible to receive the benefit of three deductions—the expense allowance, bonus depreciation and regular depreciation—on the same property purchased in 2008.
3. CAPITAL GAINS
A “capital gains” tax sounds like something negative, but it can actually work in your favor. Your capital gain—a tax assessed on profits earned from a sale—is taxed at 15 percent rather than at your regular income-tax rate.
A capital gain is the amount of return in excess of what you paid for the property. In the case of a homebred horse, your purchase cost would normally be zero, because the cost of producing the horse has already been deducted. If the horse or other property was purchased by you and depreciation was taken before the property was sold, the portion of the gain you received from the previous depreciation deductions is not a capital gain but is treated as ordinary income.
Generally, a horse has to be held for two years or longer before its sale is eligible for capital gains treatment. If you’re in the business of buying and selling horses with a quick turnaround, your sales may not be eligible for capital gains treatment, and you would have to claim the sales price as regular income instead.
4. CHANGING TAX CODES
The change in racehorse depreciation and the Economic Stimulus Act benefits discussed above are just a few examples of the continually changing tax codes that affect small businesses and agricultural businesses. Keeping an eye on what’s happening at the IRS can be exhausting, but whether you do it or you hire a qualified tax preparer to do it, knowing what tax credits and incentives are available to you is vital.