IRS mounts a new attack on horse owners, following unfavorable capital-gains treatment and Justice assault on racing

by Don Clippinger

THE E-MAIL did not have an urgent tag on it, but it certainly could have. It was from an upstanding owner, and he had a problem--a big problem.

He was being audited by the Internal Revenue Service, which in itself is not big news. It happens to horse people all the time, simply because they are horse people. This owner had followed all the rules to assure that he was an active participant in his horse business, and he went into the audit with confidence.

Under the Tax Reform Act of 1986, which had a negative effect on the horse business, operators of horse businesses can deduct their losses from all forms of income if they are actively engaged in the business. Under the common interpretation of the legislation, active participation has come to mean 500 hours of involvement, or about ten hours a week.

The owner had fulfilled the requirement with ease, and he readily cooperated with the examiner. But he was floored--and outraged--when the tax man told him that his hours were not good enough. Case closed. Pay up.

This owner was more than willing to open his books to the world to show that he indeed participated actively in the horse business. Money was involved, to be sure, but so were issues of honesty and integrity. The owner was willing to lay bare his business to prove that he was playing by the rules.

A call to Stanley Gillman, C.P.A., who writes the "Tax Matters" column in this magazine, revealed an interesting pattern. Horse owners very well may be playing by the rules in devoting at least 500 hours to their horse businesses. The IRS--not the individual agent, but the IRS itself--was not playing by the rules as they had come to be understood.

As Gillman explained through his fictional alter ego, Steve Shades, C.P.A., in the November 11 issue, the IRS formerly looked at horse-related deductions progressively to determine if they indeed fit the definition of a business. First, the expenses had to be relevant to the horse business. That was the first test.

The second test was the hobby rule. You had to conduct the business with the intention of making a profit, with a business plan and strategy for profit, if not profit itself.

Third was material participation, also known as active participation. You had to materially participate in the business to deduct your horse-business losses against current income. If you did not pass the material-participation test, you were regarded as a passive investor and could deduct your losses only when the business was liquidated.

It seems that the third test of a business, the passive-loss issue, has moved to the top of the IRS list, and the presumption appears to be against the horse owner.

Admittedly, just sitting at a desk and poring over financial records from the horse business is not enough. This is the mark of an investor. But legitimate owners who play by the rules are now taking a whack from the IRS, in an assault on both their wallets and their integrity.

Undoubtedly, if repeated often enough, more than a few owners will decide that they do not need this kind of grief and walk away from the horse business. It is a tough enough enterprise as it is without the government mounting a concerted attack on the owners' horse activities.

It appears to be of no concern to a debt-ridden government that Thoroughbred ownership is a substantial part of the American horse industry, which the American Horse Council estimates at $39.2-billion, with employment of 459,600. Without much fear of sounding paranoid, it can be said that horse ownership is in danger of being taxed to decline if not death.

Horse people should not be too surprised by this latest assault on their activities. Notwithstanding America's enduring love affair with the horse--witness the concern for Barbaro--the federal government generally has taken the view that owning a horse is a luxury and a hobby, no matter how carefully the business is run.

The evidence is threefold. A horse owner has to hold a horse for two years to qualify for preferential capital-gains rates. People who buy and sell stocks need to hold the stock only a year to get the better rate.

Second, the Justice Department is mounting a sustained attack on the racing industry by contending, in effect, that all simulcasting is illegal because it violates the Wire Act of 1961. Of course, the Interstate Horseracing Act of 1978 was amended in 2000 to specifically cover full-card simulcasting, but that apparently does not impress the Justice lawyers, who opposed the '00 amendment and refused to surrender to the will of Congress.

Now comes an IRS effort to balance a budget on the backs of horse owners by challenging material participation from the get-go.

So, what can the taxpaying horse owner and their supporters do?

First, the horse owner must document in detail all hours spent on the horse business. It may be necessary to reconstruct a schedule in case of an audit, but a detailed diary from this day forward will go a long way toward repelling the IRS assault. The "Tax Matters" column and advice from tax professionals are good places to start when cataloging the types of hours that count toward active participation.

Second, support the American Horse Council and the National Thoroughbred Racing Association in their lobbying efforts. Both groups will have their hands full with a herd of newcomers to Congress in 2007, and most of them will need to know how important the horse industry is to America.

Third, if so inclined, you can offer to help to educate new members of Congress. With the exception of the capital-gains rule on horse ownership, the assaults on the sport are emanating from the executive branch, not the legislative. The new lawmakers need to know that the horse industry is filled with hard-working people who spend each day engaged in activities for the benefit of the horse.

Don Clippinger is editorial director of Thoroughbred Times.