Accounting, for purposes of the I.R.S., is closely linked to the “style” of ownership you have chosen (see chapter on “Forming Your Business”). The most crucial term to keep in mind (since the change in tax laws in 1986) is the word PASSIVE. If you are deemed by the I.R.S. (from examination of your records) to be a “passive” owner or participant, you will, tax-wise, have absolutely no room to wiggle and nothing to gain from your thoroughbred “investment.” [The applicable Federal Income Tax Regulation states that “Passive income is investment in a business activity with no material (meaning time-and-effort, not financial) participation.”]
You must show that you have spent 500 or more hours at this business activity during the year in order to safely qualify as “active.” A small piece of good news: if your spouse accompanies you to the track to handicap, confer with your trainer or other owners, or to eye potential horses which might be added to your stable – or if he or she spends time in assisting with the running of your thoroughbred business, these hours can be used to make up the 500 hours, whether or not you file joint returns.
As a rule, the I.R.S. will accept write-offs against your thoroughbred ownership business as long as it is run in a business-like manner, with properly kept records, and is clearly being conducted with the intent of making a profit.
Limited Partners and Syndicate members are considered “passive” (i.e. individuals can take no personal deductions for losses, but will pay tax on gains) – and will also be responsible for their share of the cost of filing a tax return as an incorporated entity. Both Sole Proprietors and Partners pay taxes only on revenues they actually earn – and then, ultimately, only if the earnings result in profits.
Sole Proprietors and Partners can, on their personal income tax returns, write off against their winnings (or earnings) a wide variety of expenses – from relevant phone calls and accountants’ time to the cost of programs, losing pari-mutuel tickets and travel to and from the track. Note: to be utterly “safe,” these expenses should only be used to help reduce an owner’s “gains” to zero, and not be subtracted from zero to show “losses” for income tax purposes. But you can gamble if you wish. [Please see “Hobby Loss” section below.] In any case, Rule Number One is vigilant bookkeeping. This, above all, is the key to protecting your reported profit or loss as an owner.
If you are a Sole Owner/Proprietor, you need file no separate income tax return on your horse business, but you will be required to provide in your personal returns a separate “Schedule C of Form 1040” with figures and receipts fully detailing your stable’s income, expenditures, assets, and liabilities. You can also, following proper guidelines, write off depreciation of the purchase price of your horse(s).
If you are in a Partnership (not to be confused with a Corporation), the arrangement is considered, for tax purposes, a “pass-through” entity. Therefore, in this instance also, the “partnership” need file no separate income tax return, but all partners must report details of income and loss in their personal tax returns via a “Form K-1.” It is advisable to choose one partner who will be responsible for maintaining exact and detailed books on behalf of the partnership and for issuing the annual Form K-1 or you can collectively pay an accountant to do so. Also, periodic (ideally monthly) accountings of the partnership’s financial affairs should be issued, and there should be a time limit (ideally 30 days) set on “disputes or queries” from partners after the date of each accounting. Note: a Limited Partnership is taxed in the same manner as a General Partnership. In both cases, each partner’s tax liability is based on percentage of participation.
If you (or you and your associates) decide to form a corporation to handle the stable ownership, tax accounting becomes more complex. A corporation is created by state law and is a recognized legal entity separate and distinct from its owners, or “shareholders.” A corporation operates under very specific statutes – including the filing of a corporate tax return – and corporate tax rates, both at the state and federal level, will differ (usually disadvantageously) from your personal income tax rates. The only real upside of a corporation is that “shareholders” are liable for the acts of the corporation and its agents only to the extent of their investment. The downside is that if “after tax profits” are distributed to shareholders, these become “dividend income” and will therefore be taxed as personal income.
Technically, in order to qualify as a business and not a “hobby,” for I.R.S. purposes, your thoroughbred business should make a profit in two years out of any seven.
If, year after year on your tax return, you declare losses – that is, you write off expenses in excess of your gross income as a racehorse owner – the I.R.S. is liable to decide that your “business” is NOT a business, but a “hobby,” and disallow all deductions. (In fact, in a given year, you might opt to sell a perfectly good horse just in order to achieve that second profit-making year out of seven. Though emotionally costly, this might end up being a financially sensible move.)
Notwithstanding the fact that the horseracing industry is legitimate (it is in fact the tenth largest industry in California), and despite the fact that other highly risky businesses – such as mining, filmmaking, oil and gas development and securities trading – are just as likely to lose money, racehorse ownership is one of the businesses most likely to be down-graded to a “hobby” by the I.R.S.
Fortunately, Congress has created a “safe harbor” provision which includes racehorse owners. The provision states that any business set up for the “breeding, training, showing or racing of horses” which shows a net taxable income in two out of seven years cannot be presumed to be a hobby, but must be considered “engaged in for profit.” In this case, therefore, current losses may be deducted. The very real problem is that owners, even when trying by every means they can, may not be able to show a net income in one, let alone two, out of seven years, especially if the years in question are their first seven years. This makes maintaining your I.R.S. status as a business more difficult – but certainly not impossible. In simple terms, there will be a heavy burden of proof on you to show that your actions and expenditures are founded in a “good faith” profit motive.
There are nine factors the I.R.S. must consider in determining whether an activity is a hobby or a legitimate business. These are:
Your best “answer” to this daunting checklist is to keep records assiduously. Keep a “business diary,” noting every time you talk to your trainer, your veterinarian or your accountant on horse-related business. Make sure you subscribe to periodicals about the horse-racing business. Keep an accounting of miles traveled to and from the track and record your visits. Keep all receipts for box seats, Daily Racing Forms, programs and gratuities. In other words, keep a record of proof that you are engaging in thoroughbred ownership seriously, hopefully, and as a profit-making venture.
A final note: Taxation, in the horse industry, is a specialty within itself. At the very least you should closely consult with your accountant or financial advisor before forming your business… and your advisor, in turn, may do well to consult with a specialist in accounting for the thoroughbred industry.
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