April 9, 2020 | Guest Blogger Robert M. Swaim

Horse farm tax article Robert SwaimSeveral years ago I had a client who entered into the business of breeding horses for the purpose of sale at a profit. The IRS audited his return and declared his horse farm to be a “hobby” rather than a business and disallowed his farm loss deductions. The IRS argued that my client, being a wealthy lawyer, was not engaged in the horse farm business as it was not his primary occupation, and that he was merely a “gentleman farmer” engaging in a “hobby” that gave him great personal pleasure. The greatest evidence that it was a hobby, said the auditor, was the fact that it had not turned a profit in recent years.

I took strong issue with the government’s position and appealed the auditor’s decision. My client is a lawyer who makes his home on his horse farm in Georgia and does indeed earn his living as a lawyer. My client employs hired help at the stables and regularly consults with veterinarians at considerable expense. Financial books and records of the horse operation are maintained apart from their other financial activities by my client and his wife. There is a separate checking account just for the horse operation.

He devotes 20 to 25 hours a week to the work and business affairs of his stables. He is actively engaged in care and maintenance of the horses, barns and stables. My client attends to his stables on a daily basis and devotes many of his weekends almost exclusively to the care of the horses and stables. Tax losses in prior year audits had never been questioned or disallowed. Expenses incurred in the operation of the stables included the ordinary and necessary expenses of: veterinarian services; services of professional trainer; feed; repair and maintenance of stables; insurance; property taxes; and transportation for the horses.

We successfully argued that, in the matter of losses deducted on the federal income tax returns pertaining to the operation of a horse farm, he was in compliance with statutory law and case law. We forcefully and vigorously argued that he met all the tests and criteria laid down by the federal courts in the several circuits of the United States with regard to being “engaged in trade or business for gain or profit” and not engaged in a “hobby” as the IRS auditor argued.

My client was in compliance with the law in all material respects, to wit:

*Losses were the result of the excess of “ordinary and necessary” expenses over revenues.
*Expenses were incurred in the conduct of business engaged in for profit.
*Expenses represent actual cash outlays or expenses incurred during the tax year

The operation of a stable and breeding farm is in essence a risky business, frequently generating consecutive loss years, and has given rise to considerable tax litigation over the years.
Although horse breeding is indeed a hobby for some, it can nevertheless constitute a business for other taxpayers. The existence of substantial financial risk in the conduct of such business does not necessarily convert it to a hobby any more than in the case of any other adventurous business such as oil drilling or stock trading. All of these businesses involve a substantial risk factor and frequently occasion periods of continued losses.
In Farish v. Commissioner of Internal Revenue, the court held that, as in the case of other activities, the determination of whether a breeding stable is a business or a hobby is the intention to derive income therefrom and the expectation of a profit. The court went on to say that the intention of the taxpayer at the outset is the dominant factor in determining whether he engaged in the venture for profit or merely for pleasure. The court ruled in favor of the taxpayer and allowed the loss deduction. The court held “It is not at all improbable that men in the oil business, having ample capital, would engage in the enterprises here involved with the hope and expectation of ultimately making a fair return on the investment.”

With regard to years of continuous losses the court allowed that

“One who plants a fruit orchard must wait a number of years before the trees produce fruit in sufficient quantities to show profit, but the expense of cultivation goes on every year before that.”

While the profit motive continues, it is immaterial whether the expectation of profit is reasonable so long as it is bona fide.

The tax court held, in Morken v. Commissioner of Internal Revenue,

“A taxpayer engages in the breeding of horses in a businesslike manner if he researches and plans horse purchases, advertises, consults trainers or breeders, and becomes knowledgeable about the horse raising and breeding industry and its profitability.”

Although my client showed losses for 6 out of 7 of the total years of operation, the government could not automatically presume that he was not engaged in business for profit.

In pursuance of that appeal we relied on the definition of “business” as handed down by the Supreme Court in Flint v. Stone Tracy Co:

“Business is that which occupies the time, attention, and labor of men for the purpose of livelihood or profit.”

Clearly my clients were engaged in business under this definition.

Horse farm tax article Robert SwaimIn the case of Widener v. Commissioner of Internal Revenue, the facts are identical to the situation my client was in. In ruling for the taxpayer, the court said: “If it be a fact, as it is earnestly urged by the government, that the taxpayer was a sportsman in the sense that he is fond of racing horses, it cannot change the character of this undertaking. Success in business is largely obtained by pleasurable interest therein.”

This shoots down the IRS argument, and they always make it, that if an activity is fun then it must be a hobby and not a business, therefore they will try to deny all loss deductions.

If you have a farm, whether it be a horse farm or some other type of farm activity, and have not been taking deductions on your income tax return, it might be wise to review your position. You need not be a full-time farmer. If you have been taking the deductions, you would be wise to tailor your activity to meet the criteria laid out by the courts as cited in this article.