In the Tax Court case, Richard H. Daley, T.C. Memo l996-259, an Arizona surgeon was denied deductions with respect to his cutting horse activity. The Tax Court, which in recent years has become more and more hard-nosed, concluded that the activity was not conducted for profit within the relevant IRS Regulations.
A number of facts worked against Dr. Daley: (l) He entered the activity without the aid of a written market study; (2) the evidence suggested that his motive for entering the activity was recreational; (3) he never relied on a formal profit or business plan; (4) in managing the activity he used a ledger to record various transactions and events, and had a separate “drop” file for each horse – but failed to maintain them in a completely accurate manner; (5) while he claimed to have devoted l0-l2 hours per week to the horse activity, he was unable to validate this to the Court’s satisfaction.
The Court suggested there should have been, “a formal market study prior to undertaking his horse activity.” Under this Court’s criteria, very few horse owners would pass muster. The opinion suggested that taxpayers in the horse industry are going to have to engage in a lot more of formalities insofar as documenting how they started the activity.
If you have a significant amount of losses you have a good chance of eventually being audited; it is therefore very important to document your compliance with IRS Regulations pertaining to the hobby loss rule.
Dr. Daley was unable to show that the he consulted with industry experts prior to entering the activity. He testified that he had such consultations, but the judge found his testimony lacking in credibility. There was no documentation to back him up. This case therefore amplifies the importance of establishing groundwork documentary evidence and preserving it.
It is important to maintain inventory records on each animal, including parentage, birth date, birth weight and registration information. There should be a chart of horses owned and sold, with details. It is important to keep separate files on each horse.
If you are audited, it is important to immediately obtain legal assistance. Evidence of your businesslike purpose should be presented to the auditor in the most favorable light. Your business plan should be set forth in a clear and concise manner. How you eventually expect to make a profit should be made clear. If losses are due to unforeseen circumstances or setbacks, including disease or fluctuating market prices, you should maintain documentary evidence to prove these facts. The IRS also wants to see evidence that you keep abreast of industry practices and that you investigate the possibility of changing or abandoning current methods of operation in an effort to mitigate losses.
In many cases, taxpayers have convinced the Tax Court that their horse activity is a business rather than a hobby despite over two decades of losses. In those cases the taxpayers had good evidence showing the businesslike manner in which they operated their venture. The horse owners who come through well in audits usually have a working knowledge about genetic principles and other elements of animal husbandry. They usually strive to raise high-quality animals, and have a plan on how to market them or otherwise make a profit.
