There are two three-letter words that may strike horror in many individuals—“tax” and “IRS.” They don’t have to be as intimidating as we believe if we make time to educate ourselves and take simple steps throughout the year. Here are a few of the factors the American Horse Council considers important regarding taxes as a professional horse person.
Business or Hobby?
This is probably the most important question posed to farm owners. If you are in business to make a profit, you are not considered a hobbyist. As a professional, you may deduct ordinary and necessary expenses from the equine activity. Making a profit in two out of seven years means the taxpayer is presumed to have a profit motive. However, this rule is not conclusive. The IRS often takes a look at equine businesses regardless of the “2 in 7” rule, especially if the taxpayer has two small profit years along with five large loss years.
The IRS will evaluate all the facts surrounding an equine business, but it does have certain factors examined to determine whether the operation is a business or hobby. These include the farm being operated in a businesslike manner, with financial records and changes made to increase profitability, the expertise of taxpayers and/or their advisors, the time and effort spent on the activity, the expectation that assets will increase in value, and the amount of recreation taken from the activity. Having a business plan that shows how you will make a profit in the future is one important step. Of course, it is best to do this annually and before you are audited.
As stated above, a farm owner can deduct necessary expenses used to operate the facility. These include labor costs, feed, veterinarian, farrier, property taxes, and depreciation on buildings, machinery and horses. Most owners can use the cash method of accounting where all taxable income is reported in the year it’s earned. This allows you to plan for profitable years by deferring income and prepaying expenses.
Depreciation of horses needs to be looked at carefully. It begins when the horse is “placed into service,” not when purchased or acquired. Horses that are bred and raised can’t be depreciated if the costs of breeding and raising them have already been deducted as expenses. In the U.S., racehorses over 2 years old and other horses older than 12 are depreciated over 3 years. All other horses may be depreciated over 7 years.
Sales of property that are long-term gains are subject to a 15 percent tax. A horse that is kept for breeding or sport qualifies for the 15 percent if it is held for at least 24 months. Pleasure horses qualify if held for 12 months.
When insurance is paid on the death of a horse, any profit will not be taxed as long as the proceeds are invested in another horse that is functionally the same. You can also exchange a horse for another like-kind horse without liability as long as the sex is the same. If money is also received, that is taxed up to the gain that would’ve been recognized if the horse had been sold.
Forms of Doing Business
As an equine professional, you have to decide what type of business you have. It is best to use the simplest form available for your circumstances. Sole proprietorship is usually suitable for most people, but the LLC is also popular.
The simplest form of doing business is a sole proprietorship. Here there is only one owner of the business, and there is no separate entity for tax purposes. Your income and expenses are reported on Schedule F of the 1040 form.
A partnership is a syndicate, group or joint venture, which has a separate entity for computing income and filing taxes. A syndicate for business is also treated as a partnership. An S Corporation has no more than 75 shareholders, who have to pay tax on profits whether or not these profits are distributed to them. The sale of shares is treated as a capital sale. An S corporation pays no tax, but income and expenses are filed with the IRS.
A regular corporation is a separate entity that pays taxes on its own income. Shareholders are taxed on dividend distribution. These business entities are more complicated to operate correctly than the sole proprietorship or partnership.
A Limited Liability Corporation, or LLC, has gained popularity in recent years. It combines the limited liabilities of a corporation with the flexible tax advantages of a partnership. In other words, it acts as a corporation for legal liability and as a partnership for tax purposes.
B. Paul Husband, who has a private practice in Universal City, Calif., specializes in equine law and taxation law and has considerable experience representing horse businesses in U.S. Federal income tax matters. He points out a number of areas that horse people make mistakes when it comes to tax issues. “They pay people as independent contractors, such as stall cleaners or grooms, who are really employees. As a result, they have exposure for FICA (social security) and other employment taxes,” he says.
Lax recordkeeping is another common error. Often, people who have another line of work as well as farming do not keep any kind of records that would enable them to prove how much time they spend in their farming business. “If they have losses, they will have to prove that they ‘materially participate’ in order to use farm business losses to offset other income, which is considered ‘active’ under the ‘passive activity rules.’ If a person (or couple—spouses can combine time spent) can prove that they spend 500 hours or more per year in their farming business, that will prove ‘material participation.’ ” Husband points out that there are other tests, but the 500-hour one is best. All people have to do is keep a calendar, diary or journal to monitor their time spent on the farm.
Husband recommends using a tax preparer who is experienced in agriculture, because farm businesses are treated differently in various ways. Many preparers are timid concerning farms, so they don’t take all the deductions available to them. It is certainly possible to use a specialist for the farm portion of the return and have a regular preparer plug the results into the rest of the return.
What’s Coming Up
Several tax newsletters are reporting that the IRS is planning to audit many returns that contain a Schedule C or Schedule F, which would include most farming operations. Husband therefore recommends getting a “tax check-up” with a knowledgeable professional. Incorporating the farm or forming an LLC may be advisable because these do not use a schedule C or F, thus lowering the audit profile of the farm.
In the end, good, accurate records kept all year will go a long way. Finding someone who is experienced in farming and equine operations will help you take advantage of everything you are entitled to, while staying within the tax law.