Are More People Being Audited in the Startup Phase?
By John Alan Cohan, Attorney at Law

I have been asked to comment on what appears to be an upsurge in audits by the I.R.S. with respect to startup horse and farming activities. During the past few years there has been an unusually high number of taxpayers in the early startup phase of their activity being subjected to audits. Is this a
trend? Is there some reason for this? Is it simply a coincidence?

People who conduct horse businesses have always experienced audits at a higher rate than other categories of taxpayers. For some time, I.R.S. data has shown that horse owners were being audited at a greater rate than those making $l00,000 or more.

But in the past such audits pertained to horse owners who had sustained losses for a period of years rather than those who were just starting up. I do not have a ready answer as to why the I.R.S. appears to be auditing people in the early startup phase, but I do know that many of these people have succeeded in convincing the I.R.S. that their activity was conducted as a business, although a number of reported Tax Court cases, previously discussed in this column, spoke of situations where taxpayers have lost even in the early startup phase. (See, for example, Cramer v. IRS, 2000 RIA TC Memo ¶2000-229, or Hastings v. IRS, T.C. Memo 2002-3l0.)

The best strategy if you are selected for audit is to observe time-proven methods of aggressive defense and preparation of a convincing and professional offense. The principal issue is whether losses in the horse activity are deductible or whether they are "hobby losses" which are not deductible. It is important to hire a professional accountant to attend to the audit and to interface with the revenue agent. Many of the best accountants are former I.R.S. agents who have gone out into private practice. In larger cases, I have been asked to represent taxpayers together with or instead of an accountant.

The revenue agent will be initially concerned with verifying the accuracy of deductions that you have claimed. In order to avoid the inconvenience of scrambling around to get ledgers, bank statements, credit card receipts and so forth organized, you should be doing this on a day-to-day basis in the first place. In addition to verifying the expenditures, the revenue agent will want to see how these expenses relate to some sort of plan or strategy that you have developed. In that regard, once you start a horse activity it is imperative that you have a business plan and that you organize documents that show what
your plan is and how it is progressing. Ideally, you should be able to show through documents, letters, and other evidence what you did prior to starting the activity, that is, what sort of research and investigation you conducted before deciding to engage in the venture.

There should be no evidence of "commingling" of funds. One of the simplest ways of avoiding this is to have a separate bank account for the horse activity. There should be evidence that you obtained a business license from the local municipality, and that your farm is properly zoned for the activity.

At the audit your representative should provide only those documents specifically requested. Your representative should ascertain beforehand the specific issues involved in the audit.

One crucial area that is of concern to the I.R.S. is whether you have consulted experts or whether you yourself have become an expert. They will want to know the names of trainers whom you have employed and how you decided to hire them. Many of my clients obtain a tax opinion letter from me in which I analyze the activity, make recommendations on the business plan, and provide legal points and authorities in support of my conclusions. This is evidence that you have consulted an expert and that you have proceeded to implement any recommendations given.

Sometimes the agent will ask you to waive the statute of limitations, which I usually do not recommend, although in some instances it may be appropriate—-but that is something that depends on the circumstances. For instance, if your audit is a complex one that may take considerable time, the revenue agent may genuinely need additional time and, if all is proceeding fairly well, it may be appropriate to allow for an extension of the statute of limitations.

It appears to me that the apparent trend of the I.R.S. to audit activities in the early startup phase will continue in the foreseeable future because I continue to be contacted by taxpayers who are precisely in that situation.

The taxpayers who succeed at the audit phase are those who have had the best tax planning. Taxpayers who go to the trouble and expense of obtaining a formal tax opinion letter usually do very well because they are able to show more clearly that their activity is conducted in a businesslike manner.

[John Alan Cohan is a lawyer who has served the horse industry since l981.
He serves clients in all 50 states, and can be reached at: (3l0) 278-0203 or
by e-mail at johnalancohan@aol.com.]