Internal Revenue Service (IRS) agents are individual people with varied experience and seniority. Often, it is necessary to “educate” an auditor on an industry with which they are not familiar – such as the horse or livestock industry. If you are audited in connection with a horse, livestock or farming activity, the auditor will first want to determine whether the arithmetic matches – whether the amount of deductions claimed, for example, adds up properly. The auditor will usually want to see backup invoices and proof of payment of the various items.
Delving further into the substance of the audit, you might anticipate a variety of questions about your claim that the activity is operated for profit (despite perhaps a history of losses, or in the case of startups, little or no history at all).
So, what are some of the typical details that the auditor might want to explore?
- What was your startup year? What research did you do before deciding to enter this particular field? Who did you consult, and what advice was given? What specifically did you find out about making a profit in this field?
- Describe your operations, i.e., your breeding or racing program, how you select pedigrees, horse shows or races you have entered, and names and qualifications of professional trainers you employ. Do you have a written contract with each trainer?
- Do you have a written business plan? If not, what specifically is your business plan?
- What have you done to change your operations to cut down on costs, improve efficiency, or otherwise move towards making a profit?
- How much time do you you expend in the activity, and what sort of tasks do you perform? If you have a day-job, how are you able to put in that amount of time?
- If your activity is operated on your own farm or ranch property, describe the facilities. What is the fair market value? What improvements have you made? Did you or do you have an expectation that the property will appreciate in value as a result of your improvements and stewardship?
- How do you keep records? Is there a separate bank account? Do you keep separate files on each horse?
- What clinics or seminars have you have attended and what publications do you read to help enhance your knowledge of the industry?
- Describe your efforts to advertise and promote the animals. What actual horse sales have you achieved?
These are the types of things a thorough audit might involve. It is prudent to consider these questions and issues in mind in conducting your ongoing operations. Perhaps some of your record-keeping needs to be improved, for instance. Perhaps it would be prudent to have a written business plan, or written contracts with trainers. And so on.
Sometimes people are audited simply on a random basis; other times there are red flags that could trigger an audit – such as significant losses or large tax deductions. The best approach is to have a representative meet with the auditor (usually this involves several meetings), and narrow down the issues to the extent possible. Perhaps the auditor will find common ground in some issues, perhaps not. Either way, there is an appeal process that allows the appeal agent to take a fresh look, and often disputes can be settled at that level.
John Alan Cohan is an attorney representing people in federal and state tax disputes, IRS appeals, and Tax Court litigation, and is a long-standing author of a legal advice column published in numerous sporting magazines. In addition, he advises organizations on compliance with newly enacted laws and regulations. John is also author of the book, Turn Your Hobby Into A Business – The Right Way. Contact John at 310-278-0203, firstname.lastname@example.org or visit his website at johnalancohan.com.