By Herb Wittenberg, CPA & Bruce A. Wittenberg, CPA
These Tips Should Help You Win the Battle. Sometimes it just can’t be helped – the IRS notifies you that they’re going to audit your racing stable. Unfortunately, they’ve got their sights set on you, so you scramble to collect your records and put your books in order.
Want to feel more prepared in the event of such a scenario? Then take a few minutes to read the following hints. They’ll help to avoid having the IRS decide against you, and will put your stable’s books on firmer footing.
One of the more disagreeable events that can occur in your horse business is having to undergo an IRS audit. If you are unlucky enough to win the “audit lottery,” there are some problems that can be mitigated by planning ahead.
Note When You Acquired Your Horse for Depreciation Purposes
The IRS auditor will often ask for proof that you owned the horse that you’ve been depreciating and proof of its age at the time you acquired it. This is because two different “lives” are used to depreciate racehorses; a three-year and a seven-year cost recovery period. The three-year “life” is used if you acquired the horse as a two-year-old or older, while the seven-year “life” is used for horses acquired before they turned two, such as a yearling.
Remember, the IRS considers a two-year-old to be more than 730 days old – they do not use the universal racehorse birthday of January 1st for depreciation purposes.* Always retain a photocopy of your horse’s Jockey Club Certificate (its registration papers) even if you no longer own it. The papers show the horse’s date of birth, racing record, and the dates you had ownership of it. Retaining such documentation will prove to the IRS that you’ve been using the correct schedule to depreciate your horse. If you have disposed of the horse prior to the IRS audit and no longer have its registration papers, try to track down the horse’s current owner and obtain a photocopy of the certificate.
Consider Sales Tax Issues When Buying/Selling Horses Privately
When buying a horse from a private party, sales (or use) tax may be due. The sales tax is imposed on the seller if title to the horse passes in California. However, if you purchase a horse out-of-state and bring it into California within 90 days, California law imposes a use tax on the buyer. It’s exempt from the use tax if you bought the horse from an “occasional seller.” If the seller of the horse does not make two or more sales during a 365-day period, the sale qualifies as an “occasional sale” and no tax is due. If this is the case, you will want a letter from the seller indicating that he has not made more than two private sales in the last 12 months. Make sure to obtain a letter as part of the transaction, as your audit may be some 6-7 years down the road, and it is always difficult to obtain information at a later date. If you buy a horse overseas, instruct your bloodstock agent to obtain this letter from the seller.
Likewise, if you sell a horse privately and qualify as an occasional seller, no sales tax is due. However, if you don’t qualify as an occasional seller (you sell more than two horses a year), it’s up to you to collect the sales tax and remit it to the State Board of Equalization. Note that selling two or more horses to the same party on the same day is counted as one sale.
If you are selling a horse to someone out-of-state or country, sales tax does not apply to the transaction. Therefore, in order to prove that the horse was sold outside of California, keep a copy of the vanning bill (even if you didn’t pay it) in order to prove that the horse was shipped out-of-state or country by a common carrier.
When determining a sale, exclude sales through auctions or claiming races. Giving away a horse doesn’t count as a sale either. Just be sure that you don’t accept the $1 consideration that the new owner may want to give you. If you do, then the transaction will be considered a sale. While the sales tax on a $1 is insignificant, the extra sales transaction might disqualify you from being considered an occasional seller.
Keep Records to Prove Active Participation
The IRS sometimes questions whether you spend 500 hours or more a year overseeing your horse business. If you spend less than the required 500 hours per year, and if you have a net loss on your horse operations, the loss will be “suspended” as a “passive activity loss.” That means you can’t deduct your loss currently, but must accumulate your passive activity losses until such time as you can offset the losses with a “passive activity profit,” or cease being in the horse business. For example, assume you have accumulated $17,000 in suspended losses in prior years. You finally make a $10,000 profit. This $10,000 can be applied against the suspended losses, with the remaining $7,000 loss suspended to be written off against future years’ profits.
A better way to conduct your horse business is to keep a daily record of the time you and your spouse spend on your horse business so that you can prove to the IRS that you’re an active participant. This includes the time spent going to the track to watch workouts and races, time spent conferring with your trainer and/or bloodstock agent, trips to ranches, trips to racetracks when you are considering claiming a horse, time spent studying the Daily Racing Form, attending TOC seminars, and time spent paying your bills and keeping the books on your horse activity.
These time records should be kept contemporaneously to prove the 500-hour requirement, should you be audited. Keeping track of this time shouldn’t be time-consuming – the IRS will usually accept a simple log or journal.
How long should you keep these records? The State Board of Equalization can audit your records for the past 3 years if you have filed a sales tax return. If you haven’t filed a sales tax return, they can and do audit for the past 8 years. So, to be on the safe side, keep your racing stable’s records for at least the previous eight years.
While it isn’t fun to undergo an audit, following these hints should increase your chances of winning the dreaded IRS audit, and decrease your chances of being audited again. So get in the habit of keeping your stable’s books in good order so that you can minimize your headaches and maximize your fun in racing!
The father and son team of Herb & Bruce Wittenberg has offices located in West Covina, California. Their firm has been preparing tax returns for various racing stables since 1958.
* Note: Depreciation deductions on racehorses (or other personal property) is normally based on an assumption that any property placed into service during the year was in service for one-half of the tax year, regardless of when during the year the property was actually purchased and placed into service. However, different rules apply if 40% or more of all assets acquired during the year are acquired during the year’s fourth quarter.