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    Friday
    Apr182014

    Understanding tax treatment of casualty losses saves money at tax time

     

    By John Alan Cohan, Attorney at Law 

    Last fall a freak early snow storm killed thousands of livestock and horses in South Dakota.  Ranchers suffered a tremendous monetary loss of prized livestock and horses.  More recently in Kentucky, eight horses were killed in a fire, four of which were yearlings slated for the Keeneland September sale.  Three of the four were uninsured.

    The financial impact of casualties is significant in that it wipes out potential sales income, and sets back breeding, racing and showing efforts, not to mention the personal trauma of the tragedy.

    Under Federal tax law, if you are engaged in a horse or livestock activity as a trade or business, a casualty loss is important to account for.  Sometimes a major part of your breeding program can be interrupted by a casualty such as an aborted foal.  When the IRS asks for an explanation of why there were several years of losses, sometimes the casualty issue needs to be clarified in detail.  Sometimes if there are several casualties the IRS agent might get suspicious of insurance fraud, which requires further explanation.  If there is no insurance, the amount claimed in the casualty might be substantial, and will require proof.  In other cases, the IRS agent might need to be educated as to the economics of your venture and why the loss of an aborted foal, for example, can really throw a monkey wrench into your profit plans.

    Another kind of setback involves illness of owners, resulting in loss of time expended in the activity due to medical treatment and recuperation.  While this does not result in a casualty loss as does the death of an animal, nonetheless it impacts one’s ability to carry forward business plans, and needs to be explained to the IRS if there is a history of losses.

    Under the Tax Code, a casualty loss deduction is available when property is damaged, destroyed or lost due to a sudden, unexpected, or unusual event.  IRS Form 4684 (“Casualties and Thefts”) is submitted along with other tax forms.  A sudden event is one that is swift, not gradual, such as a sudden storm, a racehorse casualty, a fire, flood, highway accident, or other misfortune.

    A loss of horses or livestock in a casualty is allowed only if the animals are part of a horse or ranching business.  Livestock bought for resale are deductible, for example, but casualties affecting hobby horses are not.

    The amount of the casualty loss depends mainly on the cost basis of the animals in question.  To compute a loss, the IRS will look to your adjusted basis in the animals minus any insurance or other reimbursement you receive or expect to receive.  Generally, if a single casualty involves multiple animals, you must compute your loss separately for each animal, and then combine the losses to determine your total loss for tax purposes.

    If you receive insurance proceeds for the loss, but incurred legal expenses to collect that insurance, the legal costs are deducted from the amount of insurance reimbursement in calculating the amount to report.

    Losses of horses or livestock from disease are considered involuntary conversions.  This is the case if you need to sell more than the usual number of livestock because of drought.  The sale of animals above the normal volume is treated as an involuntary conversion.  Involuntary conversions are reported on Form 4797 along with sales and exchanges of horses or livestock.

    There are complications and grey areas in determining the scope of a casualty loss or involuntary conversion, and therefore you should seek the advice of your tax professional regarding the application of these rules to insure accurate reporting on your tax return.

    [John Alan Cohan is a lawyer who has served the horse, farming and ranching industries since l98l.  He can be reached at: (3l0) 278-0203, by e-mail atjohnalancohan@aol.com, or you can see more at his website:www.johnalancohan.com.]

    Thursday
    Mar062014

    Credibility a Key Factor in Taxpayer’s Testimony

    By John Alan Cohan, Attorney at Law

    In Timothy Kuberski v. Commissioner of the IRS [T.C. Memo 2002-200] the Tax Court ruled that a Phoenix, Arizona physician's horse breeding and racing activity was not engaged in for profit even though the taxpayer developed a business plan and kept business records.  The case appeared to hinge in part upon the judge's evaluation of the taxpayer's own testimony, which he found unpersuasive.  The judge said that the taxpayer, while he apparently had business plans, did not use these plans to improve the profitability of his activity.  The taxpayer testified that he made economic forecasts and otherwise conducted the activity in a businesslike manner, but the operation's 28-year loss history allowed the taxpayer to offset substantial income from his medical practice.  Also, the taxpayer did not show that he had relied upon experts in conducting the activity.  

    The taxpayer believed that he could breed a better-than-average thoroughbred horse because of his medical background and his understanding of physiology and statistical analysis.  He is a licensed trainer as well as a certified horse appraiser.  He had taken annual classes on taxes, business, shoeing horses, veterinary problems, animal husbandry, and sales preparation.  He had written several articles for the thoroughbred horse industry, including one explaining the dosage system, a horse breeding theory, and others on various equine medical problems. 

    The taxpayer claimed that he kept detailed and well thought out business plans, maintained business account records with yearly profit and loss statements, filed stallion reports and reports of all broodmares and registered all foals with the Jockey Club, used a bookkeeping service, used business stationery and a business checking account, made a yearly assessment of the market, culled nonproductive mares or poorly marketable horses, made an economic forecast of each horse's productivity, and tracked the annual cost of getting each mare and foal to the thoroughbred sales.  However, the judge said that the taxpayer's arguments “appear to have been copied from the tax guides for horse owners that [were] presented at trial and have little support from the evidence.”

    Also, the judge said the taxpayer’s testimony “was generally vague and focused on the nature of the Arizona thoroughbred industry, rather than on the manner in which he conducted the breeding and racing operations.  Petitioner alluded to one instance in which he consulted a nutritionist to eliminate a condition called epiphycytis.  Petitioner’s testimony was uncorroborated by witnesses or documents.”

       

    The judge said that even though there were adequate business records the taxpayer did not include analyses on why large losses recurred over a long period and whether any possibility of recouping them existed.  The cumulative loss of the taxpayer over the years was about $888,000.  In this case the years at issue were well beyond the startup period.

    The taxpayer claimed that his farmland appreciated in value over the years and must be considered when analyzing whether the requisite profit motive exists.  However, he failed to provide a formal appraisal of the value of the land.

    Finally, the judge said that the taxpayer's level of income permitted him to continue the horse activity without a profit.  If he had regarded the activity as a business, he would have focused more on the financial aspects and ways to cut losses.  The court said, “The magnitude of the activity’s losses in comparison with its revenues is an indication that the taxpayer did not have a profit motive.”

    The trend is that a continue series of losses beyond the startup phase will require substantial documentary and expert evidence in order to convince the IRS that the activity should be treated as a business rather than a hobby.

    [John Alan Cohan is a lawyer who has served the horse, farming and ranching industries since l98l.  He can be reached at: (3l0) 278-0203, by e-mail at johnalancohan@aol.com, or you can see more at his website: www.johnalancohan.com.]

    Thursday
    Feb272014

    Sorting wheat from chaff when seeking nutritional advice

    By Dr. Juliet Getty, Equine Nutritionist

    Experts, real and self-proclaimed, abound in every aspect of the horse world, including equine nutrition.  They tout impressive sounding titles or have a string of degrees following their names, yet one expert’s advice may conflict with another’s, making it difficult to judge whose advice is right for your horse.

    Degrees and certifications are generally earned from accredited colleges, universities, or schools of veterinary medicine; the American Registry of Professional Animal Scientists also offers a reputable certification in equine nutrition. So before taking advice at face value, examine the expert’s credentials.  Look at the school from which this person graduated and make certain it not only exists, but is accredited by a reputable accrediting agency. 

    An example of misleading “credentials” appeared recently in a prominent internet magazine. The author claimed to be a “certified holistic practitioner.” But the certifying institute is not found via a Google search. And the expertise the author offers is virtually self-taught through several years of experience using holistic equine therapies. Advice from someone with this type of credential, or lack thereof, is what you should ignore.

    Keep in mind that a person with an advanced degree, preferably a master’s degree or doctorate, has many years of training and research in the field.  A two-year program, or even a bachelor’s degree, is just not enough time to delve into all of the biochemistry, endocrinology, gastroenterology, and physiology required to become truly qualified to evaluate a horse’s nutritional status.

    Anyone can call himself a nutritionist. Anyone. Be sure that the person you are trusting with your horse’s nutritional care has a reputable degree earned by investing years of study specific to nutrition.

    Thursday
    Nov072013

    Tax Court Case considers how horse businesses are run in allowing loss deduction

    By John Alan Cohan, Attorney at Law

         In the Tax Court case, Richard H. Daley, T.C. Memo l996-259, an Arizona surgeon was denied deductions with respect to his cutting horse activity.  The Tax Court, which in recent years has become more and more hard-nosed, concluded that the activity was not conducted for profit within the relevant IRS Regulations. 

         A number of facts worked against Dr. Daley: (l) He entered the activity without the aid of a written market study; (2) the evidence suggested that his motive for entering the activity was recreational; (3) he never relied on a formal profit or business plan; (4) in managing the activity he used a ledger to record various transactions and events, and had a separate “drop” file for each horse--but failed to maintain them in a completely accurate manner;  (5) while he claimed to have devoted l0-l2 hours per week to the horse activity, he was unable to substantiate this to the Court’s satisfaction.

         The Court suggested there should have been “a formal market study prior to undertaking his horse activity.”  Under this Court’s criteria, very few horse owners would pass muster.  The opinion suggests that taxpayers in the horse industry are going to have to engage in a lot more of formalities  insofar as documenting how they started the activity. 

    If you have a significant amount of losses you have a good chance of eventually being audited; it is therefore very important to document your compliance with IRS Regulations pertaining to the hobby loss rule. 

    Dr. Daley was unable to show that the he consulted with  industry experts prior to entering the activity.  He testified that he had such consultations, but the judge found his testimony lacking in credibility.  There was no documentation to back him up. This case therefore amplifies the importance of establishing groundwork documentary evidence and preserving it. 

    It is important to maintain inventory records on each animal, including parentage, birth date, birth weight, and registration information.  There should be a chart of horses owned and sold, with details.  It is important to keep separate files on each horse.

    If you are audited, it is important to immediately obtain legal assistance.  Evidence of your businesslike purpose should be presented to the auditor in the most favorable light.  Your business plan should be set forth in a clear and concise manner. How you eventually expect to make a profit should be made clear.  If losses are due to unforeseen circumstances or setbacks, including disease or fluctuating market prices, you should maintain  documentary evidence to prove these facts.  The IRS also wants to see evidence that you keep abreast of industry practices and that you investigate the possibility of changing or abandoning current methods of operation in an effort to mitigate losses.

    In many cases, taxpayers have convinced the Tax Court that their horse activity is a business rather than a hobby despite over two decades of losses.  In those cases the taxpayers had good evidence showing the businesslike manner in which they operated their venture.  The horse owners who come through well in audits usually have a working knowledge about genetic principles and other elements of animal husbandry.  They usually strive to raise high quality animals, and have a plan on how to market them or otherwise make a profit. 

     

      [John Alan Cohan is a lawyer who has served the horse, livestock and farming industries since l98l.  He serves can be reached by telephone at (3l0) 278-0203 or via e-mail at JohnAlanCohan@aol.com.  His website is www.johnalancohan.com.]

    Thursday
    Sep122013

    Manual shows IRS views horse and cattle industries with suspicion By John Alan Cohan, Esq.

    The IRS Manual has a section in the Audit Technique Guide entitled “IRC Section 183: Farm Hobby Losses With Cattle Operations and Horse Activities.”  The guide is intended for to alert IRS auditors to situations pertaining to the horse and cattle industries. 

    The guide says that “Current trends indicate that these two activities, due to their nature, contain certain opportunities for taxpayer abuse.”  Auditors are advised:  “Many of the taxpayers who potentially fall under the provisions of IRC section 183 with respect to horse and cattle activities have been involved in such activities during their youth. These taxpayers have grown up on farms or had close relatives who operated farms.  Other taxpayers had unfulfilled childhood aspirations to be involved with such activities, but circumstances prevented participation.  As adults, these taxpayers have achieved the financial wherewithal which permits participation.”

    Other selected provisions in the guide are quoted below:

    “The taxpayers who have had prior experience in these activities find peace and solace in returning to this lifestyle.  These taxpayers have affection for the horses as well as the cattle.  The taxpayers find pleasure and satisfaction from watching their herds and baby animals grazing in the pastures.  Examiners will frequently find retirement homes nestled on the land set aside for the activity.”

     

    “Some taxpayers have found that agricultural status will reduce the property taxes on their land.  Small numbers of cattle have been maintained on large parcels of land in order to qualify for this agricultural status.  In such situations, the cattle activity was not engaged in for profit, but rather for the purpose of reducing property taxes.”

    “The examiner should be alert that some taxpayers may not maintain the contemporaneous records necessary to satisfy the requirements of the breed association.  Some of the data may be “plugged.”  Contemporaneous records would include some type of field book that is carried out to the pasture.  The data would be transferred from the field book to a permanent record.”

    “The taxpayer’s use of incomplete records could indicate a lack of profit motive.”

    “The taxpayer should have a formal written plan.  The plan should demonstrate the taxpayer’s financial and economic forecast for the activity.  The plan should not be a “fantasy Schedule F or C.”  In other words, some taxpayers may wish to submit a business plan that is nothing more than a Schedule F or C, which unrealistically overstates the expenses for the activity.  This is not an acceptable business plan.”

    “The examiner should not request the business plan in the first Information Document Request (IDR).  Otherwise, the examiner will possibly receive a ‘canned’ document.  The examiner should inquire as to the business plan during the Initial Interview and follow-up with a subsequent IDR.”

    “Some taxpayers will attempt to downplay any pleasurable aspects of the activity.  Some will attempt to portray the activity as laborious with emphasis placed on the drudgery.  These taxpayers know where the examination is leading.  They will emphasize the labor to clean or muck the stalls.  The examiner needs to understand that if these taxpayers care about their animals that any such task is a labor of love or concern for the wellbeing of the animal.”

    “The examiner should establish if the taxpayer has used any advisors or experts in the operation of the activity.  Obtain names, position titles, and addresses of these advisors.  Document how the advisors were chosen by the taxpayer.  Establish the credentials of the advisors.  Document if a personal relationship exists between the taxpayer and his advisors.”

    “Many taxpayers will express a passion for their activity.  A skilled examiner will be able to draw this passion from the taxpayer through conversation.”

     

    “The tax return may have minimal or zero gross receipts.  The activity’s history of gross receipts should be addressed.  The examiner needs to determine why there have been minimal or no gross receipts.  The examiner needs to determine specifically when the taxpayer expects for gross receipts to increase and specifically how the taxpayer expects to accomplish this.”

    “Determine that the income source truly relates to the activity contained in the Schedule.  Examiners should also determine that the income source truly exists as some taxpayers have manufactured income in order to make it appear as though the activity earned some income.  Manufactured income raises a potential fraud issue.”

    “Horse activities provide a competitive outlet for some taxpayers.  For example, some taxpayers have been quoted as saying that cutting horse competitions provide stress relief from the chaos in the corporate world.”

    “The thrill of competition draws participants into various shows and competitive events.  A sense of accomplishment attracts participants to compete in events where there may not be any monetary compensation for their efforts.  Great pride accompanies the receipt of large trophies and fancy rosette ribbons and award banners.”

    “The taxpayer knows about the nine relevant factors.  A taxpayer with a savvy representative has been advised to downplay the pleasurable aspects and emphasize the drudgery and dirty work of the activity.”

    “A significant amount of showing and showing-related expenses could be indicative of an activity not engaged in for profit if the prizes are minimal in financial remuneration.  The examiner needs to determine the specific purpose for which the taxpayer participates in show competitions.  The examiner needs to determine if the show winnings justify the showing expenses.”

     [John Alan Cohan is a lawyer who has served the horse, stock and farming industries since l98l.  He serves can be reached by telephone at (3l0) 278-0203 or via e-mail at JohnAlanCohan@aol.com.  His website is www.johnalancohan.com.]