Taxpayer fails to show profit motive
Jerald worked full-time at Turbine Traders Ltd. as a marketing and sales representative. His main job was selling parts and services for helicopter engines. He earned $132,000 a year in wages.
Jerald has owned interests in and has raced horses for more than 20 years. He purchased his first race horse in 1987 when his nephew’s friends invited him to co-own a race horse with them. After successfully racing this horse, they purchased another horse for $100,000 where Jerald owned a 10% interest. That horse won a race in San Diego, and they sold the horse for $200,000.
In 2001, Jerald purchased a five-acre property in Ravensdale, WA for $650,000, where he lived with his roommate. The property included a barn with horse stalls, an arena, various outdoor shelters and nine pastures. Several improvements had been made to the property over the years, and in 2015 it had an appraised value of $919,228.
During the years at issue, Jerald used the Ravensdale property to board his horses when they were not racing. Additionally, his roommate paid $6,000 a year rent for using the property for his own business of training show horses, boarding the horses he trained and teaching horse-training clinics. Beginning in 2007, Jerald waived his roommate’s rent in exchange for a reduced rate on supplies and care for the horses Jerald owned.
There were three or four horses in which Jerald owned an interest that were actively racing at two racetracks. These horses were housed and trained at the racetracks for the season. Jerald spent time researching race horses on the Internet, including horses he used to own and horses he was interested in purchasing. On the weekends, he cleaned stalls and pastures, attended races at the racetracks, helped his roommate care for the horses and watched videos of the races during the evenings. Jerald engaged in these activities throughout the entire year.
After purchasing the Ravensdale ranch, Jerald adjusted his work schedule at Turbine Traders, Ltd. to spend more time on his horses. He loves horses and enjoys betting on the races. He watches all the races in which his horses participate, and reports his gambling winnings separately on his federal income tax return as gambling income.
Over the years, some of Jerald’s horses did win. Purses ranged between $8,000 and $25,000, though occasionally a purse would bring in $50,000. When a horse’s racing career was over, Jerald and the other co-owners would either give the horse away or sell it.
Despite some racing success, Jerald’s horse-racing activity resulted in a loss every year. His average loss from 2005-2014 was $62,422. He also reported gains and losses for selling his interests in the race horses and horse-racing equipment.
He kept the income and expenses for each horse in a manila folder with the horse’s name on the outside. Jerald never created a formal written business plan, annual budgets or profit and loss projections for his horse-racing activity. From 2005-2014, Jerald sold interests in 36 horses but realized a gain on only eight of those sales.
He had a personal bank account and a horse-racing bank account but paid expenses for the horse-racing activity out of both accounts. He used his wages from Turbine Traders Ltd. to fund his horse-racing activity. He also took money from his pension and IRA accounts during these years to fund this activity.
Jerald hired an accounting firm specializing in horse racing to prepare his federal income tax returns. They sent him a worksheet detailing expenses he may have paid in that year and asked him to fill out and return it so the accountant could prepare his return.
The IRS determined the horse racing activity was not-for-profit based on the following:
- Manner in which activity is conducted. Jerald maintained that he operated the horse-racing activity in a businesslike manner since he kept accurate books and records. The IRS argued that although he kept records he did not implement any methods for controlling losses, including efforts to reduce expenses and generate more income. This factor favors the IRS.
Taxpayer’s time and effort to carry on activity. The IRS contends that Jerald’s time and effort spent on his horse-racing activity was limited by his full-time employment. Although Jerald was employed full-time while conducting the horse-racing activity, he: (1) used the Internet to check horses’ past performances, research horses that were racing on upcoming weekends and research horses he was interested in purchasing; (2) altered his work schedule at Turbine Traders to accommodate his horse-racing activity; and (3) performed menial tasks, such as cleaning the barn stalls and picking up horse manure on the weekends. The IRS accepted these factors, which weighed in favor of a profit objective for Jerald.
- Taxpayer’s success in other activities. There was no evidence Jerald was involved in any other successful business enterprises as an owner or operator. This factor is neutral at best.
- History of income and losses for the activity. Jerald realized no profits in more than 20 years of engaging in his horse-racing activity. He argued that he suffered losses because he reinvested his gross receipts back into the horse-racing activity and used the money to improve the barns, arena and other horse-racing activity property. This did not justify or even explain the unbroken string of losses over 20 years. This factor favors the IRS. Amount of occasional profits for the activity. Jerald started to have success from one horse, Dare Me Devil, where in 2014 and 2015 he thought he might be profitable. This speculation of possible profitability does not outweigh the 20 years of losses. This factor favors the IRS.
Taxpayer’s financial status. Jerald did not earn substantial income from his horse-racing activity to pay basic living expenses. He took out retirement income of $48,000, $25,000 and $25,000 between 2010 and 2012. The racing activity generated tax savings by creating losses to offset this other income. This factor favors the IRS.
Expectation that assets may appreciate. Although the Ravensdale property has increased in value over the past years, there is no evidence in the record that the expectation of future appreciation of the Ravensdale property even begins to approach the amount of losses Jerald has reported since beginning his horse-racing activity. This factor is neutral. The expertise of the taxpayer and his advisors for this activity. Jerald presented no evidence that he conducted a basic investigation of the potential profitability of his horse-racing business. He did not show he consulted with any experts in the field on how to run a profitable horse racing business. He did not use his accounting records to cut expenses or increase income to become profitable. This factor favors the IRS.
After considering all these facts and circumstances, the IRS concluded that Jerald did not engage in his horse-racing activity during the years at issue with the predominant, primary or principal objective of making a profit independent of the tax savings. The IRS determined that his horse-racing activity was a not-for-profit activity, limiting the losses to the extent of income.
Tax Pro Monthly Issue 8 Vol. 39 August 2017
CONGRATULATIONS TO GARY SKOP!!!!
Gary was recently elected by his peers as Vice President of the Michigan Society of Enrolled Agents. He will serve a 2 year term among Americas Tax Experts. What an achievement! Gary has been in business for over 40 years, and has been an Enrolled Agent for over 24 years. He loves what he does, and is looking forward to serving the other EA’s in Michigan.
What is an Enrolled Agent??
An enrolled agent is a tax professional who has been authorized by the United States Department of the Treasury to represent taxpayers in audits, collections and appeals by the Internal RevenueService (IRS).EA’s are considered tax specialists. They have a vast knowledge of anything pertaining to income tax, inheritance tax, gift tax, estate, payroll, retirement, and non-profit taxation.
According to the National Association of Enrolled Agents, “enrolled” means that an individual is licensed to practice, and “agent” means authorized to serve as the proxy for a taxpayer.
Becoming an Enrolled Agent
To become an enrolled agent, a candidate must either successfully pass a comprehensive 2-day exam covering all tax codes or have worked at the IRS for five years, regularly interpreting tax regulations. A background check must also be performed. Then, there are continuing education requirements similar to those of CPAs. Unlike CPAs who study and practice in all areas of accounting, EAs specialize in taxes and IRS problems
All enrolled agents are mandated to comply by the provisions highlighted in the U.S. Department of Treasury Circular 230, which governs the actions of enrolled agents when interacting with the IRS.
Most people realize that they should put aside enough cash to protect themselves against an emergency or a sudden loss of income. If the unexpected happens and an adequate cash reserve is not readily available, you may be forced to sell investments or real estate for less than they might be worth at another time under less pressing circumstances.
That’s why it’s wise to plan your emergency cash needs carefully. Here’s how to go about it.
How Much Cash is Enough
Step 1: Estimate your living expenses. It’s fairly simple to estimate your annual living expenses, but be careful not to forget anything. Rent or mortgage payments, food, clothing, car maintenance, utilities, and monthly debt payments are seldom overlooked, but people tend to forget insurance premiums (car, life, medical, homeowner’s, etc.) and payments which are made quarterly or semi-annually.
To determine how long your cash reserves should last, a good rule-of-thumb is to set aside enough cash to pay your expenses for six months if your household has only one wage-earner. If your household has two wage-earners, a three month cash reserve is adequate in most cases.
Modify these time periods by considering how long it might take you to find new employment if you lost your present job, and how long it would take your disability insurance to take effect if you couldn’t work because of illness or injury.
When you calculate how much cash you’ll need, don’t count on certain kinds of income to provide that cash. For example, you might be tempted to include anticipated dividends from equity investments as part of your cash reserves. That’s a mistake because income from stocks is not guaranteed.
Step 2: Establish your inner comfort level. Everyone is different and you should consider whether you’ll really feel secure that your cash reserve is adequate. If you’re uncomfortable about only having enough money to meet expenses, then put aside a specific amount beyond and above those expenses.
Keep in mind that your needs will vary depending on your circumstances. For example:
- If there’s a new baby in your family, you should increase your emergency cash level.
- If you are young, single, and without debt, you may not need to maintain a high level of cash – particularly if you have skills that make you easily employable.
- If you are about to retire, chances are that you’ll feel insecure in what will be an entirely new way of life. A cash reserve that’s well above regular expenses may be called for, at least until you feel comfortable about living as a retiree.
- If you’ve started a new business, don’t count on it to produce immediate personal income. Instead, increase your emergency cash until you’re certain that the business will generate a steady income. In some cases, this can take a few years.
Put Your Cash in the Right Place
Security and liquidity are the major criteria for where to keep your cash reserves. Put your money where it will be readily available to you when you need it. The two most common choices are:
- A savings account. You’ll earn a low interest rate, but if you’re very conservative you’ll know your money is completely safe.
- A money market fund. Bank money market funds are federally insured, but other money market funds earn a higher interest rate and are usually quite safe. Look for funds that have check-writing or telephone withdrawal privileges.
Wherever you put your emergency cash, make sure it earns compound interest. It’s possible that you may never have to use your cash reserves and over a period of time, the power of compound interest can build a tidy nest egg for you.