Category: Horse Taxation

Larry Rosenblum, President of The Equine Tax Group, spoke to Alfred University students on select topics in Equine Business and Taxation.

In the morning session, Larry’s presentation enabled the audience to understand the importance of having a business plan for business and tax purposes in farming or related agricultural businesses.   The presentation walked the audience through each step of the process.

In the evening session Larry focused on select equine tax and tax audit issues.

Larry’s firm partners with taxpayers, C.P.A. firms, and Attorneys to resolve disputes with the Internal Revenue Service (IRS) and State Tax Departments, with a special focus on resolving section 183 (hobby loss) and section 469 (passive loss) issues in the equine industry.

Larry’s practice also includes IRS dispute resolution and general taxation issues, and Agriculture and Excise taxes. He possesses expertise in IRS Examination, Collection and Appeals procedures, and is an experienced witness in court cases and income reconstruction cases.

Bonus depreciation under §168(k) provides that the taxpayer may deduct 50% of the cost of qualifying new assets put into service in taxable years from 2015 to 2017, phasing down to 40% in 2018 and 30% in 2019.

This means that an unraced, untrained Thoroughbred yearling is eligible for bonus depreciation because a buyer will be placing the horse in service for the first time. It’s a “new” horse for bonus depreciation purposes. However, a Thoroughbred sold as a 2-year-old in training probably is not, nor is a mare in foal.

Note that changing how the horse is used, buying a show hunter as a broodmare for example, does not constitute a new “original use” for bonus depreciation purposes.

To summarize, the tax rules provide that a horse business with “used” qualifying property may:

1. First take a 179 expense, if any
2. Then take MACRS expense

However, a horse business with “new” qualifying property may:

1. First take 179 expense, if any
2. Then take 168(k) bonus depreciation
3. And then take MACRS expense

Importantly, if §179 does not apply because of certain limit triggers then bonus depreciation and MACRS still apply.

So you can see that by taking §179, and bonus depreciation, and MACRS, those taxpayers with qualifying property have significant cost recovery tools.

Section 179 is a very business friendly tax provision meant to give small to medium-sized businesses the tax incentive to purchase qualified property. When combined with §168 MACRS deduction, and §168(k) Bonus Depreciation (to be discussed in a later post), those in the horse business can usually recover a significant amount of their depreciable costs immediately.

Although a generous tax provision, §179 is subject to three limitations:

1. Type of property – qualified property must generally be new and used tangible property, but also may include computer software and real property, as specified in §1245(a)(3). Horses qualify.
2. Dollar limitation – the maximum expense allowable starting in tax year 2016 is $500,000, and is reduced dollar-for-dollar over $2,000,000 of the aggregate costs of those qualified properties placed in service in the same taxable year. Both amounts will be indexed to inflation.
3. Income limitation – bars a taxpayer from expensing an amount greater than their taxable income (including wages and salaries) from the active conduct of all their trades or businesses. Section 179 may not by itself create or increase a loss, and any excess not used in that taxable because of the income limitation may be carried over to the next taxable year.

Section 179 is also useful because it provides taxpayers with significant planning opportunities:

• The taxpayer can allocate their deduction amounts among their qualified property, meaning that they may want to consider applying their section §179 amounts first to those qualified properties that depreciate slower than others.
• Applying §179 to an asset may impact whether the half-year or mid-quarter convention applies to those assets placed in service in a taxable year.

Note that §179 property is subject to the recapture rules so that any prior §179 expense may have to be recaptured as ordinary income if the asset is later sold.

Depreciation under §§ 167 and 168 is an important way in which horse businesses recover their costs. Horses are tangible assets and can be depreciated unless they are inventory, meaning if your business is buying and selling horses and not breeding or racing them then they are inventory and thus not depreciable.

Depreciating a tangible asset requires answering two questions:

• When can I take a depreciation deduction?

You generally start depreciating in the taxable year in which you engage in a trade or business, and your asset is “placed in service.” The placed-in-service date is the date the depreciable property is ready and available for a specific use, even if not actually used yet. Purchasing the asset is not enough, and if it was held for personal use and then converted to business use then the property becomes depreciable on the conversion date.

Generally, a racing or a show horse is placed in service the earlier of when their training begins, or when they start racing or are shown.  And if previously placed in service, then they may be depreciated when purchased from the prior owner. For broodmares depreciation begins when the mare is first brought to the farm to be bred, and if already in foal then when purchased. A breeding stallion is placed in service when its services are first offered.

• How much can I take as a depreciation deduction?

Answering this question is a function of the following four elements:

The cost basis under §1012, and any adjustments under §1016. For example, a horse’s cost basis is increased by adding the cost of a trip to acquire it.  Rul. 72-113, 1972-1 C.B. 99.

The depreciation method, as in the 150% declining balance Modified Accelerated Cost Recovery System (MACRS), for example.

The asset’s useful life, where horses generally fall into the three or seven year class, depending upon its age and use when placed into service. Yearlings, racehorses and breeding horses over 12 are depreciated as three-year property; all others are depreciated as seven-year property.

The depreciation convention, where generally the half-year convention is used unless the 40% rule is triggered under §168(d)(3) which requires the mid-quarter convention. The key is to determine in which quarter of the taxable year the asset is placed “in service.”

Note that selling depreciated property for a gain may result in recapturing some of the previously depreciated amounts as ordinary income.

If your horse activity rises to the level of being a trade or business, and more than just a hobby (see §183), then congratulations! Subject to the passive loss limitation rules of §469, you are now entitled to recover some of those costs as §162 Trade or Business Expenses where expenses are generally deductible without limitation when they are paid or incurred:

1. In carrying on any trade or business;
2. Are ordinary and necessary, and,
3. Are reasonable in amount.

“Ordinary” refers to those expenses that are common in your industry, and “necessary” does not mean absolutely necessary but instead means the expense is helpful to create income. The key here is that your business expenses should be similar to those in your industry and in line with similar budgets, where the amount expensed bears a reasonable relation to the benefit expected. It does not mean that you have to be a carbon copy of another business; however, you should be prepared to explain yourself to the tax authorities if asked.

Note that when taxpayers establish that they have incurred deductible business expenses but are unable to substantiate the exact amounts, the tax court can estimate the deductible amount in some circumstances, but only if the taxpayers present sufficient evidence to establish a rational basis for making the estimate. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

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.