The subject of this article is Section 183 of the Internal Revenue Code. This section of the Code is entitled “Activities Not Engaged In For Profit,” or more commonly known as the “hobby loss” rule. While the code section is fairly short and easy to understand, it has far-reaching and potentially costly consequences to the unwary taxpayer.

Below is a hypothetical first meeting I had with a hypothetical client some years back. I cannot disclose the name of the client, but his farm name was Flyin’ High Farm. While he was a teenager during the sixties, the name of the farm was derived from his very successful career as a pilot. I will refer to him as “Joe.”

Greg: It’s a pleasure to meet you, Joe. You mentioned on the phone that you had some problems with the IRS. Can you give me a little more detail?

Joe: Sure. About eight months ago I got a notice from the IRS that I was being audited. I turned it over to my accountant to handle for me, and I assumed that everything was going just fine. My accountant asked me to attend a couple of meetings with the agent and bring all of my records to the first meeting. The agent asked me numerous questions about my horse business, but my accountant didn’t act like anything was wrong.

Greg: I’m sorry to interrupt, Joe. Who is your accountant?

Joe: His name is Jimmie. He runs Jimmie’s Accounting Service and Feed Store. He really is a nice guy and I get a really good deal on my feed.

Greg: Oh. Go ahead.

Joe: Well, the next thing I know I get this second notice in the mail. I don’t know exactly what it is, but it looks like they want me to pay them almost $100,000! I asked Jimmie what we should do, and he said I didn’t have much choice other than to pay it. Jimmie did say that they might let me pay it in installments, though. Is that true?

Greg: Take it easy, Joe. May I look at that for a minute? (The notice had the agent’s report attached to it. It didn’t take long to determine that the agent was disallowing the losses that Joe had claimed on his Schedule F for the past five years.) Joe, I am afraid we have a lot of work to do. After you and I have a chance to review the details, I may recommend that you hire an attorney to work with me. I will meet with the agent and his supervisor to see if we can still present additional information to them. If not, our next step will be to prepare our response for an appeals conference. This is where it becomes difficult. We really need to prepare our argument in a way that shows we are prepared to go to court, even though we may not do that.

Joe: Whatever you say, Greg. It sounds like you know a little more than Jimmie does.

Greg: What exactly do you do in the horse business, Joe?

Joe: I breed and race Thoroughbreds.

Greg: How long have you been in that business?

Joe: Since I retired about five years ago. I inherited quite a bit of money from my parents.

Greg: Did you have any previous experience with Thoroughbreds?

Joe: Several of my friends owned them and I loved going to the track. I thought it would be fun to be around my friends and be able to write off my trips to the track to watch my horses run.

Greg: Okay. Did you happen to prepare a business plan for the activity?

Joe: A what?

Greg: Never mind. You mentioned that you provided records to the agent. Did he ask for both business and personal records?

Joe: Yes, but I only have one checking account because just about everything I spend is business-related.

Greg: How did Jimmie segregate your personal and business expenses?

Joe: He would ask me if something looked personal, like when I would buy Christmas presents and birthday presents. I assumed that he knew what he was doing. I thought all horse owners operated like this.

Greg: I noticed a reference to “cash” expenditures in the agent’s report. What was that about?

Joe: Several of the guys that worked on the farm would not work unless I paid them in cash. I would cash a check once a week and pay them on Friday afternoon. I hope that was okay. Jimmie says he does it all the time.

Greg: I’m afraid that it isn’t O.K., Joe. We’ll talk about that later. I was just reviewing your depreciation schedule. It looks like you are depreciating part of your house. Is that correct?

Joe: No, I am depreciating all of it. Like I said, almost everything I do is business-related.

Greg: So the Mercedes, the GMC 3500 and the Suburban are all used 100 percent for business?

Joe: Well, they are all used for business at some point. You aren’t comfortable with this, are you?

Greg: Joe, I am afraid that this is not going to be a fun process for either one of us. Fortunately, we still have an opportunity to prepare for the appeals process if the agent will not consider additional information. Now we need to discuss my fees. I’m sure that whatever I charge won’t bother you because you have lost several hundred thousand dollars over the last few years in your business.

Joe: Well, I enjoy being around horses, and I can’t take it with me. It really doesn’t matter if I make a profit or not.

At this point, because CPA’s do not have the same privilege as attorneys, I decided that Joe needed to hire an attorney who would then hire me.

The Specifics
While IRC Section 183 deals with all activities not engaged in for profit, the only activity specifically referenced is “…an activity which consists in major part of the breeding, training, showing, or racing of horses…” The reference is actually made in order to provide temporary relief to this type of activity and seems to acknowledge that the startup costs of this type of activity could be potentially large. It could also mean that you should never underestimate the value of contributing to the appropriate Political Action Committee.

The purpose of the hobby loss rules are to deny the taxpayer a deduction for losses incurred in an activity if it is determined that the activity was not engaged in for profit. For most individuals that are engaged in one or more aspects of the horse industry, this activity would be reported on Schedule F of their Form 1040. The activity could also be reported on Schedule C of the Form 1040 or, in the case of a partnership, Form 1065. Another option rarely thought of, and almost never discussed, is that the deductions that exceed income from the activity not be reported at all!

Let’s cut to the chase. Congress has written IRC Section 183 to presume the taxpayer is engaged in an activity for profit if (in the case of an activity which consists in major part of the breeding, training, showing, or racing of horses) the gross income derived from the activity for two or more of the taxable years in the period of seven consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity, unless…the IRS establishes to the contrary. Did I say that this was easy to understand? The bottom line is that if you can show a profit (no, not just a dollar or two) in two out of seven consecutive years, the burden shifts to the IRS to prove that you were not engaged in the activity with the purpose of generating a profit. If they cannot do this, you are allowed to deduct the losses from the activity, assuming you can meet the “ordinary and necessary” tests and are not subject to the passive loss rules.

In order to help us navigate the mine field of IRC Section 183, the Treasury Department has provided us with a 9-volt metal detector know as Reg. Sec. 1.183-2. This section of the Treasury Regulations cite nine relevant factors that should be examined to help determine whether or not the taxpayer held a profit motive in undertaking the activity.

These nine factors are as follows:
1. Manner in which the taxpayer carries on the activity
2. The expertise of the taxpayer or his advisors
3. The time and effort expended by the taxpayer in carrying out the activity
4. Expectation that assets used in activity may appreciate in value
5. The success of the taxpayer in carrying on other similar or dissimilar activities
6. The taxpayer’s history of income or losses with respect to the activity
7. The amount of occasional profits, if any, which are earned
8. The financial status of the taxpayer
9. Element of personal pleasure or recreation

It is difficult to “document” your way through this list in order to preserve your losses for tax purposes. Many cases have been lost with T’s crossed and I’s dotted. The bottom line is that you really should have an objective of making a profit from your involvement in the activity. You should then conduct the activity in a business-like manner which supports your objective. Why would anyone lose money for eight years in a row without abandoning the activity or using the losses to offset other taxable income? Well, maybe they are convinced that the ninth year will be the year they make it to the top! The only person who truly knows if they have a profit objective is the person who has invested their time, effort, energy and capital.

The outcome of every audit or court case will ultimately be determined by the facts and circumstances of each case. Because the stakes can be very high at times, I suggest that anyone who is uncertain of potential profits of a horse-related activity that will be reported on their tax return seek competent professional help. If the hired professional does not discuss these concepts with you to your satisfaction, I suggest you find someone else. Remember, it is very difficult to recreate history.

In addition to hiring professional help, you might consider joining the American Horse Council. At the appropriate membership level, they will send tax information directly to your accountant or lawyer. Contact AHC at (202) 296-4031 or www.horsecouncil.org.

This article is not intended to be tax advice. Consult your personal tax advisor to determine whether some or any of this information applies to you.