Generally tax court decisions involving horse farm activities delve into the question of whether the activity was for-profit or a hobby.
In T.C. Memo. 2014-65 (Tolin), the IRS took a different route, arguing that the taxpayer’s horse business was a passive activity. Under the passive activity rules (section 469 of the Internal Revenue Code), the taxpayer’s losses from the horse business would be disallowed for the years at issue (2002, 2003, and 2004), unless the taxpayer’s activities rose to the level of “material participation.”
Income tax regulation 1.469-5T(a) lays out seven statutory tests for material participation. Do you know what they are?
The regulations also say that generally any work done by an individual in connection with an activity in which she owns an interest at the time the work is done is treated as “participation” of the individual in the activity. However, work done by the individual in her capacity as an investor in the activity, such as studying and reviewing financial statements, is not treated as participation unless the individual is involved in the day-to-day management or operations of the activity.
Finally, the regulations state that the extent of an individual’s participation in an activity may be established by any reasonable means, and contemporaneous daily time reports or logs are not required.
In this case, the taxpayer, an attorney who lived in Minnesota, owned a Thoroughbred stallion that he entered in races. After the horse was injured, the taxpayer retired the stallion to stud at a farm in Louisiana and used the stallion to breed mares the taxpayer owned as well as other mares.
In his effort to promote the stallion’s stud services, the taxpayer telephoned the farm in Louisiana frequently, sometimes on a daily basis, and also made multiple in-person visits to the farm (14 three-to-five day visits during the years at issue). In addition to the phone calls and visits, he prepared and distributed promotional materials, reviewed and paid bills, kept up with bookkeeping, and attended seminars.
The taxpayer says he satisfied the material participation requirement of working 500 hours a year in the business. He presented the court with a narrative summary to support his participation. He also presented telephone bills showing the number and length of his phone conversations with the breeding farm owners and others related to the business, as well as credit card records.
The IRS disputes the time taxpayer claims he spent performing the activities described in his narrative summary, arguing that his estimates are unreliable because the summary was prepared solely for purposes of litigation and is based in large part on the taxpayer’s “unreliable memory.” The IRS also says a substantial amount of the taxpayer’s work was undertaken in his capacity as an investor in the thoroughbred activity and does not qualify as participation.
Why do you think the court made that decision?
Only one test needs to be met to prove material participation.
1.____ Does the taxpayer and/or spouse work more than 500 hours a year in the business?
2.____ Does the taxpayer do most of the work? Even if the taxpayer does not meet the 500 hour test, but her participation is the only activity in the business, she materially participates. Example: sole proprietor with no employees.
3.____ Does the taxpayer work more than l00 hours and no one (including non-owners or employees) works more hours? Example: If the owner puts in l75 hours a year and an employee works 190 hours a year, the taxpayer would not meet material participation test.
4.____ Does the taxpayer have several passive activities in which she participates between 100-500 hours each, and the total time is more than 500 hours? The following activities should not be included in the above test: rental activities; activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.
5.____ Did the taxpayer materially participate in the activity for any five out of ten preceding years (need not be consecutive)? Example: the taxpayer who retired and her children now run the business, but she stills owns part of the partnership.
6.____ Did the taxpayer materially participate in a personal service activity for any three prior years (need not be consecutive)? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
7.____ Do the facts and circumstances indicate the taxpayer is materially participating? Test does not apply unless the taxpayer worked more than 100 hours a year. Furthermore, it does not apply if any person, other than the taxpayer, received compensation for managing the activity; or, if any person spent more hours than the taxpayer managing the activity.
On the basis of that evidence we are satisfied the taxpayer performed more than 500 hours of qualifying “work done” in connection with the thoroughbred activity in each of 2002, 2003, and 2004; accordingly, he is treated as materially participating in the activity for each of those years.
Because he materially participated, the thoroughbred activity was not a passive activity and section 469 does not prohibit petitioner’s deduction of the loss therefrom for any of the years at issue.