The Farm CPA
Paul is now part of the fourth generation in America that is involved in farming and hopes the next generation will be involved also. Through his blog he provides analysis and insight to farmer tax questions.
Cutting Horse Loss Not Always Deductible
Jan 02, 2014
One of the most challenged "businesses" by the IRS is anything that involves a horse. In a US Tax Court case issued on Monday, December, 30, 2013, a rich Texas family found out how much it can cost when the loss is not allowed. In the Travis Mathis and Bettina Jary-Mathis case, the facts are as follows:
- In 1992 Ms. Bettina Jary married Travis Mathis, the grandson of one of the founders of Brown and Root, a very lucrative engineering and construction company. As one of the owners of the company, the taxpayers enjoyed dividend and investment income of several million per year.
- Ms. Jary-Mathis had grown up on a ranch in South Texas and had taken part in cutting horse competitions during her years before marriage. A cutting horse competition involves a judging of a rider and their horse based on how well they cut a cow from the herd. I have personally have watched a couple of these competitions and there is a lot of skill involved. If I tried it, I am sure I would end up off the horse and in with the cows.
- In 1995, the taxpayers decided to get into the cutting horse business. From 1995-2000, they managed it as a training operation. She bred her mares to high-quality stallions to produce horses capable of competing in the premier cutting events. However, as you can probably guess, the winnings did not cover their losses.
- After sustaining losses for the first five years and losing her on site trainers, they decided to shift the farm's focus to breeding rather than training. To build the reputation of the ranch, they only purchased broodmares with strong bloodlines and kept only those that produced successful foals. By 2007, the farm possessed an exceptional broodmare collection.
- The taxpayers had a written business plan, maintained very good records and ran the cutting horse operation like a "business".
However, the IRS somehow decided that any business that had shown a cumulative loss of over $8 million from 1996 to 2008 with over $3 million occurring during 2006-2008 is not a business, but a hobby. The IRS assessed an income tax liability of about $1.2 million for 2006-2008 and assessed a 20% accuracy-related penalty of another $240,000. With interest, the taxpayers would owe over $1.5 million.
The Tax Court addressed several components of whether the farm was a business or hobby as follows:
- Manner in Which the Taxpayer Carries on the Activity - The fact that the taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate a profit motive. On balance, this factor favored the taxpayers.
- The expertise of the Taxpayer or Their Advisors - The taxpayer's expertise, research, and extensive study of an activity, as well as their consultation with experts, may indicate a profit motive. The Tax Court indicated that a failure at the outset of starting the farm to consult experts indicated they lack a profit motive (not sure if I totally agree with that conclusion, many successful businesses never consulted an expert before they got started).
- The Time and Effort Expended by the Taxpayers in Carrying on the Activity - Ms. Mathis typically spent at least 40 hours per week on the cutting horse activity and more than 60 hours during top cutting events. However, the Tax Court noted that although she worked hard, there was substantial personal and recreational aspects. On balance, this factor weighed in favor of the taxpayer, but the personal and recreational aspects limit its effect.
- The Expectation That Assets Used in the Activity May Appreciate in Value - An expectation that assets used in the activity will appreciate in value may indicate a profit motive even if the taxpayers derive no profit from current operations. However, the expectation is that the appreciation will exceed accumulated operating losses. The total value of the cutting horses owned by the taxpayers at the time of audit was only $1.2 million. This is substantially less than the accumulated net operating losses of over $8 million. The Tax Court also indicated that any appreciation in the land and buildings would be related to an investment nature, not the cutting horse operation. Therefore, the Court indicated the evidence did not show the activity was operated for profit under this factor.
- The Success of the Taxpayers in Other Similar Activities - None of the taxpayer's past activities provided any evidence of a profit motive.
- Taxpayer's History of Income or Losses - A history of continued losses with respect to an activity may indicate the taxpayers lacked a profit motive. Although a series of losses during the start-up stage can be normal, the taxpayers had never incurred an operating profit over a 13 year period. The taxpayers also showed dramatically lower losses in the years after audit, however, the Tax Court indicated this was not from greater sales, but rather lower expenses. They also specifically stated that the audit, not the desire to earn profits, may have triggered the reductions. Accordingly, the Court gave little weight to the decline in expenses in determining whether they had a profit motive. Therefore, this factor weighed heavily against finding a profit motive.
The Tax Court added up the factors in favor of the taxpayer (about 1.5) and the factors against the taxpayer (at least 4) and most likely placed a large amount of weight on factor 6 and agreed with the IRS that the cutting horse farm was a hobby and not a business. Therefore, the taxpayers ended up owing $1.2 million of taxes plus interest, however, the Court did rule that the 20% accuracy penalty was not owed which saved them about $240,000.
The bottom line - If you have a farm business that shows large losses for many years with substantial non-farm income, you will most likely get audited at some point and in most cases, you will lose the audit.