Converting from Sch C to Hobby Activity

[rsandy]

Since 2002 my client has reported his thoroughbred horse breeding and racing activity on a Schedule C.
Only in 2006 was he able to report a modest profit from that activity. The Losses have been substantial, in 2007 over $ 100,000.00. Each year we have discussed his situation relevant to reclassifying his activity as a hobby. In my opinion he has been making a sincere effort to establish his business on a profitable basis, but for those that know the throughbred horse business, profits don't come easy. Because of injuries to 3 of his horses this year, it looks like 2008 will produce another serious loss. He is ready to accept a hobby classification for 2008 going forward, but neither one of us wants to raise a red flag to the IRS. Suggestions...comments? Thanks very much.

[DaveO]

This is a tricky subject.

I have several clients with a "C" that have several years of losses of a few thousand $ per year. I usually try to turn down the expenses first. Get rid of the cell phone, computer and mileage if a good log isn't present. If a small profit is left, fine. Otherwise in the case of someone doing direct sales I put the income after COGS on line 21.

The problem with hobby rules is that most IRS employees either don't understand the rules or don't apply the rules correctly. COGS is an allowable deduction to sales when entering a hobby on line 21. The blance of expenses go on "A" subject to 2%. When I've had an auditor reclass one of these businesses to a hobby I have had to fight all the way to appeals to get the COGS deduction.

It seems that the IRS position is that if there is a loss it's a hobby, if there is a profit then it's a business. I had an audit ast week with for a college professor. We had reported $1000 in honorarium income. The auditor suggest that should be self employment income.
I said my client is a professor, he is not in the trade or business of collecting honorarium. How can the act of giving a couple of speeches be construed as a regular and continous activity? Now, for someone like Bill Clinton, Al Gore or Newt Gingrich there is no doubt they are in the business of giving speeches for pay.

Your case is tough. What expenses of throughbred breeding are COGS? Breeding stock must be depreciated. Most other expenses would belong on "A". Perhaps stud fees or semen might be COGS.

[rsandy]

Dave: Cost of Goods is non existent. Training Expense represents the client's biggest cost and we've always treated it as a regluar Operating Expense. My biggest concern is a potential "flag" being raised when we change the manner in which we have been treating the client's activity. I wonder if there any presidents that cover shuch a change? Thanks for your comments.

[DaveO]

RSandy, I would worry more about the "flag" raised over a $100k loss. I don't have anything to back that up with except that the IRS seems to be taking aim at money losing "C" schedules. The professor I mentioned before has been audited 3 years in a row over a money losing "C" which I will convert into a hobby this year. I will be relieved to have it off the return.

[JON]

Hobby

Training is capitalized as inventory or horse costs and depreciated. If your looking for winnings from competetion to make money-good luck, but capitalize cost until selling or winnings start. If they are pets they are hobbies.

[solomon]

Since 2002 my client has reported his thoroughbred horse breeding and racing activity on a Schedule C.
Only in 2006 was he able to report a modest profit from that activity. The Losses have been substantial, in 2007 over $ 100,000.00. Each year we have discussed his situation relevant to reclassifying his activity as a hobby. In my opinion he has been making a sincere effort to establish his business on a profitable basis, but for those that know the throughbred horse business, profits don't come easy. Because of injuries to 3 of his horses this year, it looks like 2008 will produce another serious loss. He is ready to accept a hobby classification for 2008 going forward, but neither one of us wants to raise a red flag to the IRS. Suggestions...comments? Thanks very much.

Perhaps may be of interest to you.

See Keating and Shearer in TC Memo 2007-39.

[rsandy]

Thanks for the suggestion; however, I have know idea how to get to source you suggest I review. I would certainly appreciate alittle more direction.

[rsandy]

Appreciate your comments. I believe you are referring to UNICAP rules when suggesting training expense could be capitalized and depreciated or treated as inventory. My understanding is that there is an exception to those rules for businesses producing under $10,000,000 in revenue. I hope so or we may have an issue regarding prior year returns.

[solomon]

Thanks for the suggestion; however, I have know idea how to get to source you suggest I review. I would certainly appreciate alittle more direction.

Here is a link - don't know if it is of any use other than it is a case similar to yours..

http://www.ustaxcourt.gov/InOpHistoric/Keating.TCM.WPD.pdf

[rsandy]

Thanks for the link info. It was helpful.

[cpadan]

You might find the case of Whitecavage interesting, in which an IRS Auditor gets audited!

http://www.ustaxcourt.gov/InOpHistoric/Whitecavage.TCM.WPD.pdf