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Tax Court Relies on Horse Sense in New Case

It’s more than just semantics when it comes to the difference between a “business” and a “hobby.” While you can deduct ordinary and necessary business expenses—and even a loss—you currently get zero tax benefit from hobby expenses. Thus, the stakes are often high.

Jan 23rd 2020
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It’s more than just semantics when it comes to the difference between a “business” and a “hobby.” While you can deduct ordinary and necessary business expenses—and even a loss—you currently get zero tax benefit from hobby expenses. Therefore, as shown in a new case involving a “cutting horse” operation (Besten, TC Memo 2019-154, 11/25/19), the stakes are often high.

Be aware that this case was decided under the law in effect prior to the Tax Cuts and Jobs Act (TCJA).

Previously, when an activity was treated a hobby, you could deduct expenses up to the amount of your hobby income. But the TCJA eliminates the deduction for miscellaneous expenses, including hobby expenses, for 2018 through 2025. In any event, you can’t deduct a loss from an activity characterized as a hobby, rather than a business.

The IRS often challenges deductions relating to certain activities, such as horse breeding or racing, that may be enjoyable or personally rewarding to taxpayers.  So it wasn’t surprising in the new case when a renowned horse enthusiast was under the gun.

Facts of the new case: The taxpayer, a highly-regarded cutting horse competitor,  had been operating a seed business in South Dakota since 1964. In 2002, he sold the seed business to his son and looked to expand his cutting horse business. This included breeding, raising, boarding, training, selling and registering cutting horses, as well as showing horses in national competitions.

However, the taxpayer ran into financial difficulties before his cutting horse operation could turn a profit. Notably, his son was struggling with his seed business, so the taxpayer was forced to help out. In addition, the cutting horse business was hurt by the unexpected death of a champion cutting horse that was expected to provide substantial future income from breeding.

The taxpayer’s cutting horse operation showed significant losses for five consecutive years. The IRS denied the losses because it said that the activity constituted a hobby.

Traditionally, the courts have traditionally relied on the following factors to distinguish a business from a hobby:

  • The manner in which you carry on the activity
  • The expertise possessed by you or your tax advisors
  • The time and effort you expend in carrying on the activity
  • Any expectations you have that assets used in the activity may appreciate in value
  • Any prior success in carrying on other similar activities
  • Your history of income or losses with respect to the activity
  • The amount of profits, if any, which you earn
  • Your financial status
  • Any elements of personal pleasure or recreation

No single factor by itself is conclusive, but a preponderance of factors can tip the scales in your favor.

In this instance, the Tax Court was swayed by the taxpayer’s efforts to engage in a profit for his cutting horse operation, even in the face of mounting financial difficulties. Also, although the taxpayer took personal pleasure in the operation, it required physically demanding work. Accordingly, the Court allowed the losses.

Be aware that a special tax presumption may be on your side. If you show a profit in any three out of the last five consecutive years, it is generally presumed that you’re carrying on a business. Furthermore, this tax presumption is enhanced for an activity involving the breeding, training, showing or racing of horses. In that case, the activity is presumed to be a business if you show a profit in only two out of the last seven consecutive years.

Note that the IRS can rebut the tax law presumption by providing evidence that the activity is actually a hobby. Best approach: Keep detailed records supporting your position.

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