"They look at whether the operation is carried out in a businesslike manner,
with appropriate recordkeeping and financial planning," Tharp says. "It's imperative you maintain a separate checking account for your horse expenditures. Meeting with an accountant may prove useful in this area, if you can learn how to maintain thorough financial records."
Another factor is the expertise of the taxpayer or her advisers.
"Document every convention or lecture series you go to, or every time you meet with a trainer, breeder, farm manager or appraiser. Keep detailed notes with your records," Tharp says, noting that IRS frowns on the amateur owner who appears lackadaisical in becoming educated about the industry.
Time and effort exerted are other factors. IRS wants proof that you have engaged in the "necessary and unpleasant" labor of the operation. "This includes feeding and cleaning stalls rather than just showing up at the barn on the weekend to show or pleasure ride," says Tharp. "If the taxpayer hires the labor, she must be certain that the money spent in doing so is justified and reasonable in light of the work being done, and that the person is qualified to do the work." Tharp's advice is to do all the labor-intensive chores you can around the barn to show your personal involvement in the business.
More than a tax deduction
"The tax court has disallowed deductions by taxpayers on the basis that they were only actively involved with their horses during the summer months," cautions Tharp.
She says IRS looks to see whether you have a reasonable expectation that your horses will appreciate in value; whether you have successfully run another profit-making business; and how knowledgeable you were when starting a horse business.
The history of income and loss is another consideration.
"According to tax regulations, a history of losses in the initial or start-up phase of an operation may not be conclusive proof of a lack of profit motive," says Tharp. "But if you continue to operate the business at a loss for several years, deductions will be suspect and will likely be disallowed." IRS does not believe that someone who continually loses money will stay in business very long.
"The taxpayer's intent to make a profit is further evaluated by the amount of profits made, as compared to the money invested and losses incurred," Tharp says. "If the profits are few and far between, and never match the losses, IRS will contend that they are insufficient to prove a profit motive."
Taxpaying horse owners often run into trouble with IRS due to their financial status. "Generally, those involved in the equine industry are on a relatively high economic level. If you have a substantial income from a profession or business other than your horse operation, you will be a likely target for IRS scrutiny. This area is difficult to defend if you have substantial income," she says.
The most subjective factors IRS considers in an audit are the personal pleasure or recreation involved.
Hobby or profit?
"Most people in the industry derive pleasure from working with their horses, whether it's for a hobby or profit," says Tharp. "Although personal pleasure is not conclusive proof of the activity being a hobby, this is another area where regular performance of labor-intensive chores of feeding, grooming and mucking stalls may serve as good proof of your motives. "
She cites two cases where the tax court disallowed deductions: one because the taxpayers admitted that their introduction to horse breeding was due to their daughter's love of horses; another because the taxpayer referred to her foals as "babies."
However, the court allowed deductions in a case where the taxpayer sold or disposed of animals deemed unfit for his operation, and another where all horses were for sale, reasonable offers accepted.
"If you're going to be audited by IRS, consult with an attorney knowledgeable in the equine 'hobby loss' area of the tax law before you speak with IRS," Tharp counsels.