Category: Business Taxation

The IRC is chockfull of legislative provisions meant, among other things, to encourage private investment through tax shelters which are usually based on: a) deferring tax liability, b) converting ordinary income into capital gains, or c) leveraging.

Offsetting losses in the horse business against other taxable income defers tax liability and is effectively an interest-free loan from the government which becomes due only when the investment starts to generate profits, is sold, or is otherwise disposed of.

It’s no surprise then that while Congress provides tax incentives for certain economic activities, it also looks to shut down abusive taxpayers, and in 1986 Congress enacted § 469 – the passive loss rule – which limits the extent to which losses in passive business activities can be used to offset income from other non-passive sources.

Section 469 is the second most popular IRS tool used against those in the horse business, after section 183, and generally defines passive businesses as any trade or business or income-producing “activity” in which the taxpayer does not “materially participate.” Therefore, the key issues under §469 are:

1. What counts as an activity?
2. How is material participation measured?

Treasury Reg. §1.469-4 generally defines an activity as involving the conduct of, or in, the anticipation of a trade or business; however, “activity” does not necessarily mean a single business or separate entity owned by the taxpayer. Depending on the “grouping decision” the taxpayer makes, a taxpayer can treat several business entities as one single “activity” if they form an “appropriate economic unit”. Or, there could be two or more “distinct activities” within a single entity.  Defining an “activity” is key under §469 because it is that entity against which material participation is measured. Treasury Reg. §1.469-1 provides that grouping is determined taking all the facts and circumstances into consideration.

Treas. Reg. § 1.469-5T generally defines methods for determining material participation; however, of those seven, those in the horse business predominately use:

1. 500 hour test, where spouses times are included, but time from any children are excluded
2. The facts and circumstances test

Ultimately, it’s the taxpayer and their advisors who must marshal documentation by any reasonable means to meet these tests.

The horse business is a challenging and slow starting business, particularly for breeders.

With lots of expenses yet little or no income the first few years, those in the horse business usually offset their losses from horse activities against other sources of income.

It’s no surprise then that the most significant tax concern for most in the horse business is that the IRS will wrongfully declare their business is a “hobby” and “not engaged in for profit,” and under section §183 severely limit deductions to the extent that no losses can be generated.

Treasury Reg 1.183-2 provides that “not engaged in for profit” is a subjective standard – it looks to the taxpayer’s intent to create a profit, no matter if the belief is unreasonable. It’s not a reasonable person standard, it’s a subjective standard, but because the temptation to lie is so great, the determination is made by the IRS and courts by using a nine-factor objective standard.

A tax advocate would do well to study these factors, and especially the relevant case law when they represent their horse business clients before the IRS.