Horse owners and Sec. 183 challenges.
While a loss disallowed due to basis, at-risk limits or the passive activity rules is merely deferred, one disallowed under the so-called Sec. 183 "hobby loss" rule is disallowed permanently. Thus, an awareness of Sec. 183's provisions and interpretations is critical to horse owners and their tax advisers.
Sec. 183(d) creates a presumption that if an equine activity produces a profit in two years out of seven, it is engaged in for profit. The two-in-seven-year test is unique to an activity that consists in major part of the breeding, training, showing or racing of horses. For all other activities, the taxpayer faces a more demanding test: having to show a profit in three years of five.
While the IRS may rebut the presumption, taxpayers who meet the two-in-seven-year test are several lengths ahead of those who fail it. If the taxpayer fails to produce two profit years in the seven-year period, the courts examine nine factors identified in Regs. Sec. 1.183-2(b) to determine whether the activity was engaged in for profit; see below under "Planning to Prevail, Even without Profits."
In determining whether an activity has produced a profit, Kegs. Sec. 1.1831(c) looks at the gross income from the activity, less the allowable expenses without regard to any potential disallowance under Sec. 183 (i.e., all ordinary and necessary expenses in connection with the activity are allowed in determining whether the activity generated a profit or loss) . Thus, although unrealized asset appreciation is a factor identified in Regs. Sec. 1.183-2(b) to determine whether an activity was engaged in for profit, the unrealized appreciation cannot be used to establish a profit year for purposes of the presumption.
Planning to Create Profit Years
The desire to report two profit years can turn normal tax planning upside down. While the general objective is to defer revenue and accelerate expenses, horse owners and breeders looking to report a profit year seek the opposite. Areas that provide the greatest opportunity to control the timing of income and expenses include depreciation and sales.
Depreciation: Horses are depreciated under the modified accelerated recovery system, using a three- or seven year life (see Sec. 168(e)(3)(A) and (c)), depending on the horse's age and use when it is placed in service (e.g., for racing or breeding) (the Equine Equity Act, introduced by Sen. Mitch McConnell of Kentucky (RKY), co-sponsored by Sens. Jim Bunning (R-KY) and Blanche Lincoln (D-AR), would, among other provisions, establish a three-year depreciation period for horses, regardless of age). The cost can also be expensed under Sec. 179, if the requirements are met.
A taxpayer who would report a profit but for a potentially large depreciation deduction for horses purchased and placed in service in the current year, may elect out of Sec. 168(k), thereby depreciating the entire cost of the horses over three or seven years. If the depreciation deduction still results in a loss, the taxpayer may consider electing to use Sec. 168(g)'s alternative depreciation system (ADS). Under ADS, racehorses are depreciated on a straight-line basis over 12 years. Taxpayers making either of the two elections discussed above must keep in mind that the depreciation forgone in the election year will ultimately be claimed in future years, and could prevent the activity from showing a profit at that time. (For more details, see Hereth, Sprohge and Talbott, Tax Clinic, "Post-JGTRRA Racehorse Ownership," TTA February 2004, p. 72.)
Sales: Owners and breeders can also manage their income by tinting horse sales. Those contemplating a sale of a horse at a gain should consider deferring the sale to the subsequent year if the gain will not be sufficient to offset other operating losses from the year of the activity. By deferring the gain, the sale may help create one of the two profit years that will result in the presumption that the activity is engaged in for profit.
Planning to Prevail, Even without Profits
If a taxpayer fails to establish a presumption that the activity was engaged in for profit and the Service asserts that the activity was not engaged in for profit, the courts look to nine factors identified in Kegs. Sec. 1.183-2(b):
1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or his or her advisers;
3. The time and effort expended by the taxpayer in carrying on the activity;
4. The expectation that the 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 loss with respect to the activity;
7. The amount of occasional profits earned, if any;
8. The taxpayer's financial status; and
9. Whether elements of personal pleasure or recreation are involved.
Regs. Sec. 1.183-2(b) states that these factors are not the only ones taken into account in analyzing whether an activity is conducted for profit; the court opinions almost invariably discuss each of them separately and rarely identify other factors or discuss the relationship among the factors. However, the first factor identified--the manner in which the taxpayer carried on the activity--frequently receives the lengthiest analysis by the courts, which evaluate whether the taxpayer conducted the activity in a "businesslike manner," by maintaining separate books and records, preparing budgets, analyzing results and operations and attempting to improve profitability.
Numerous cases demonstrate that keeping books and records and preparing budgets and financial reports is insufficient if the taxpayer does not use them to analyze results and take steps to achieve or improve profitability; see Freed, TC Memo 2004-215; Harston, TC Memo 1990-538; and Kuberski, TC Memo 2002-200. In two recent cases, however, the Tax Court cited changes that the taxpayer made in conducting his business in holding that the activity was engaged in for profit; see Rabinowitz, TC Memo 2005-188, and Morrissey, TC Suture. Op. 2005-86.
Although neither case involved an equine activity, the court's analysis and observations are equally applicable to such businesses. However, one of the opinions is only a Tax Court Memorandum opinion; the other is a Tax Court Summary Opinion, which may not be cited as precedent. Even with this limitation, the latter is instructive, because it provides an analysis of the relevant rules and the application of such rules to a specific set facts.
Aircraft: In Rabinowitz, the taxpayer, based in California, owned a company that designed and marketed women's clothing. To provide the opportunity to meet with potential clients in the Midwest, the taxpayer purchased a jet. It was offered for charter to third parties when the taxpayer was not using it to visit clients and potential clients.
Rabinowitz obtained the necessary Federal Aviation Administration (FAA) certificate to offer the jet to third parties on a charter basis, engaged an outside management firm to manage the charter activity, advertised in a trade publication and offered commissions to the pilot to solicit customers. After a few years of unprofitable results, the taxpayer believed that the acquisition of a larger plane with the ability to travel cross-country without having to stop to refuel, would attract more customers and revenue. Accordingly, he purchased such an aircraft.
The court cited the taxpayer's acquisition of the FAA certificate, the various means of marketing and the change of aircraft in an effort to improve the charter activity's economic performance, in concluding that the taxpayer carried on the activity in a businesslike manner and holding that it was conducted for profit.
Drag racing: Morrissey involved a bank's senior vice president and chief financial officer who engaged in drag racing. The taxpayer appeared pro se.
In addition to the business and financial acumen that the taxpayer brought to his position as a bank officer, he had extensive knowledge of physics, mathematics and mechanics that he brought to the racing activity. He performed almost all of the work on the car himself. He prepared detailed expense estimates for the activity, which he modified frequently as circumstances changed.
The taxpayer knew that sponsorship was critical to financial success in drag racing, and obtained sponsorship from a casino after engaging in it for seven years. The casino did not renew the sponsorship after the first year. After an additional year of racing without sponsorship, the taxpayer realized that he could not continue the activity profitably, and offered his car for sale. Most of his activity over the next two years was intended to market and sell the car.
Although the taxpayer suffered losses in 10 of the 11 years in which he conducted the activity and made a profit of only $587 in the year the casino sponsored him, the court held that the activity was conducted for profit. It cited the detailed forecasts and their frequent modifications, the specific business plan and the ultimate abandonment of the business when the taxpayer concluded that he could not operate at a profit.
Horse owners and breeders should be prepared to address an IRS challenge to Sec. 183 losses. When possible, depreciation deductions and gains and losses on sales should be timed to show profits in two years during a seven-year period. These two profit years will result in a presumption that the activity is engaged in for profit.
Recognizing that several years of losses might be incurred, horse owners and breeders should also develop a business plan prior to commencement of the activity, monitor results versus forecasts and document any changes in the manner in which business is conducted, in an effort to improve profitability.
FROM BARRY NAGLER, CPA, J.D., LL.M., HOLTZ RUBENSTEIN REMINICK LLP, MELVILLE, NY
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|Publication:||The Tax Adviser|
|Date:||Oct 1, 2005|
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