There’s an old saying in the horse industry: “To make a million dollars in the horse business, start with two million.”
Some involved with the equine industry of whatever breed do so purely as a hobby. It is an activity from which one can derive great pleasure and enjoyment, while at the same time, providing an opportunity to meet new friends and share a common interest. There are, however, many of us who, because of the investment of time and money involved, or because of our personal goals for our horse activity, wish to be in the horse BUSINESS. Doing that successfully and having the IRS agree with us on this characterization of our activity is the question at hand.
If the horse activities are a business, there is no problem with deducting losses from unrelated income. However, when a taxpayer incurs losses from horse activities year after year, and those losses are deducted from unrelated income, the Internal Revenue Service begins to question whether the horse activities are more a hobby than a business. If the IRS is successful in declaring a horse activity to be a hobby, it can re-compute your tax liability for at least the past three years. You can be required to pay the additional taxes for those years, plus interest, plus possible penalties for the underpayment. The result can be financially quite devastating.
If your horse activities incur loses year after year and if you have substantial unrelated income that those losses offset in part, then the IRS begins to become curious. Professionals who engage part-time in horse activities–or whose spouses do so–are a prime target, but the risk of being declared a hobby is not restricted to doctors, lawyers, and accountants.
The ultimate question is not whether you turned a profit or incurred a loss, but whether your horse activities were engaged in for the purpose of turning a profit. So long as you in good faith intend a profit, your losses are business loses, not hobby loses.
Hobby Loss Criteria
1) Is the activity managed in a business-like manner?
Does the taxpayer keep complete and accurate books and have a separate checking account for the business?
2) The taxpayer’s expertise or that of his advisors.
Did the taxpayer take the time and effort to become an expert in the field of activity in which he is engaging or to employ experts to advise him?
3) The time and effort expended by the taxpayer in carrying on the activity.
The fact that the taxpayer devotes substantial personal time and effort to the activity may indicate an intention to derive a profit, or if he devotes only limited time but employs other competent and qualified persons to carry on the activity.
4) The expectation that the assets used in the activity may appreciate in value.
5) The taxpayer’s history of success in other similar or dissimilar activities.
6) The taxpayer’s history of income or losses with respect to the activity.
7) The amount of occasional profits, which the taxpayer may have earned in connection with the activity.
8) The taxpayer’s personal financial status.
The cases in which the IRS challenges deductions under the hobby rule are cases in which the taxpayer has a very substantial income from sources unrelated to the horse activity.
9) The elements of personal pleasure or recreation associated with the activity for the taxpayer.
The presence of personal pleasure or recreation may indicate the lack of a profit objective. However, the mere fact that the taxpayer enjoyed engaging in the activity does not mean it wasn’t engaged in for profit.
While each of the above criteria is important, the primary objective of the taxpayer at all times should be to run the horse operation in a way that would most improve his opportunity to make a profit. In other words, one should run their horse business with the same diligence and using the same business principles and judgment that they would use in conducting other business enterprises.