If you’ve got clients in the horse business, you know how tough it can be to generate consistent profits. The Tax Court docket is filled with plenty of professionals that run afoul of the hobby loss rules. But here’s a story with a happy ending for a horse breeder we helped through an IRS audit.
“Amelia,” we’ll call her, had been breeding, showing and selling Arabians and half-Arabian, half-Paint horses for more than 20 years. In that time, she turned a big profit one year when she sold a prize-winning stallion for $100,000. Most years, though, she operated at a loss.
Amelia also had two traditional jobs: She was the night pharmacist for the regional poison control center, and she worked part-time as a pharmacist for a big chain. “I don’t sleep much,” she laughed when we asked her how she managed to do everything.
Amelia came to our office when her prior CPA dropped the ball and didn’t show up when the local revenue agents made a site visit for her Schedule C audit. She was referred to us by one of our clients, “Circle Square Farms,” we’ll call it, which had a successful horse operation.
The local revenue agents had made up their minds and wanted to disallow all her losses from her horse business for the three years under audit. My boss and I weren’t ready to give up, so we appealed the decision.
We prepared a defense based on the Section 1.183-2 regulations for distinguishing between hobbies and businesses. There were several we looked at in particular:
1. Manner in Which the Taxpayer Carries on the Activity: Amelia kept impeccable records and was able to show the IRS agents documentation for every expense. She used a separate bank account just for her business. Based on advice from a variety of Arab horse experts, she changed the direction of her business from showing horses to breeding and selling them, as this appeared to be less risky and more sustainably profitable over the long term. We also found a few Tax Court cases with similar patterns of loss but which the judge allowed because the taxpayers had entered into the business with the intention of earning a profit.
2. The Expertise of the Taxpayer or His Advisors: Before Amelia launched her horse business, she lived and worked on the grounds of Circle Square Farms for several years and continued to consult with the owners on a regular basis. She also consulted with the owners of other successful Arabian horse breeding operations in other states, who suggested the change in direction.
3. The Time and Effort Expended by the Taxpayer in Carrying on the Activity: When she wasn’t working or sleeping, Amelia was caring for her horses. She performed virtually all the work herself except for training, which she hired someone else to do. On the advice of the owners of Circle Square Farm, who lived nearby, she built a barn, stalls and corrals on her property to save the time and expense of using a separate boarding facility.
4. Expectation That Assets Used in Activity May Appreciate in Value: Adding horse facilities to her property increased its value. When Amelia began her breeding and selling approach, she expected that her horses, which were an unusual half-Arab, half-Paint combination, would sell for enough to recoup her expenses. It took her several years to acquire the right brood mares and breeding rights and to raise several horses and prepare them for sale.
5. The Success of the Taxpayer in Carrying on Other Similar or Dissimilar Activities: Amelia had successfully bred, raised and trained a show horse that sold for $100,000. We argued that this was a separate phase of her business, which she discontinued when she began her current operation focused on breeding and selling horses.
6. The Taxpayer's History of Income or Losses With Respect to the Activity: As mentioned, Amelia did have one extraordinary year when she sold a prize-winning stallion during the earlier stage of her business. However, it was not until about 2008 that she had horses from the new phase of her company ready for sale. In the years following the economic recession, the horse market collapsed. Breeders at the top of the market were able to sell their horses for slightly reduced prices, but many in the middle and bottom tiers weren’t able to even give their horses away. Rescue operations across the country were overwhelmed with a glut of animals owners could no longer afford to keep. We provided the appeals officer with multiple news stories documenting these bleak market conditions. Amelia had the unfortunate luck of having exceptional horses available for sale at a time when no one was buying them, and this was very the period the IRS was examining. As the regulations say, “If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit.”
7. The Amount of Occasional Profits, if Any, That Are Earned: Amelia did have one good year, as mentioned. But since she had begun her breeding and selling program, her sales and barter transactions hadn’t resulted in a profit. However, it did appear that her losses in the second and third years under examination had markedly decreased compared to her previous norms. Her expenses suddenly dropped by more than half. The appeals officer noticed this anomaly. When we asked Amelia about it, she told us her previous CPA had counseled her to leave out some of her expenses during those years. The appeals officer allowed us to submit documentation of the unclaimed expenses, which he added to her tax returns.
8. The Financial Status of the Taxpayer: Amelia did earn a very comfortable living from her career as a pharmacist. However, her losses from her horse business did not wipe out her tax liability for any of the years under examination, nor had they ever, according to the IRS database.
9. Elements of Personal Pleasure or Recreation: As the local revenue agents noted when they performed their site visit, Amelia did not herself ride the horses. She had neither bridles nor saddles nor any kind of horse tack at all on her property. As my boss said, “To call this a hobby, you have to count mucking stalls as a hobby, because that’s all she did with her horses.” Amelia simply had no time for fun with her busy work schedule. This appeared to be the pivotal point for the appeals officer: Why have horses if you never even ride them?
This case required a great deal of patience, since it took two-plus years to wind through the appeals process. But, in the end, the appeals officer gave her a favorable ruling. He allowed the expenses she had not claimed previously but reduced the allowed losses by 50 percent.
Overall, Amelia saved nearly $10,000 in taxes compared to the original ruling by the local revenue agents. She was grateful for our efforts, and I was grateful that our accounting superpowers allowed us to help her win a seemingly unwinnable fight with the IRS