Horse owners facing more hurdles with IRS audits
Dr. Louis Novak, a radiation oncologist in Cleveland, OH, wanted to realize a long-standing dream of successfully breeding and selling Arabian horses. Dr. Novak did many of the right things, although he incurred over $1 million in losses over an 11-year period.
He had $269,000 in sales for the years in question, but in a Tax Court case the judge questioned why some of the commissions Dr. Novak paid to sellers were as high as 50 percent and even 60 percent in one instance. Dr. Novak was not able to explain this. Perhaps the seller was really being given a bonus, which is perfectly permissible, but the judge received no explanation to satisfy him.
Also, the judge said that Dr. Novak had not prepared “a written analysis to determine how he could make a profit or what he would have to do to break even,” and that he hadn’t consulted with people with expertise regarding the financial aspects of his horse activity. The judge said: “A taxpayer’s failure to obtain expertise in the economics of horse-related activities indicates a lack of profit motive.”
The judge held Dr. Novak’s breeding, training, and showing of Arabian horses was not engaged in for profit, which meant that tax deductions for losses were denied against his principal source of income.
For most individuals, a horse activity is not one’s principal occupation, and the “day job” helps finance a customary startup phase. For many horse owners with the best of intentions, profits are not forthcoming, and with a difficult economy, profits are even more elusive. Being a physician or in some other high income profession is a red flag for IRS audit selection if you are operating a horse activity for which you are declaring tax losses.
With a tax audit, as with Dr. Novak’s case, the revenue agent might argue that you have little time to devote to the horse activity because of a heavy work schedule. One of the factors in the “hobby loss” rule is the amount of time devoted to the activity, and this is usually difficult to prove other than by your verbal statement. But it can become very important if you have a history of losses and no business plan or other elements to help prove your overall objectives to make a profit. The judge did not believe that Dr. Novak had any spare time in which to engage in the horse activity, given his demanding work schedule at a hospital where he saw patients as well as taught medical classes.
The judge also felt that some of the taxpayer’s actions seemed contrary to a profit objective, such as paying the high rate of commissions on horse sales instead of the standard 10-15 percent commission.
There were other deficiencies in his case. He failed to show that he had bought his farm primarily with appreciation in mind, or that he expected the value of his horses to increase over time. Finally, the judge believed that recreational objectives were a significant component in Dr. Novak’s horse-related activities. [The case, Novak v. Commissioner, is reported at 2000 RIA TC Memo ¶2000-234.]
In summation, this case demonstrates the importance of planning horse activities with a view towards insuring that your business records, including a business plan, show that you are in compliance with IRS Regulations in the event you are ever audited. Statistics show that 27 percent of audits every year focus on horse, ranching or other farm operations. At the same time, the horse industry pays $1.9 billion in taxes to the government.
john alan cohan is a lawyer who has served the horse, livestock and farming industries since 1981. he can be reached at: 310-278-0203, by e-mail at email@example.com, or you can see more at his web site http://www.johnalancohan.com.
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