The horse industry is a vital industry that serves the economic lifeblood of millions of Americans. Veterinarians, trainers, farriers, grooms, farm personnel, tack shops, feed supplies, farming services, horse registries and associations, equine publications and advertising? transportation, trainers, bloodstock agents, auction companies, parimutuel wagering, jockeys--in short, billions of dollars in revenue are generated each year in virtue of the many breeds of horses that are owned throughout the country.
I receive many phone calls and e-mails from readers who have read my column for a number of years, but it is not possible to provide personal replies to legal questions unless I am your attorney or unless you engage me as your attorney. I am often asked whether it is advisable for a horseman facing an IRS audit to agree to sign an "election to postpone audit" under section l83(d) of the Code. This is rarely advisable. In fact, I do not recall ever recommending a client to sign such an election.
This provision is entirely for the benefit of the IRS, not the taxpayer. It permits the IRS to postpone an audit until the end of the seven-year period that is counted from the first year in which the taxpayer engaged in the horse activity. For more established horse owners, the seven-year period would be counted starting with the first year selected for audit. After the seven-year postponement the IRS will then audit all seven years to see if you have had two profit years out of the seven. If you have, that would likely get the IRS off your back; if not, they would likely assess a deficiency.
Actually, any taxpayer has the right to initiate this election under section l83(d). It is conceivable that a horse owner, faced with an IRS audit, might want to make the election and postpone the audit for now, if he feels confident that at least two profit years are imminent. Still, it seems to me you are asking for a lot more entanglement with the IRS by making the election, and you will have to open up your books and records for seven tax years in the end, as opposed to the one or two tax years presently contemplated by the tax auditor. And, given the unexpected circumstances that attend to the horse industry--occasional profits might not materialize, there can be casualty losses, and good luck is not always ready-at-hand--it is often difficult to predict how the next few years might turn out.
More people are apparently being audited in the horse industry in the early phase of their horse activity than I have ever before seen. If you are audited in connection with your horse activity, the best defense is to anticipate and take offensive measures in advance. That means complying with applicable IRS guidelines, consulting with expert advisers such as a tax lawyer, and conducting your activity in as businesslike manner as possible.
Recent Tax Court cases emphasize once again the importance of accurate and businesslike recordkeeping. Haphazard and incomplete records are almost always going to give the impression that you are inattentive to business practices.
Under current law, a determination of whether a horse activity is engaged in for profit is made by reference to objective standards and subjective standards, taking into account the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the circumstances should indicate that your activity was entered into and continues to be conducted with the intention of making a profit, and that you subjectively believe that you will make a profit.
Over the years it seemed sufficient if you could prove that there was just a small chance of making a large profit. Thus, an investor in a wildcat oil well who incurs very substantial costs might be in the
venture for profit, although the expectation of profit might be quite remote. This is analogous to many a horse owner who can articulate circumstances in which the expectation for profit seems remote but potentially great. There are other ways of proving that you have an "actual and honest objective of making a profit," such as relying on the expertise of farm managers, trainers, a professional drafted business plan with cost analysis and projections, and engaging in promotional activities and advertising. These indicate a good-faith effort to push the activity into producing a profit.
The horse business is not the only area where the IRS scrutinizes deductions. Taxpayers in a wide range of activities take tax deductions on claimed part-time businesses. Cases have recently been handed down involving taxpayers who claimed to be conducting "research and experimental" businesses of various kinds, "import-export" activities involving extensive world travel, "investment advice" given by retired taxpayers who kept no formal books or records, an individual who sponsored seminars to disseminate his views on economic reform (also involving significant travel expenses), a taxpayer who tried to give a film-lecture series on big game hunting--and many other examples that got short shrift from the IRS.
John Alan Cohan is a lawyer who has served the horse industry since 1981. He serves clients in all 50 states, and can be reached for legal consultation at (310) 557-9900 or via e-mail at firstname.lastname@example.org.