A hobby loss is defined as a loss that is determined by the Internal Revenue Service to be the result of an activity not entered into for profit. The effect of a determination that your business is a hobby is that the loss cannot be deducted from income. This effect is usually devastating, and usually results in the taxpayer owing taxes, penalties and interest for three years WITH liabilities reaching $50,000, $100,000 and above. We routinely handle cases involving close to 7 figures.
The IRS likes to argue that certain businesses are actually a hobby because many people lose money in them due to its high risk. The rules say you have to gain a profit in two out of five to seven years (if it is a farming related activity) to be called a business. But what if you don’t? We have won many cases where there were not two profitable years. Let us ” risk assess” your return and handle any issues in this regard.
Tax time can be a shocking reminder to some horse business owners about how much they actually spend on their businesses throughout the year. Of course, you should be reviewing your profit and loss statements monthly or at least quarterly, but nothing brings it home like filing your taxes. If your business expenses exceed your income for the year, the IRS sees this as a loss. This loss can be used to offset other income you might have during that year or you can accumulate those losses to be applied later. However, if you continually show a loss for your business, particularly in five or more consecutive years, the IRS might flag your business as a hobby instead of a for-profit venture. And that could cost you a lot in taxes.
My client started a show horse business consisting of two horses “Jackpot” and “Bustout”. The two horses were purchased for $50,000 and $25,000 respectively. The horses were trained by a local trainer in Florida and were ridden by several riders. The most noteworthy was the business owner’s son Wellington Chatsworth III, who was an intercollegiate rider.
After five years in business, the business showed loss years of:
The IRS challenged the validity of the business saying the primary purpose of the venture was to further the client’s son’s collegiate riding career and not a for-profit venture.
All names and number on the preceding case study have been changed from the original cases to protect confidentiality. The actual fact patterns however closely follows those of actual case(s).
It was important that I showed the taxpayer kept good records, had a business plan, and had a solid background running other businesses. However, the key issue the IRS was questioning was the purpose of the business (for profit or just to support their son’s riding career).
I performed an economic study of the horse business and presented it to the IRS showing that the horse sales that occurred were in the range of industry averages during the period in question and the poor results were not the fault of the taxpayer. I also used one of our experts who was able to document that young Wellington’s performance on the horses actually increased the value of the horses. This helped to refute the agent’s claim that the business was really a hobby..
The key to being successful in hobby loss cases is knowing what a client’s strengths and weaknesses are and minimizing the weaknesses by presenting a solid defense of them. I believe too many accountants and taxpayers alike worry about discussing their strengths and do not address their weaknesses. You’ve likely won your strengths already at the agent level most of the time, or they are easily won. Why spend excessive time on them when you have to defend a glaring weakness that will destroy your case? If we had not addressed the issue of the taxpayer’s son riding the horse, in our case we would have lost the issue regardless of anything else.
This case demonstrates that appeals can be much more objective than agent’s on these cases. In my opinion most hobby loss cases need to be taken to appeals. I have found agents and most managers handle them in a robotic like fashion and their reports are often lacking any depth.
This works to the advantage of those willing to invest the time money and effort to produce a successful result.
The best defense in these types of cases is always conducting your business like a business:
Keep receipts on all expenditures and enter them into a computerized system such as Quickbooks, or hiring a bookkeeper to do it for you. Not only will this help you show you are running a business, it’ll also help you run your business by understanding where every dollar is being spent.
Create a business plan that outlines how you will market and run your business and that you have the expertise to do so.
Seek professional help from an expert such as The Equine Tax Group.
Earn a profit. The simplest way to avoid IRS scrutiny is to show a profit on your returns. Sometimes that’s easier said than done of course. However, it might just come down to holding off on a major purchase until Jan. 1 instead of buying it right before the end of the year. A good accountant can help you make those decisions.
Any questions feel free to contact me at the number below.
2865 South Eagle Road Unit 319
Newtown PA 18940
Phone 888-338-2999, 844-777-7200