California Riding Magazine • August, 2010

Know The Rules
Strict rules differentiate business
or hobby status for equine activities.

by Polly Hey Panos, of Hey & Hey Attorneys at Law

Starting in March of 2010 the IRS began a three-year process of random audits known as the IRS Employment Tax National Research Project (NRP). These audits are not limited to any one industry or size of business and will be the most comprehensive of the past 20 years.

The IRS started the NRP campaign because of the belief that non-compliance in the employment tax area accounts for a $15 billion tax gap. The audits focus on five primary areas: worker classification; fringe benefits; reimbursed expenses; compensation of officers and owner-employees; and non-filers. A significant issue is that, unlike past audits, where revenue agents could ignore small dollar items, in these audits, agents will not have that discretion and no issue will be ignored.

Historically the IRS examined equine activities and determined whether they were engaged in a trade or business by looking at whether the activity was operated with a profit motive. If an equine activity is not engaged with a profit motive, then the activity is considered a hobby. This distinction is important because if an activity is truly a trade or business it qualifies for deductions under the tax code. However, if the activity is considered a hobby the deductions available are strictly limited. There are nine “hobby loss” factors, which the IRS applies in determining if an activity is engaged for profit or is instead a hobby. These factors include:

• The manner in which the taxpayer carries on the activity.
• The expertise of the taxpayer.
• The time and effort expended by the taxpayer in carrying on the activity.
• The expectation that assets used in the activity may appreciate in value.
• The success of the taxpayer in carrying on other similar or dissimilar activities.
• The taxpayer’s history of income or losses with respect to the activity.
• The amount of occasional profits earned, if any.
• The financial status of the taxpayer.
• The elements of personal recreation or pleasure in carrying on the activity.

While there is no exact equation of what will amount to a profit motive, some factors seem to be more thoroughly examined than others. For instance, auditors focus on the manner in which the taxpayer carries on the activity. Formal business plans, separate and distinct record keeping, maintenance of financial records and the abandoning of unprofitable methods can help show a profit motive. Other “hobby loss” factors often given more weight are the financial status of the taxpayer and whether the equine activity is engaged in for recreation and pleasure. The IRS is always in the process of adapting and refining their rules and thus it is necessary to use a CPA and/or tax attorney who keeps up with these changes.

With the NRP campaign underway, it is critical that those involved in the horse industry be aware of the factors the IRS is focusing on and perform internal compliance reviews to assess potential areas of concern. This article should not be used as a substitute for conferring with your CPA and/or your tax attorney regarding compliance with IRS rules. If you are engaged in the equine business, you should regularly confer with tax professionals. If you are not inclined to do this and/or cannot afford to do this, you should not be treating your equine activities as a business. One additional word of caution, if you receive a request for information from the IRS you must immediately contact your CPA and/or tax attorney. They will help you gather and prepare the information for the IRS. The IRS treats the information initially received from the taxpayer as an admission. Many times cases are won or lost based on the information gathered by the auditor during the initial interview.