For decades Congress has recognized that the potential exists for a taxpayer to claim federal income tax losses for activities as to which the taxpayer has no genuine intention of creating a profit. In such situations, Congress has prohibited claiming such losses. Within the industry, these have become known as the "hobby loss" provisions.
     If the government is successful in a hobby loss challenge, virtually of the owner's horse activity deductions, sometimes for many consecutive years, may be completely lost. That contrasts with the newer "passive loss" rules, under which the owners who do not "materially participate" in their horse activity are still allowed to utilize their losses to offset their current future taxable income from other "passive" activities to offset future taxable income from the horse activity, or to offset all types of taxable income from the discontinuance of the horse activity. Thus a hobby loss determination can be far more detrimental to the owner than a passive loss challenge.
    Activities involving horses have always been a primary subject of hobby loss challenges and resulting court decisions. The determination to be made is simple enough: whether the horse owner's activity was "engaged in for profit." The burden of proof is, by statute, on the owner. The owner will carry this burden successfully only by presenting objective facts as opposed to self-serving statements as to his or her subjective intent.
     Any Thoroughbred owner with five to 10 years of consecutive losses (slightly longer if a breeding operation is involved) is at risk of a government challenge, both federal and state. A number of recent IRS successes in the United States Tax Court indicate that the best way to avoid a hobby loss challenge is through preventive planning. Indeed, horse owners have lost 15 of the last 19 published hobby loss decisions dealing with horses (since 1992).
     A reading of these adverse decisions leads on the the conclusion that an ounce of prevention would have been worth much more than a pound of cure. There are several basic planning steps which are a "must" for the owner. Separate financial records and business books and records and a separate bank account are the most elementary requirements. Engagement of an accountant who has knowledge of the horse industry to help set up the financial record-keeping system will also be a positive factor in the eyes of the IRS, as well as maintaining business records on a horse-by-horse basis. This includes health, training, race, show, and breeding information.
    But these recent adverse cases indicate another factor that may carry the day for the owner--or lose it. That is the maintenance of a written business plan. Numerous decisions have emphasized the presence or absence of a business plan. The courts have never required that such a plan be in writing, but any owner who can present such a written plan to a government auditor will be far ahead of other targeted taxpayers.
     A written business plan need not be voluminous. A presentation of five to 10 pages could be adequate for most operations. If the first written plan comes after several years of operations, it should provide a brief history of the operation but, most important, tell where the operation is going and how it expects to get there. It should be updated regularly, with special emphasis on modification to the plan.
     The critical event is not whether the owner has experienced losses over many consecutive years but whether the owner attempts to modify the operation if it is unsuccessful. Maintenance of a written business plan which specifies those changes in the operation's direction is a valuable tool. A record of all such modifications should, of course, be maintained.
     Here are some other ideas on preventive planning:

     1. The owner should prepare an annual budget of expenses, whether or not it is included in the written business plan.
     2. The owner should maintain a log of the time and effort he or she has devoted to the horse activity.
     3. The owner should maintain records of all the hardships experienced in he operation and of all the advice obtained from industry experts, especially regarding financial matters and industry economic trends.
     4. The owner should engage in self-education, such as subscribing to and reading trade journals, attending seminars, and being active in trade organizations (and record the time spent).
     5. The best preventive planning technique is the creation of a cash basis profit year to break a long string of consecutive loss years (check with a tax advisor).

     The government appears to be attacking horse owners' profit intentions more frequently than ever before. Thoroughbred and Quarter Horse owners have the advantage of being able to demonstrate profit potential through both purse earnings and appreciation in value, unlike showhorse breeds. But even the Thoroughbred and Quarter Horse owners begin to be at risk after unbroken years of losses. 
     The best way to guard against government attack is to have good financial and business records, including receipts for all expenditures, along with a separate bank account, and--almost as important--that formal, written business plan. 
     The presence of such records and plans will go far toward making any owner immune to successful IRS challenges.