What Kind of Records Should I Maintain?
One of the main hurdles that many taxpayers face in an audit with the IRS is the presentation of books and records pertaining to their horse activity, and substantiation of the amounts claimed as business deductions. If you are audited, you will be expected to show how you keep records in connection with the day-to-day business of your activity, such as files showing the number of horses owned at a given time, the date of purchase, sale prices, breeding data, horse show entry dates, racing results, and so on. You will also be expected to show underlying invoices or other proof of expenditures incurred, in addition to canceled checks and credit card statements.
The accuracy and businesslike nature of records is something that the IRS has been scrutinizing more than in the past. Many revenue agents will take the position that if you have not made a profit within the first few years of operating a horse activity, that you are not engaged in a trade or business, but that you are trying to reduce your taxable income from other sources by declaring business deductions from the horse activity. In addition to examining the records you keep, the IRS may want to visit your ranch or farm to see whether it appears to be conducted in a professional, businesslike manner.
Alternatively, the revenue agent may want to visit the facility where your trainer or trainers keep the animals. I always encourage my clients, if they are audited, to make an appointment with the revenue agent to visit their facility, because that is usually a good way of impressing upon the agent that your activity is indeed operated in a businesslike way.
Another point that revenue agents are making currently is whether you are operating according to a business plan, and just what your plan consists of. Many people do not have a business plan as such, but they have general ideas in their mind as to how they are operating the activity and where they are headed. If you have a written business plan that projects your activity into the future, this will be helpful in dispelling any claim that your activity is conducted as a hobby. Also, it is helpful if your business plan was written before you started the activity, rather than midway through it. Finally, your plan should be modified periodically to show that you are mindful of changed circumstances, setbacks, or other situations that make it prudent to modify you direction.
The IRS also may inquire about animals that are not productive or which are not being used for breeding, showing or racing purposes. For example, if an animal has become ill and has incurred significant veterinarian fees, the question is whether this animal is going to be laid up for a long time, and whether it might be prudent to sell the animal or donate it to a school or other equine charity. By doing so, you are showing that you are mindful of the costs of keeping an animal that might not be productive, and that you are reducing your costs by culling the animal from your inventory.
Most of my top clients have me prepare a tax opinion letter, which consists of an analysis of the horse activity and recommendations on how the activity can be improved in line with IRS regulations and Tax Court developments.
This can be used in evidence in your favor to prove that you have sought out expert advice with a view towards enhancing the prospects of making a profit, and that you have followed the advice given. A tax opinion letter becomes part of your permanent records, and should be updated periodically to address changes and developments in your activity.
It is important to keep signed copies of all documents, such as leases, sales agreements, stud contracts, partnership agreements, and so forth, rather than unsigned or draft copies. Also, it is important to keep some kind of log that shows the amount of time you expended in the activity on a weekly basis.
This can be something as simple as a desk calendar, or a more complex computer format. It should be kept as current as possible. Often the IRS will question how someone who has a full time occupation such as a physician, investment broker, lawyer or other professional, can afford to put in time to attend to the activity, and keeping a log will help substantiate and prove the fact that you put in a certain number of hours per week.
Another type of record that is extremely important consists of appraisals of bloodstock. For example, if you have a principal stallion that you are hopeful will become a champion and will produce significant revenue in your venture, you should get an appraisal that shows that the horse has increased in value under your stewardship. The appraisal should be from a bloodstock agent or a trainer. In addition, if you operate your horse activity from a farm or ranch that you own, and you have made improvements, an appraisal on the realty, showing that it has increased in value as a result of your efforts, will also be important to show that the overall value of the land has increased in value.
Finally, at some point it is highly recommended to prepare (or have a professional accountant prepare) a cost benefit analysis that projects your anticipated income and expenses, and shows how and when you reasonably expect to realize a profit year.
John Alan Cohan is a lawyer
who has served the horse industry since 1981.
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