Economic and tax implications of thoroughbred racing.

There's more to horse racing than a fast horse.

Sunday Silence: Many will recognize the name of the 1989 Kentucky Derby winner even though they have never set foot on a racetrack. This horse failed to bring $17,000 as a yarling but then went on to win almost $5 million as a three-year-old before being sold for a reported $10 million to Japanese breeding interests.

Figures such as these make all but the most risk-averse investors sit up and take notice. Certificates of deposit lose their appeal as investors contemplate the fame, glory and financial rewards of horse racing. Are such rewards really possible, or is the more likely scenario heralded by the 1991 bankruptcy of famed Calumet Farm in Kentucky's bluegrass region? To answer this question, this article examines the economics of thoroughbred horse racing and the accompanying tax implications.

TRAINING COSTS AND REVENUE

Exhibits 1, 2 and 3, pages 52 and 53, show training bills at three major race tracks in the United States. Approximately 80% to 90% of horses in training do not earn enough to cover training costs. In addition to a per diem charge currently ranging from $45 to $85, depending on locale, a variety of miscellaneous charges results in monthly horse training costs of at least $2,000. As the Aqueduct bill (exhibit 3) shows, a horse's trainer is entitled to 10% of any money the horse is fortunate enough to win. Some trainers even take (pay) the stable help out of a horse's winnings.

The proliferation of off-track betting opportunities has led some investors to believe purses will increase substantially as wagering becomes more accessible. Thoroughbred racing, however, is characterized by parimutuel takes ranging from 17% to 25%. This means that for each dollar wagered, the track, horsemen and state divide between 17 cents and 25 cents and return the remainder to the wagering public. These figures do not compare favorably with the 5% to 6% take by casinos in Las Vegas or Atlantic City and may limit how much the public wagers on racing.

HOBBY LOSS PROVISIONS

Since it is possible for a thoroughbred horse owner to lose money, the "hobby loss provisions" of Internal Revenue Code section 183 need to be considered. In general, this section says taxpayers cannot deduct expenses greater than the income from an activity if they do not engage in it for profit. Taxpayers normally bear in the burden of proving a profit intent. Section 183 does, however, permit taxpayers to shift the burden of proof to the Internal Revenue Service when they show a profit in any two of seven years for horse-related activities, in which case there is a "general presumption of profit intent."

Proving a profit movie hinges on each activity's facts and circumstances. Treasury regulations section 1.183-2(b) specifies nine relevant factors to consider in determining whether an activity is a hobby or a business:

1. The manner in which the taxpayer carries on the activity. 2. The expertise of the taxpayer and his or her advisers.

3. The time and effort the taxpayer expends carrying on the activity.

4. The expectation that assets used in the activity may appreciate in value.

5. The taxpayer's success in carrying on other similar or dissimilar activities.

6. The taxpayer's history of income or losses with respect to the activity.

7. The amount of occasional profits earned, if any.

8. The taxpayer's financial status.

9. Elements of personal pleasure or recreation related to the activity.

No one factor, or even a majority of factors, ensures the courts will determine an activity to be profit-motivated.

Several studies were conducted in the early 1980s to analyze the courts' reliance on the nine factors. Each study applied a different method of analysis to identify and rank the factors and each reached a different conclusion. However, there was agreement that conducting an activity in a businesslike manner was of primary importance. For a taxpayer to prove an activity is profit-motivated, he or she also should contribute physical effort and possess or acquire the necessary expertise to conduct it.

The factors the courts use in determining whether a profit motive exists generally are controllable by the taxpayer. Planning, including a projection of expected revenues and expenses, and setting objectives before entering a new activity or operating an existing activity help corroborate that the activity is profit-motivated. With horse racing, the general presumption of a profit motive applies only to the second profit year and all years thereafter in a seven-year period beginning with the first profit year.

If, for example, Sally Saratoga has losses from 1984 through 1988, profits in 1989 and 1990 and losses from 1991 through 1995, the burden of proof rests with the IRS for 1991 through 195 to show Saratoga did not have a profit movie. The first five years, however, are not protected under the general presumption by the profit years of 1989 and 19690 and the burden of proof rests with Saratoga.

SPECIAL PRESUMPTION OF A PROFIT MOTIVE

It is possible to combine a special presumption with the general presumption and shift the burden of proof to the IRS for the start-up years if the two profit years fall in the seven-year time frame. This requires filing Form 5213, Election to Postpone Determination as to Whether the Presumption that an Activity is Engaged in for Profit Applies. This election can be made only once and is effective only for the first seven years of a new activity. Since there are two profit years in the first seven years of operation, Saratoga can shift the burden of proof for 1984 to 1988 by electing the special presumption.

However, in making the election to postpone determination of a profit movie, the taxpayer may increase the probability of an audit. In addition, section 183(e)(4) extends the statute of limitations for the first five years of the seven-year period until two years after the date of the return for the last taxable year of the seven-year period. This permits the IRS to assess a deficiency for the early years in the event the activity is found to be a hobby at the close of the presumption period.

In the illustration above, the election to postpone profit determination extends the statute of limitations for assessment for 1984 to April 15, 1993. This extension is not limited to tax matters associated with the horse activities but is a general consent extending the assessment period for all tax matters relating to that year's return. After considering the increased probability of audit, the extended assessment period and the general consent of the election to delay determination, a prudent tax adviser seldom recommends an election be made.

MATERIAL PARTICIPATION

If taxpayers with economic losses survive the hobby loss challenge, they will be confronted with the material participation requirements of IRC section 469. Material participation determines whether a taxpayer's horse losses are currently deductible. If not, such losses must be deferred and written off in subsequent years when the taxpayer generates passive income from racing operations or disposes of the entire interest in the horse activity, assuming he or she has no other passive income.

According to temporary regulations section 1.469, a taxpayer materially participates in the horse activity if one of the tests listed in exhibit 4, on this page, is met. A sole proprietor racing horses may meet test one or test four. However the proprietor probably is precluded from using tests two and three since the horses' trainer substantially participates for more than 100 hours and the sole proprietor's participation does not constitute substantially all participation in the horse-racing activity. Furthermore, the trainer usually will participate more than the proprietor. General partners, S corporation shareholders and limited partners have even more trouble than sole proprietors in meeting the material participation tests when racing horses. Failure to meet the material participation requirements may not be particularly devastating, however, from a tax standpoint. Since sale of an entire interest in a passive activity triggers the deduction of all suspended losses, it may be possible to put together short-term partnerships or temporary S corporations so losses will not be held in suspense for long periods.

A horse-racing partnership, for example, could buy yearlings or two-year-olds and terminate the partnership when the horses were three or four years old. Any losses from these partnerships should be deductible at that time. The partnership agreement also could provide that the partnership would not be terminated if it was profitable. This strategy makes both tax and economic sense. It has been our experience that an unwillingness to terminate unprofitable individual horses leads to certain financial disaster because poor or unsound horses do not become good performers. Continuing to race these horses will lead to losses, but the practice is common becaue few owners are willing to admit they own bad horses.

DEPRECIATION

Horses must be depreciated over three years or seven years, employing a 150% declining-balance approach. The approximate percentages are illustrated in exhibit 5, page 56, and an examination provides an intuitive strategy for taxpayers contemplating entering racing.

If a taxpayer buys a race horse over two years of age, 62.5% of the cost is recovered in the first two years. If a taxpayer uses the traditional method of entering racing and purchases a yearling, however, only 29.84% of the cost may be deducted during the first two years. The present value of the tax savings from these depreciation charges suggests taxpayers should enter racing by purchasing horses more than two years old.

A caveat is in order. By concention, race horses in North America have a uniform birthday of January 1. Nevertheless, the more advantageous three-year depreciation rates cannot be employed unless a horse actually is over two years old at the time of purchase. A two-year-old colt purchased on March 15, 1993, and born May 2, 1991, would be subject to the less favorable seven-year rates. In addition, if over 40% of the horses acquired during any year are purchased in the last quarter, the midquarter convention is required and rates different from those in exhibit 5 must be used. The midquarter convention says items or personality are depreciable beginning with the middle of th e quarter in which the property is placed in service. This prevents taxpayers from loading up on yearend purchases and obtaining a half year of depreciation.

CAPITAL GAIN TAX RATES

Before the Tax Reform Act of 1986, gains on the sale of thoroghbred horses in excess of depreciation generally qualified for favorable long-term capital gain treatment under IRC section 1231 if a two-year holding period was met. Losses on the sale of thoroughbreds were treated as ordinary under section 1231, assuming the taxpayer experienced net section 1231 losses. The investor, therefore, had the best of both worlds.

Assume Bud Belmont bought a $40,000 two-year old horse, fully depreciated the cold and sold him for $200,000. While the $40,000 of depreciation had to be recaptured as ordinary income under IRC section 1245, the remaining $160,000 of gain was eligible for the 60% long-term capital gain exclusion. Only $104,000 of the $200,000 gain was taxable. If Belmont was in the then 50% tax bracket, he would have had an effective tax rate on the sale of only 26%, providing a strong tax incentive to invest.

Under current law, the statutory maximum tax rate on ordinary income is 39.6%; the reduction in personal and dependent exemptions and itemized deduction can increase the maximum rate for wealthier taxpayers to over 42%. The maximum rate on capital gains is 28%. Individuals paying the higher rate will have a 14% tax savings on the sale of horses qualifying for net section 1231 and capital gain treatment.

FINDING A WINNER

Individuals in the two highest marginal tax brackets are potential race horse investors strictly from a tax standpoint. Assuming problems with the hobby loss and material participation rules are overcome, high-bracket individuals could have the government subsidize more than one-third of their losses.

If, however, an investor is fortunate enough to invest in a horse like Sunday Silence, all taxable income from the sale of the horse will be taxed at 28% once depreciation has been recaptured.

Although the economic scenario presented previously is not a get-rich-quick scheme, the opportunity to make large sums of money with a limited investment does exist. Events such as this month's Breeders Cup, which provides $10 million of pursue money in one day, and corporate sponsorships like Chrysler Corp.'s $3 million bonus to a triple-crown winner, have provided additional money-making possibilities. The challenge for most is to purchase a horse like Sunday Silence instead of one of the majority of horses whose earnings fail to pay their training bills.