By Herb Wittenberg, CPA
COVINA, Calif. (Feb. 7, 2014) — An IRS Audit is disagreeable. It’s time consuming, requiring you and/or your accountant to gather up your supporting documentation. Perhaps you can end up paying additional taxes. Some things trigger an audit, so here are some tips to help you avoid them.
The Schedule C Form requires you to enter an occupational code number for your business. The correct number for Thoroughbred Racing and Breeding is 711210. Failure to enter this number on the Schedule C can get you an IRS Audit.
Each Race Track sends you a Form 1099 at year end showing your gross purse earnings. They also send the IRS a copy of the Form 1099. You must show gross purse income of at least this amount on your return or it will trigger a letter, (and perhaps an audit), from the IRS. The actual money you receive from the Race Track will always differ from the Form 1099 because the track deducts various expenses – i.e. jockey fees, trainer’s fees, nomination fees, win photos, box seats, etc. You must record the gross purses and then list the various deductions as business expenses.
Often, you own a horse with co-owners. The track paymaster will issue a Form 1099 to only one of the co-owners, usually the one whose name is alphabetically first. So if Adams, Jones, and Smith each own an interest in the horse, Adams will receive a Form 1099 for the entire gross income, while Jones and Smith will not get a 1099. In that case, Adams must report the gross amount and then show a deduction, (in the income section), for the gross amounts paid to the co-owners. This should be listed as “less purses paid to co-owners.” Adams should limit his “track deductions” to his correct percentage interest in the horse. He should issue a Form 1099 to his co-owners, listing their share of the gross purse income, and send them a copy of the track statements so that they can claim their share of the track expenses. Failure to send 1099’s to co-owners, trainers, ranches, vets, accountant, etc., (who are not incorporated), can result in a $100 penalty per 1099. The IRS Schedule C Form requires you to indicate if you are required to issue 1099’s, and also asks if you have complied. Form 1099’s are required if you pay $600 or more during the year for each person providing services to your business. Co-owners not required a Form 1099 should, nevertheless, report their share of all income received.
Another “Red Flag Trigger” that can cause an IRS contact is failure to report wagering income shown on a W-2G. You may very well have gambling losses in excess of your gambling income, but you must report your gross gambling income as Miscellaneous Income, and then claim your gambling losses as an itemized deduction. (The deduction is limited to the gambling income reported.) It would be prudent to report some extra gambling income, (in excess of the amounts shown on the W-2G, since small amounts of wins don’t require the track to issue you a W-2G. You should retain all your losing tickets throughout the year. In addition, you should ask the Pari-Mutuel clerk to give you a receipt showing the cost or the winning tickets, when you collect on your bet.
In summary make sure that your racing stable income reported on your Schedule C equals or exceeds the amount shown on the 1099 you receive and report your gambling (W-2G income.) Also, report the sales proceeds of any horses you sell during the year.
Next – How to Prepare For an IRS Audit
If you are unfortunate enough to be selected for an audit, let’s try to mitigate the problem by planning ahead. The typical audit will require you to prove your business deductions by showing the IRS examiner your books, cancelled checks, invoices, track statements, etc., to support the deductions claimed on your returns.
You should keep good records – including a cash disbursement record of your expenses. The tax courts have stressed the importance of keeping good records to support your contention that your Racing/Breeding operation is a business and not a hobby. Keeping a separate checking account for the horse activity is important.
The IRS sometimes contends that the thoroughbred horse activity is not a business, entered into with the hope and expectation of making a profit, but simply a hobby.
If deemed to be a hobby, your net annual losses are not deductible. We all recognize that racing is a high risk business, often generating losses; however, it has great potential for large profits if you are fortunate enough to earn large purse income, perhaps followed by large stud fees and Breeder’s Awards income.
You must run your operation in a business-like manner, keep books, keep your cancelled checks and invoices, track statements, etc. You should be knowledgeable about the business. If you are a novice, consider becoming a co-owner with your horse trainer or an experienced horse owner. Become knowledgeable and be involved. If you can show a net profit for at least 2 years out of the past 7 years, then the activity is not presumed to be a hobby, and all losses are deductible. This is called the safe harbor.
Unfortunately, all too often, we fail to make a profit for 2 out of 7 years. All is not lost, but we must show that we have a good faith expectation of making a profit. The U.S. Treasury lists 9 factors that the IRS must consider in determining if an activity is a hobby or a bona fide business, engaged in with the expectation of making a profit.
The factors include:
The manner in which the taxpayer carries on the activity.
The expertise of the taxpayer or his advisors (Trainer, Blood Stock Agent, Vet).
Time expended by taxpayer in carrying on the activity.
The expectation that assets used in the activity may appreciate in value.
The success of the taxpayer in carrying on other business activities.
Taxpayer’s history of income and losses with the activity.
The amount of occasional profits, including gains on sale of horses and related realty (farm assets).
The financial status of the taxpayer.
The elements of personal pleasure and recreation.
The 2 most important factors are the conduct of the activity in a businesslike manner, (i.e. good record keeping, expertise and time expended by taxpayer in the activity), and continuous losses.
In the event that an IRS examiner determines your activity is a hobby, you and your accountant should prepare a rebuttal listing the 9 factors, and your response and explanation for each of the 9 factors.
Your responses should show the future potential, (i.e. the current value of your horses- including self-raised horses in which you have no cost basis, but are valuable).
You should always make a photocopy of each horse’s registration paper, (pink slip), showing the races the horse was engaged in during the period you owned the horse. In case of an audit, we would list the potential gross purses had each horse won each race it engaged in. Make this copy prior to turning the papers over to a new owner, so you have a record if you are audited. Discuss potential stud fee income, breeder’s awards, etc. with the auditor.
The IRS has a second weapon to use against the unwary – by asserting that you are engaged in a passive activity and; therefore, your losses are “suspended”, and not deductible in the year they are incurred. Suspended losses are accumulated, and can be deducted against income realized, (in future years).
For example, let’s assume you have accumulated “suspended losses” over the prior 4 years, totaling $200,000. In year 5, you have a $40,000 net profit. You report your profits of $40,000, apply $40,000 of your suspended losses against it, and carry the $160,000 remaining suspended losses over to future years.
When you cease your Horse Racing/Breading business, then all remaining suspended losses are deductible in that year.
Needless to say, having the horse activity deemed a “passive activity” is not in your interest, and you should strongly dispute this IRS position.
You, (and your spouse), must be engaged at least 500 hours per year in the activity to be active, (and not passive). One method is to keep a daily record of your activities for a time-period, (let’s say 3 months), listing the time you spend as an active participant. This includes the time spent going to the track to watch workouts and races, time spent conferring with your trainer, bloodstock agent and veterinarian, trips to horse ranches, trips to race tracks when you are considering claiming a horse, time spent reading the daily racing form, attending TOC seminars, and time spent keeping your books and paying your bills.
Most owners will not take the time to keep daily records, but you will need to calculate your hours involved in the activity should the passive activity issue be raised.
Do deduct your cash expenditures on your Schedule C, which indicates time spent. These would include the cash outlays for racing forms, programs, outlays for out-of-town meals and travel, and business meals with your trainers. You should deduct your auto mileage to race tracks, farms, horse auctions, etc. These indicate participation in the business, as well as, giving you a deduction for the expenditures. Retain copies of horse magazines, (Blood Horse, etc.), and racing forms. They all indicate your participation.
Do claim these expenses, even if they are relatively small in relation to total expenses, because they show participation.
Now what happens if you can’t convince the IRS examiner that this isn’t a passive activity, or worse, a non-deductible hobby loss? The IRS will issue a report denying the deduction and asserting a tax deficiency. You are also required to send a copy of the final IRS determination to your state tax agency, and paying additional state taxes.
If appropriate, you should disagree with the IRS report, gather up your supportive documentation, (i.e. time estimated for the passive activity issue), and discussions of the 9 factors if you have a hobby loss disallowance. These should include computations showing the unrealized gains on your existing horses, potential purse income if your horse had won all these races it was in. And then request a new hearing with the IRS examiner and his supervisor.
Your accountant should assist you in preparing this documentation. Then you and your accountant should be at the meeting. You will need to impress the IRS that you are knowledgeable about the horse activity.
If you again fail to prevail, you should request a hearing with the appeals office.
The Appeals Office is separate from the IRS Audit Division. Appeal Officers are generally competent and well trained, and are often attorneys or CPA’s. You offer the same explanations as before, perhaps strengthening the areas where the IRS examiner rebutted you. If you still can’t prevail with appeals, (who have the authority to split the issues with you), and you feel you are not getting a fair deal, then you should file a petition to the U.S. Tax Court. Your accountant fills out a simple 2 page document. One page lists your name, address, social security number, the issues involved, (i.e. disallowance or suspended business losses). The second page lists the IRS city you wish the meeting held. You send these 2 pages, (along with the IRS Appeals report), and a $60 check to the U.S. Tax Court. You get a second shot at an appeals officer. The new appeals officer and the IRS Attorney, who will try the case, will meet with you and your accountant to discuss the issues involved, and weigh the hazards of litigation, and hopefully reach an agreeable solution.
If you can’t prevail at this final hearing, then you must actually go to tax court or pay the deficiency. Actually going to tax court is an expensive endeavor. We have been to the tax court only once. You will need an attorney. You and your accountant will need to prepare a written protest, along with your documentation indicating time spent on the activity, knowledge of the horse business, with copies for yourself, your attorney, the IRS attorney and the judge. It will take many hours to prepare the documentation. You will pay a significant retainer to your attorney. Your accounting fees will be high. If the IRS contends this is a passive activity, it may be easier to cease the horse activity, sell your horses, go out of business and deduct your suspended losses in the year you cease operations. You can always go back in business in a later year.
I hope that this information will prove of use to you in preventing audits, and in prevailing if the IRS disputes your deductions.
In summary:
Keep good records
Be knowledgeable about Horse Racing/Breeding
Use good Horse Trainers, Bloodstock Agents, etc.