Could a couple deduct losses from a horse farm that trained and sold horses for fox hunting despite losses and no separate bank account?

Subject

Taxpayers conduct the horse farm for purpose of making a profit.

Plain-English summary

A couple could deduct their 2005 and 2006 horse-farm losses because Virginia found that they operated the farm to make a profit. The farm trained retired racehorses and young unbroken horses for fox hunting and advertised through specialized magazines, the Internet, and horse shows.

The wife had substantial horse-training and fox-hunting experience. Together, the taxpayers spent about 139 hours per month on the farm in 2005 and 152 hours per month in 2006. Although the farm had no separate checking account, its books adequately identified income and expenses.

A serious 2003 injury to the wife forced major operating changes. The couple transferred a horse for outside training, hired assistance, sold some horses before training was complete, retired others because of injury or age, and did not deduct care expenses for the retired horses. Those responses, together with cost reductions and a refocused business model, supported businesslike operation.

Virginia concluded that startup losses did not outweigh the profit-motive evidence. It abated the 2005 assessment, restored the Schedule C deductions on the 2006 return, and ordered refunds with applicable interest for both years. Later federal changes to the Schedule C would still have to be reported to Virginia.

What this means for you

• Losses in startup years are only one factor in the profit-motive analysis.
• Relevant expertise, substantial work time, advertising, records, and operational changes support business status.
• A separate bank account helps, but its absence was not decisive where the books still identified farm income and expenses.
• Excluding personal or retired-horse costs from business deductions supported the taxpayers' position.

Common questions

How much time did the taxpayers spend on the farm?

Approximately 139 hours per month in 2005 and 152 hours per month in 2006.

Did the lack of a separate checking account defeat the deductions?

No. The Department found the books and records sufficient to determine farm income and expenses.

What relief did the ruling grant?

The 2005 assessment was abated, the 2006 business deductions were allowed, and refunds with applicable interest were ordered for both years.

Citations and references

• Va. Code §§ 58.1-219, 58.1-301, 58.1-311, 58.1-312(A)(3), and 58.1-322.
• I.R.C. § 183.
• Treas. Reg. § 1.183-2(b).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-207

Original ruling text

September 7, 2010

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessments issued to your clients, * (the "Taxpayers") for the taxable years ended December 31, 2005 and 2006. I apologize for the delay in responding to your letter.

FACTS

During the taxable years at issue, the Taxpayers, a husband and wife, operated a horse farm. The horse farm incurred losses, which were reported on a federal Schedule C. The resulting losses offset the Taxpayers' salary and investment income, as well as any income generated by the properties themselves.

Under audit, the Department concluded that the Taxpayers did not meet some of the factors used to determine if an activity is conducted with a profit motive. As a result, the auditor disallowed the deductions claimed on the Schedule C. The Department issued an assessment for additional tax and interest for the 2005 taxable year and reduced the Taxpayers' refund claimed on their 2006 income tax return.

The Taxpayers paid the 2005 assessment, but have filed refund claims for the 2005 and 2006 taxable years, contending the horse farm was active during the taxable years at issue and they were entitled to deduct the expenses incurred from the horse farm operations.

DETERMINATION

Business Deductions

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident its subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the Internal Revenue Code (IRC). See Va. Code § 58.1-219.

Under IRC § 183, deductions can be disallowed for activities not engaged in for profit to the extent that the expenses exceed income generated by the activities. The determination whether an activity is engaged in for profit is determined by taking into account all of the facts and circumstances of each case. Taxpayers must have the objective of making a profit.

Treas. Reg. § 1-183-2(b) identifies nine factors that should be taken into account when determining whether an activity has a profit motive: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.

The regulation makes it clear that all facts and circumstances must be considered in determining if an activity is engaged in for profit. The regulation further states that no one factor is determinative and that consideration is not necessarily limited to these nine factors.

The horse farm began operations in 2001 for the purpose of training horses to participate in fox hunting. The wife was the principal operator of the horse farm. She trained the horses and was the sales agent.

The Taxpayers assert that they were in the process of starting up and expanding their horse farm as a trade or business from its inception. The Taxpayers began purchasing retired race horses and young unbroken horses for training for foxhunting and advertised the horse farm in specialized magazines, on the Internet, and at horse shows.

Under Treas. Reg. § 1-183-2(b)(6), a series of net losses during the initial or start-up years of an activity would not necessarily be an indication that the activity is not engaged in for profit. Thus, the fact that the Taxpayers incurred losses for the taxable years at issue is not strong evidence in this case that the activities were not conducted for profit.

An examination of the evidence shows that the wife had substantial experience with horses, including training and fox hunting. In addition, the Taxpayers spent approximately 139 hours per month in 2005 and 152 hours per month in 2006 engaged in activities in support of the horse farm. The facts indicate that the Taxpayers had the expertise to conduct such a business and spent significant time and effort in carrying on the activity.

Due to significant injuries sustained by the wife in 2003, however, the horse farm was unable to proceed as initially planned, and had to make substantial changes while she was in recovery. The Taxpayers also had to refocus the operation of the horse farm based on the wife's abilities after recovery. The adjustments included transferring one of the horses to another farm for training, and hiring a trainer to assist the wife with care for the horses.

In addition, the Taxpayers took steps to reduce the horse farm's costs of operation and refocus on its core operation. Several horses were sold prior to completion of their training or were retired due to injuries or age. Expenses related to the care of the retried horses were not deducted on the Schedule C.

Although the Taxpayers did not maintain a separate checking account for the horse farm, the books and records were sufficient to determine the income and expenses associated with operation of the horse farm. Coupled with operational decisions made in order to accommodate the wife and changes in the business model, the horse farm appears to have been run in a business-like manner for the taxable years at issue.

After weighing all the facts and circumstances in this case, I find that the preponderance of the evidence supports a finding that the Taxpayers did conduct the horse farm for purpose of making a profit. Therefore, they are entitled to claim the full deductions generated by the activities related to the horse farm for the 2005 and 2006 taxable years. As such, the assessment for the 2005 taxable year will be abated, and the Taxpayers' 2006 return will be adjusted to permit the business deductions reported on the federal Schedule C. Refunds, including applicable interest, for both taxable years will be issued.

While the Department has ruled that the horse farm appears to have been conducted for the purpose of making a profit, Va. Code § 58.1-311 would require the Taxpayers to report a change or correction in federal taxable income, including Schedule C, within one year of the final determination of such change or correction by filing an amended return with the Department. If a taxpayer fails to file an amended return, Va. Code § 58.1-312 A 3 permits the Department to assess the appropriate tax at any time.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Linda D. Foster

Deputy Tax Commissioner

AR/1-2107770960.E