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Are you a passive investor or a material participant in your horse business? Why does it matter? This is one of the more frequent questions asked by your existing clients as well as individuals purchasing horses for the first time.
How active do you have to be to pass IRS scrutiny regarding this issue?
Material Participation
For an individual to materially participate in an activity, he or she must be involved in the operations of the activity on a regular, continuous, and substantial basis. To determine if this standard is satisfied, all the "facts and circumstances" of each situation must be examined.
The IRS regulations state that, an individual deemed to have materially participated in a horse business or any other activity during the tax year only if the individual satisfies at least one of the seven tests discussed below:
1. 500 Hours - The individual participates in the activity for more than 500 hours during the tax year.
2. Substantially all of the work - The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals for such year.
3. More than anyone else - The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity during the year by any other individual.
4 . Significant participation activity - The activity is a "significatnt participation activity" for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours. A significant participation activity is a business in which the individual participates more than 100 hours during the tax year, but does not materially participate within the meaning of one of the other tests.
5. 5 out of 10 years - The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the taxable year.
6. Personal service business - The activity is a personal service activity and the individual materially participated in teh activity for any three taxable years preceding the taxable year. A personal service activity is a business where capital is not a material income-producing factor.
7. Facts and circumstances - Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during such year. The regulations do not discuss what facts and circumstances are important. However, the regulations do indicate that na individual's services performed in the management of the business shall not be taken into consideration in applying the test if.
a. A paid manager participates in the operations.
b. The management services performed by such individual are exceeded by those performed by another individual, including employee's and non-employee's who are paid to work in the business.
In addition, the regulations state that an individual must, in any event, participate for more than 100 hours during the tax year to meet the facts and circumstances test.
Looking to the seven tier test set forth in the IRS regulations, it is clear that you have to spend more than 100 hours on teh horse business during the year. Otherwise, there is no way you will be treated as materially participating in a business unless your participation is substantially all of the work done by all others involved, including farm managers, trainers, consultants, and any other employees. An unlikely situation for most.
Limitation on Passive Losses
The Internal Revenue Code (IRC) section 469 places restrictions on the deductibility of passive losses. As a general rule, losses from a business in which you do not materially participate cannot be deducted against salaries, active business profits, or portfolio income. However, losses from passive business activities are deductible against other "passive" income. Losses, which are not currently allowed, can be carried forward indefinitely and used in subsequent years to offset passive income. Passive losses, which are not allowed while a taxpayer owns an interest in the activity, will be allowed in full when the entire interest in the activity is sold or otherwise liquidated.
A horse owner's interest in a proprietorship, a general partnership, a limited liability company, or an S corporation is a passive activity if the owner does not himself "materially participate" in the operations of that business. The activities of one spouse will be attributable to the other spouse, but the activities of other family members, employees, or consultants will not be attributed to the owner to determine whether he or she has materially participated.
Participation
Generally, all the work performed in connection with a business in which you own an interest counts towards hours spent. And, as mentioned above, you can also include the time of your spouse. Other work that is not customarily performed by an owner is not counted towards time spent if done just to meet one of the tests.
Work performed by an individual in their capacity as an investor is not taken into account. For example, studying and reviewing financial statements and reports on operations of the business for your own use, and monitoring such operations of the business in a non-management capacity does not count. But, if the individual is directly involved is directly involved in the day-to-day management of the operation of the activity, reviewing and analyzing financial or operational data is participation and the time spent counts.
In the case of an individual engaged in breeding, racing or showing horses, there are a variety of activities, which should clearly be counted towards meeting the annual hourly requirements of the regulations. These activities were discussed in an article written by Richard Craigo.
1. Time spent evaluating and engaging professional trainers or farm personnel
2. Time spent communicating with industry professionals
3. Consulting with experts regarding the economics of the activity
4. Making decisions with regards to purchases and sale of horses
5. Attending horse sales
6. Making decisions regarding the veterinary treatment of the horses
7. Making decisions regarding breeding including the study of pedigrees
2. Visiting farms where horses are boarded
There are other activities, which clearly should also be taken into account, but may, in some situations, be more closely scrutinized by the IRS. These include, time spent at race tracks or horse shows, educational time, travel time, other investor related activities, and comparative time expended by the owner and other individuals
Documenting Participation
The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means may include, but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing such services, based on appointment books, calendars, or narrative summaries.
While contemporaneous records are not required, some method of documenting the time spent with respect to a horse activity should be maintained. If not, the owner will not be able to remember, much less convince the IRS of the time spent. Most people cannot recreate a schedule of their participation for an entire year without some form of written documentation. These records are also needed to prove that the individual engaged in the activity as a business not a hobby.
Bottom Line
For many horse owners and breeders, the Facts and Circumstances test is the only one that they will have a realistic chance of passing. It requires 100 hours of participation on a regular, continuous and substantial basis. There may be some who will be able to put in 500 hours of participation a year. However, if you do not live on the farms, this may be difficult to achieve.
For additional guidance, one should look at the adit techniques recommend by the IRS, as guidelines to substantiate your active participation.
Besides what has been previously mentioned above, a horse owner should visit the farms where his horses are located on a regular basis, he should show genuine exercise of independent discretion and judgement, and must have sufficient knowledge or experience so that his decisions are meaningful to the business. Documentation of all his time and decisions are critical as well.
Many of the factors that are revelant to the "business versus hobby" issue are also relevant here as well. For example, business plans, the owner's knowledge of the business, and consultation with experts. However, records also must show the extent of the owner's involvement in the daily operations of the business and must establish the importance of his own expertise and
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