As IRS targets horse owners, a written business plan is a necessity for proving a profit motive

At 5:30 a.m. on a Saturday, Steve Shades is at the wheel of his new Audi and questioning his sanity. The accountant is headed for the training center to watch one of his client Bob's horses work five-eighths of a mile. The drive is a half-hour from his Ocala home, and the workout takes about one minute.

He then remembers that business is business. "Bob and Penny send me a lot of business. I owe them," he thought as he accelerated down the highway. "I'll be in a better mood after a cup of coffee."

Bob and wife Penny own a small breeding farm in the Ocala area and race homebreds. Bob has only one outside training client, Dr. Bruce Longstreet. Bob, a retired Pan American World Airways pilot, is living his dream. Penny manages the farm and engages in some pinhooking on occasion. All characters are fictitious.

Penny has been trying to persuade Steve that buying an interest in a two-year-old will give him some hands-on knowledge of Thoroughbred ownership. It will enhance his knowledge about the business when handling the affairs of horse owners, she reminded him regularly.

She convinced him that watching their colt, Winderness, work five furlongs on this particular Saturday morning would get him excited about horse ownership.

"Winderness is the best horse we've ever bred, Steve," Bob began as they walked into the barn's tack room. "By the way, you remember Dr. Longstreet?"

"Sure. How are you, Doc?" Shades replied. "This must be an important horse if you're here."

"I think he's a good one, Steve," Longstreet said. "I've watched Winderness since he was a yearling and just recently convinced Bob to take me in as a partner. We would love to have you join us."

Shades, beginning to feel the pressure, responded: "Thanks for asking me. I'm quite flattered."

As they walked down to the training track, Longstreet mentioned an article he had read in a recent issue of the Kiplinger Tax Letter. "The article mentioned a couple things that have me concerned," Longstreet said. "It said that the IRS is hiring hundreds of new agents to focus on audits of folks making over $100,000 per year.

Focus on horses

"As a result, audits on high-income people will increase by 50,000 examinations each year for the next two years," Longstreet continued. "One of the main targets of these agents, according to the article, will be so-called hobby farming. The report specifically mentioned horses and the two-of-seven years rule for profits. It said the auditors are specifically to focus on examining business plans and efforts to control costs and show profits."

"I'm not surprised," Shades replied. "Tax Court judges have been focusing on business plans in more sophisticated ways in recent years. Controlling costs as part of a business plan is always a factor in proving a profit motive. Do you have a business plan, Doc?"

"Of course I do, Steve," Longstreet answered. "I plan to buy the most expensive yearlings I can afford until I win the Kentucky Derby (G1). After winning the Derby, I'll syndicate the colt for $20-million. And retire. Isn't that everyone's plan?"

"Doc, I hate to burst your bubble, but that sounds more like hopes and dreams than a plan," Shades said. "You could develop that into a mission statement, although you might want to set your sights a bit lower, commensurate with what you can afford to buy in the yearling marketplace. A business plan should have a few basic elements, such as:

• "The business that you are in, whether it is racing, breeding, pinhooking, or a combination of them;
• "A market analysis to determine the market segment in which you will be competing, which would include where you intend to race, the level of purses versus training costs, and other factors;
• "A market forecast of yearling prices, purses, and training costs;
• "A strategic plan for selling or donating horses that do not make it to the races, those that do race but not up to expectations, those you might want to keep for breeding, and a plan for sales. A sales plan should always be in place, which requires a market forecast to estimate the residual value of a horse;
• "A description of your team of experts;
• "A budget forecast for each horse you buy, including expected purses, training costs, and residual values. This should be updated and compared with actual results annually; and
• "If you are breeding, the cost of each foal, including a portion of the mare's cost, stud fee, and projected sale price based on the average of the sire's offspring.

"Steve, let me interrupt here," Longstreet said. "What you are talking about is way over my head. I would have to spend thousands of dollars on experts to develop the information you are talking about. I only have five or six horses at any one time. I can't justify these costs at my level of operation. How can I comply with the business plan requirement?"

"It's not that difficult to do, Doc," Shades said. "Stop by the office on Monday, and I'll show you examples of business plans."

"I'll be there at 1:30 p.m., Steve," Longstreet replied. "Here comes Winderness now. I love to watch this colt work."

Tax Court cases

Longstreet arrived promptly on Monday, but Shades had changed his approach to the topic. "Instead of specific plans, Doc, let me run through some recent court cases where the judges have mentioned business plans and show you how the taxpayers fared, okay?"

"Whatever you think is best, Steve."

"There was a Ms. McNaught," Shades began. "In 16 years, she never showed a profit in breeding and selling Appaloosas. She convinced the judge that she had an unwritten business plan and that she consistently modified it to accommodate the shifting market. The judge bought her story and allowed her losses. That was a very surprising result."

"There you go, Steve," said Longstreet. "You've shot your argument in your first example. I can make up a plan after the fact if I ever get examined. I don't need a plan."

Shades disagreed. "If you read the case, Doc, you will see that McNaught convinced the judge that she did have a plan. That is the important point.

"Stay with me, Doc. I just wanted to tease you with that one. Take the case of Mr. Pitts. He bred, raced, and trained Quarter Horses and Thoroughbreds. He did not have a business plan and did not prepare expense projections or budgets. He lost his case.

"Ms. Lundquist sought to make a profit by buying dressage prospects in Europe and breeding them to American mares. She asserted that notes written on the back of a letter from a former adviser constituted her business plan. The judge disagreed, stating that there is nothing to show how she intended to make a profit.

"Mr. Filios did not make a profit racing horses in 36 years, and during that time he lost more than $6-million. His accountant testified that he had detailed records of expenses on each horse and substantiated all costs. The judge thought that was interesting but noted that Mr. Filios had no budgets, profit projections, income statements, or balance sheets. Mr. Filios lost his case and also paid a 20% negligence penalty."

"Steve," Longstreet interrupted, "what's this about a penalty on top of the tax? I would hate to lose if I got examined, but to pay a penalty of 20% is pretty steep."

Negligence penalty

"I agree with you, Doc," Shades replied. "The negligence penalty is for not making a reasonable attempt to comply with the law. It is a subjective judgment on the part of the Tax Court, but it is always a risk in these types of cases. That is why a business plan is so important. Even if you lose your case, a business plan will convince a judge that you attempted to comply with the law.

"Let's move on. The McKeevers raised and sold Paso Finos. They never showed a profit from 1987 through '93. They did not have a business plan, did not keep records of costs attributable to each horse, and were unable to determine profits or losses on individual horses sold at sales. The judge commented that without those kinds of records the McKeevers would never be able to institute cost-saving measures or increase profitability. The judge's logic is pretty simple. Unless you know where you've been, it's hard to figure out where you should go to make things better.

"The judge in the case of Mr. Davis agreed that Davis had a profit motive and a business plan. Davis's Arabian breeding operation was in the start-up phase when it was examined and, even though Davis did not have a written plan, the judge felt that Davis's actions constituted a plan. The judge also noted that, once past the start-up phase, he might not look favorably on Davis's continuing losses without a written plan."

"I've heard enough, Steve," Longstreet said. "While I'm here, let's start putting together a business plan right away. I don't want to face the hassle of trying to persuade a judge or an IRS agent that my business plan was in my head."