Often enough taxpayers who are audited in connection with their farming or livestock activities are questioned on the issue known in the tax law as the “material participation test.”
Under this legal test, you are permitted to deduct losses against outside salary and wages only if, among other things, you “materially participate” in the activity. Many duties, such as training of animals, showing of show horses and racing of race horses, are delegated to qualified experts, and sometimes the IRS will question the validity of your own participation in decision making, in an effort to say you have failed to meet the material participation test.
This usually happens in the context of ventures that involve a partnership or joint venture. For instance, Joseph Machado of Long Beach, Calif., entered into the LB Partnership with four other partners to purchase a broodmare named La Barbara. One partner was the managing partner and was responsible for maintaining the books and records of the partnership and for paying all expenses. The partnership made decisions by majority vote of all six partners. The broodmare was bred to a number of stallions, but the partnership generated losses over a period of seven years.
The Tax Court denied Machado the right to write off these losses against his income because it held he did not materially participate in the partnership. Accordingly, his losses were limited by the passive income rules of Section 469 of the IRS Code and could not be used to offset his nonpassive income.
This case illustrates the importance of obtaining advance legal guidance whenever you enter into a partnership if you intend to write off possible losses against nonpassive income sources. The material participation test is something you must plan on meeting and complying with. As a general rule, a taxpayer will be regarded as materially participating in a partnership if he is involved in the operation of the activity on a “regular, continuous, and substantial” basis.
What does that mean? A threshold requirement for meeting this test is that the taxpayer has participated in the activity for more than l00 hours during each taxable year. A taxpayer can establish the extent of his participation by any reasonable means including “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”
The kind of activities that a taxpayer should be able to document during each year may include: consulting with advisers, other breeders and veterinarians, attending horse shows, tending to the physical labor that is part of proper animal husbandry, and performing other tasks and decision-making functions. It is imperative that records be kept of hours involved, and the number must be l00 or more hours per year.
It is important to keep in mind that the material participation test is supplemental to the overall IRS Regulations concerning the objective intention to make a profit. Even if you can prove material participation in a horse activity, the IRS could still find the venture was merely a hobby by arguing that you do not have the overall intention to be engaged in a trade or business for profit.
