With tax season in full gear, a worry heard this time of year, especially with the poor economy, is am I at risk for an audit? While the best defense is to be profitable, factors beyond your control may have come into play. So how should you proceed?
To avoid the hobby loss rules, the circumstances should indicate that the business owner entered into or continued the activity with the honest objective of making a profit. So how do you demonstrate that?
Below is a self-checklist to see where you stand. These are factors that should be considered to establish the existence of a profit motive. The IRS leans heavily on these factors to determine a profit motive. “Yes” answers tend to indicate the existence of a profit motive. “No” answers mean there is some work to be done (subsequent blog posts will detail out and provide examples of the nine factors).
1. Manner in which the activity is conducted:
a. Is there a legitimate profit or gain motive?
b. Are complete and accurate books and records maintained?
2. Taxpayer’s or adviser’s expertise:
a. Does taxpayer have prior expertise in the business?
b. Does taxpayer seek advice from qualified advisers?
c. If adviser’s advice is not followed, are reasons documented?
3. Time and effort:
a. Does taxpayer devote substantial time to activity?
b. Are others employed to carry on the activity?
4. Is there a reasonable expectation of asset appreciation (in lieu of operating profits)? Actual appreciation is not necessary; only an honest expectation of appreciation.
5. Has the taxpayer previously turned a similar unsuccessful business into a profitable one?
6. Has the activity previously generated significant profits?
7. Are profits substantial in relation to any losses and the taxpayer’s investment?
8. Is the activity a meaningful part of the taxpayer’s overall source of income?
9. Do profit motives outweigh any elements of personal pleasure or recreation associated with the activity?
Ideally most of the above items should have “yes” answers. For horse businesses, a written business plan is critical to document this intention to be profitable. While I am sure you have heard that refrain many times, we work with you to achieve the IRS objectives but, more importantly, help you design a plan so that you profitable.