Volume 5 Issue 2

Mar/Apr 2001

© by Newland & Associates

For years, Ms. Rhe But Able ("Rhe") has raised and shown quarter horses (which are, she says, three quarters the size of a regular horse). Rhe, however, does not have a traditional farm. Instead, she and her spouse both work for Hi-Tech Execs in Reston, Virginia, and live in Catharpin.

Rhe purchased her horse, Sea Basket ("Sea") with the intent to make a profit from winning at horse shows. Busy developing software, Rhe boards Sea at the farm of a neighbor who is also a horse trainer. 

Despite Rhe and Sea’s best efforts each year, Sea fails to win enough prize money to offset the expenses of oats, travel, etc. Accordingly, the efforts show a financial loss. Rhe has been advised by her return preparer that she should attach a Schedule C, Profit or Loss From Business, to her joint Form 1040 and deduct the losses created by Sea’s activities.

Piebalded?

Claiming the horse show losses on their tax return will lower Rhe and her spouse’s income tax. Is there anything wrong with this scenario? Depends on whom you ask.

Rhe will probably respond that her desire to make a profit from showing Sea is beyond question, and, but for a few prejudiced judges who don’t like horses with piebald eyes, her horse would have made a profit every year. As you may have guessed, our friends at the IRS have a different perspective. Actually, it’s more our friends in Congress who have dictated that expenses incurred in connection with activities perceived as hobbies are generally not deductible. To be deductible, there must be a business purpose and the expenses must be ordinary and necessary.

Ordinary and necessary cuts a pretty wide swath across the business terrain. What if the horse show judges never get over their prejudices, and this animal with multi-colored eyes never shows a profit?

The Presumption

To address this problem, Congress enacted IRS Code Sec. 183, called Activities Not Engaged In For Profit, which nearly everyone refers to as the Hobby Loss section. The section denies a deduction for any expense relating to an activity as to which there is no bona fide profit motive. Usually, merely hoping to make a profit is not enough.

Under Sec. 183, there is a rebuttable presumption that, if the horse showing activity does not make a profit in at least two of seven consecutive years, it is a hobby, not a business. (The time frame for other activities is two of five years.)

Rhe may be able to "force a profit" in the requisite number of years if she does not claim all of the deductions related to the activity, such as Sea’s travel expenses.

If Rhe cannot show a profit in two years but the losses are incurred in a sensible commercial manner, she may be able to defeat the presumption. If Rhe had a 300-acre farm with barns, farm equipment, employees, etc., and the farm lost money over the seven-year period because of an outbreak of hoof and mouth disease, a flood and then a drought, the losses could be deductible because Rhe can prove that she intended to make a profit but for the unexpected disasters that befell her.

Ask the IRS to Wait?

Assuming she wanted to red flag the situation, Rhe could ask the IRS to wait to make a determination until the end of the sixth year (or the fourth year for other activities) by filing a Form 5213. However, filing the form suspends the normal three-year period within which the IRS can audit a taxpayer to the longer five or seven-year period stated in the presumption. Additionally, if you file the Form and then fail to meet the specifications, it would appear that your options would be limited and the chances of being audited would be increased.

In theory, just about any hobby can be turned into a profitable business, if conducted in a business-like manner. If it does not generate the expected profits, however, the risk of the Hobby Loss problem looms.

If your business or horse farm becomes the subject of an audit, call us to discuss your options for dealing with the presumption.

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