Did years of losses show that a Virginia couple's horse-breeding and hippotherapy operation was not conducted for profit?

Subject

For profit operations to market and sell horses, and improve business operations

Plain-English summary

Virginia found that a couple's horse-farm and hippotherapy operation was conducted for profit despite reporting losses during 2002 through 2006. An auditor had disallowed Schedule C and Schedule F deductions after concluding that the single-member LLC was not operated for profit.

The Department applied I.R.C. § 183 and the nine-factor federal profit-motive test. Startup losses alone were not strong evidence of a hobby. The wife had grown up around horses, trained with a professional trainer and breeder, had relevant speech-pathology and hippotherapy experience, and worked full time in the business during most of 2004. The business also used horse-farm and hippotherapy consultants.

The couple kept business records and generated significant annual sales after the early years, though almost all revenue came from services provided to the husband's rehabilitation-services corporation. The operation did not sell horses after its first two years and remained unprofitable, but it changed practices after a valuable horse died, other horses were injured, and breeding costs exceeded expectations. Expenses and net losses fell substantially from 2004 through 2006.

Considering all circumstances, the Department found a profit objective and directed that the assessments be adjusted. If the IRS later changed federal adjusted gross income or the reported business schedules, the taxpayers still had to report that federal change to Virginia.

What this means for you

• Repeated losses do not automatically turn a startup business into a hobby.
• Expertise, time devoted, outside advice, business records, sales efforts, and responses to losses all matter.
• No single federal profit-motive factor controls the result.
• Virginia may revisit the state return if the IRS later changes the federal business deductions.

Common questions

Did the business make a profit during the years at issue?

No. It reported net losses, but the Department found those losses consistent with startup and expansion circumstances.

What evidence most supported a profit motive?

The wife's relevant expertise and full-time effort, consultants, records, sales activity, operational changes, and declining expenses and losses.

Were the assessments completely erased?

The ruling says they would be adjusted in accordance with the profit-motive determination; it does not state a final dollar amount.

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. 10-209

Original ruling text

September 9, 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, 2002 through 2006. I apologize for the delay in responding to your letter.

FACTS

The Taxpayers, a husband and wife, operated several businesses in Virginia during the taxable years at issue. The husband was the sole shareholder of the * (VSC), an S corporation engaged in the business of providing medical rehabilitative services. The wife was the sole member of *** (VALLC), a single member limited liability company that operated a horse farm and hippotherapy business.

The Taxpayers filed individual income tax returns for the 2002 through 2006 taxable years only after they were contacted by the Department. Under review, the Department's auditor concluded that VALLC was not operated for profit and disallowed the deductions related to VALLC claimed on the Taxpayers' Schedule C for the 2002, 2004, 2005 and 2006 taxable years, and Schedule F for the 2003 taxable year. As a result, assessments were issued for all the taxable years at issue. The Taxpayers appeal the assessments, contending they intended to make a profit from the operations of VALLC, they aggressively attempted to market and sell horses, and they sought to improve business operations.

DETERMINATION

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 is 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 consideration is not necessarily limited to these nine factors.

VSC and VALLC were formed in April 2002. VSC intended to send patients needing hippotherapy treatment to VALLC. Because of the impact of potential insurance reimbursement issues and medical "safe harbor rules" on profitability, VALLC explored other potential revenue streams. To that end, in addition to providing hippotherapy services, VALLC began horse breeding, training and sales. At issue is whether the operations of VALLC were sufficient to show that the Taxpayers intended to make a profit.

During the taxable years at issue, the Taxpayers state they were in the process of starting up and significantly expanding VALLC. VALLC was not profitable during this time. Under the federal regulation, 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 significant losses for the taxable years at issue is not strong evidence in this case that the horse-related activities were not conducted for profit.

An examination of the evidence shows that the wife grew up around horses. She worked for, and obtained training from, a professional horse trainer and breeder. She was trained as a speech pathologist, worked with sensory integration, and received training in hippotherapy. She was also experienced in the treatment of traumatic brain injuries. The wife worked full-time at VALLC during most of 2004. These facts indicate that the wife had expertise to conduct a business and spent significant time and effort in carrying on the activities of VALLC.

VALLC also utilized the services of consultants in the fields of horse farms and hippotherapy in order to increase the potential for success in the business.

The Taxpayers maintained records of VALLC's activities. These records reflect significant annual sales after the first several years, but net annual losses. Almost all of the revenues generated by VALLC resulted from services provided to VSC. VALLC did not sell any horses after the first two years of operation.

The Taxpayers cite unanticipated events that impacted the business, including the death of their most valuable horse, injuries to other horses, and unexpected breeding expenses. VALLC responded to these events by changing the business practices in order to control expenses in an effort to become profitable. The records reveal that VALLC's expenses and its net losses decreased substantially between 2004 and 2006.

After weighing all the facts and circumstances in this case, it is my determination that the preponderance of the evidence supports a finding that the Taxpayers did conduct VALLC for profit for the taxable years at issue. Accordingly, the assessments for the 2002 through 2006 taxable years will be adjusted in accordance with this determination.

In addition, it is my understanding that the Taxpayers timely filed amended individual income tax returns for the 2003, 2004, and 2006 taxable years. These returns will be processed in due course.

While the Department concedes that VALLC was operated for profit during the taxable years at issue, if the Taxpayers' federal adjusted gross income (FAGI) is changed by the Internal Revenue Service, including changes to Schedules C and F, Va. Code § 58.1-311 requires any individual to report a change or correction in federal taxable income within one year of the final determination of such change or correction by filing an amended return with the Department. If an individual 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, along with other reference documents, are available on-line in the Tax Policy Library section of the Department's website, located at www.tax.virginia.gov. If you have any questions about this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Acting Tax Commissioner

AR/1-2696005637.E