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November 1, 2010
Is the IRS seeking to wreck the horse industry? Of late, the IRS has engaged in more aggressive audits in the horse industry that have derailed many people who thought they were doing the right thing, attempting to make a profit in their horse venture, only to be denied tax deductions. It then becomes necessary to appeal the matter and if necessary, pursue the case in Tax Court. In some instances taxpayers are able to withstand scrutiny at the audit stage if they have a formal business plan that shows how they expect to turn the activity into a profitable venture.
Even owners in the thoroughbred industry, who have opportunities to garner lucrative purses, have been affected by aggressive audits. A recent thoroughbred case in Tax Court, for instance, came down against the taxpayer, Jo Anne Chandler [Chandler v. Commissioner, T.C. Memo 2010-92]. She had lost her audit and again lost her case in Tax Court. Three years were at issue. The facts indicated that the taxpayer had incurred losses over a 20-year period.
The judge made the following findings:
1. The taxpayer did not provide “specific details” about her purse winnings for the years at issue.
2. She raced “the same unsuccessful horses year after year, even though they failed to generate enough money to exceed the expenses for any year.”
3. In addition to racing, the taxpayer engaged in horse breeding in an effort to develop an “outstanding horse,” but that did not happen.
4. The taxpayer, who had obtained a trainer’s license, “failed to provide documentation to establish that her decision to train her own horses was an economic decision and there was no cost-benefit analysis to quantify the benefit to her horse activity.”
5. The taxpayer consulted with horse trainers and owners, but the court said that there was no evidence that these individuals provided her with economic or business advice.
6. The taxpayer “has not set any limit on the amount she is willing to lose.”
7. The taxpayer “retained, and continues to incur expenses for, several horses that are useless to her horse activity.”
8. The taxpayer “scribbled down expense records but failed to organize them into any usable form, and her expense records for the years at issue were incomplete and indecipherable.”
9. She “failed to keep a separate record of each horse’s income and expenses.”
10. She “did not maintain any record of what she paid to claim each horse and how much that horse had won.”
11. She “did not review any documents at year’s end to make changes to the horse activity to improve profitability.”
12. She maintained a folder for each horse, but the judge said that these “contained sentimental documents with limited health and training records.”
These facts, and others, led the judge to conclude that the taxpayer failed to conduct her horse activity in a businesslike manner. The judge noted that the taxpayer had no business plan or cost projections to indicate when she might make a profit, and that she did not make meaningful changes in her method of operation to improve profitability. The court also said that casualty losses, such as death of injury of horses, or personal illness, should not be viewed as unforeseen hardships, as they are common occurrences.
Perhaps the lesson from this and other cases like it is to be prepared if you are unlucky enough to be audited. And preparation means establishing a formal business plan as well as maintaining records that can be utilized to analyze the economics of the venture. Further, it is important to maintain separate files on each horse, with information pertaining to improving each horse’s profitability.
IRS agents are required to use its internal manual, the Audit Technique Guide, in auditing taxpayers engaged in the horse and livestock industries. Among the questions auditors are required to ask are these: Do you have a written business plan? How was this business plan prepared? When was this business plan formalized into writing? A business plan is something that takes time and care to develop, and in preparing these documents I work with the taxpayers or their accountants to develop a cost-benefit analysis that projects when the venture will turn a profit. It is also recommended that should you be audited, that you take a pro-active approach with your professional adviser at the outset.
[John Alan Cohan is a lawyer who has served the horse, livestock and farming industries since l98l. He can be reached at: (3l0) 278-0203, by e-mail at firstname.lastname@example.org, or you can see more at his website: www.johnalancohan.com.]