Taxing Matters for Breeders
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By William Given
Income tax time has come again. To a good many breeders this means the drudgery of wading through the shoe box filled with last year’s receipts to see just how much was spent and through the bank statements to find out just how little revenue was realized. Time is then spent compiling some kind of list containing both income and expenses. This list is then taken to the accountant so he or she might work some kind of magic during the tax return preparation.
The breeder can of course complete his or her own tax return simply by inserting the amounts in the appropriate boxes on the Form 1040. However, allowable deductions are frequently overlooked. Consequently, the breeder either experiences a higher balance due or leaves himself or herself vulnerable to costly disallowances.
HOBBY vs. BUSINESS
A person conducting a small breeding operation as a hobby may not deduct a loss on their individual 1040 tax return. This generally means that if the expenses exceed the income, the receipts will be ignored and the losses will not constitute allowable deductions. This ruling is of particular interest to small scale breeders and those whose real interest is showing their dogs. In both cases, losses can be quite high.
The major problem fledgling breeding operations experience is that they must first raise their bitches to breeding age before they will ever have puppies available for sale. This means the breeder will experience about two years of expenses with little or no income received. This situation frequently takes at least three or four years before it corrects. It is a well-established fact that small scale breeding operations are not highly profitable. We can however, minimize our losses and take advantage of tax deductions legally afforded us by the Internal Revenue Service.
INTENT
The question of a breeder’s intent of operating for profit (business) or pleasure (hobby) is a matter to be determined in each case based on the facts and circumstances. The fact that a breeder may have operated another related business interest and has experienced an operating loss for several years is in itself not enough to warrant classifying his or her dog breeding operation as a hobby. As a former supervisory tax examiner of the IRS, I am aware of at least four cases in which breeders were deemed to be a hobby by the IRS. In each case, the Tax Court ruled the breeding operations to be a business and the losses deductible.
In order for a breeding operation to be classified as a business,the activity must have been entered into in good faith with the intent of making a profit. It need not be the breeder’s primary occupation or major source of income, but the breeder must be actively engaged in the business. The breeding operation must be conducted in a businesslike manner. The factors that would indicate a small scale breeding operation is a business and not a hobby include the following considerations:
• The Internal Revenue Service will assume that a prudent business person would conduct some type of inquiry into the profit potential prior to the beginning of business operations. The breeder should have some kind of breeding plan and sales policy. Your breeding plan and sales policy is open to change over the years that your breeding program is in operation, but the existence of a breeding plan and sales policy helps to establish the intent of this breeder.
• The Internal Revenue Service looks for businesslike activity. One of the items on the auditors’ checklist is a business plan. Create one and make it professional, whether or not you stick to it. Businesses review and revise their business plans periodically. Your goal is to appear business-like in all things you do. For example, your plan should include a business overview, market analysis, competitor assessment, advertising & marketing plan, operating plan, financial plan, and an exit strategy for discontinuing the business should it become an unsuccessful venture.
• The IRS will expect a breeder to make reasonable efforts to increase income and reduce expenses. It is important to understand your need to show some concern for the economics of your breeding operation. For example, a breeder must be able to show some justification for incurring expenses for showing his or her dogs. Such reasonable justification might well be demonstrated by the present or potential revenue that can be generated by champion breeding stock with winning show ring records. A couple of blue ribbons will not impress an IRS Revenue Agent.
• Let us look at the case of a breeder who experiences considerable expenses year after year showing his or her males with the hope of recovering the costs through stud fees. If his or her expectations do not materialize after allowing a reasonable period of time, a breeder should choose to eliminate this part of his or her operation and treat these as personal (non-deductible) expenses. However, you should keep in mind there is the possibility of justifying these as true business expenses, because champion-sired puppies can command higher prices or because it makes the puppies more sellable.
• If you retain the assistance of an expert, or are taking active steps to become an expert, the more business-like you will look. If you have a college degree or are working to gain a degree, or have in some way obtained significant expertise in the activity, the more business-like you will look. If you do not have a degree, but have completed extensive research in the sport of purebred dogs and breeding, keep records of that experience in the event you need to show the amount of time, effort and energy you have invested. Similarly, if you hire an experienced consultant to help you complete a thorough pedigree analysis of potential sires, research the major and minor faults of conformation of the stud dogs on your list, or study the congenital health concerns in your breed, you will have a head start on convincing the IRS of your business status.
• If your breeding activity consistently produces losses, it will be more at risk of being treated as a hobby by the Internal Revenue Service. But if it can be combined with a profitable activity, the IRS should have no issue with it. The IRS policy is that your characterization of what constitutes a single activity will be accepted unless it is artificial and cannot reasonably be supported by the facts and circumstances. That means you cannot combine your profits from your primary employment as a software engineer or school teacher with your losses from breeding and report them as a single business activity. However, if you have a profitable sideline selling antique and contemporary dog figurines or handcrafted silver dog jewelry at dog shows and also happen to have a somewhat unprofitable sideline breeding dogs, you are able to combine the two on a single Schedule C, making it more likely that you will show a profit three years out of the five.
• In most cases the IRS will question the tax returns of breeders who attempt to write off his or her expenses against the other income from their regular job. If you work 40 hours a week in an office and bred purebred dogs on the side, does that mean you have no profit motive and breeding dogs is just a hobby? No, of course not; you can still have a business that is part-time. In fact, you can have multiple side-line dog businesses. Nevertheless, the Internal Revenue Service is more likely to consider your breeding activity a true business if you are able do it full-time.
ACCOUNTING PROCEDURES AND RECORDS
Internal Revenue Service regulations require all business organizations to maintain accurate accounting records. This is so that an accurate determination of net income can be made for tax purposes. If a business entity’s records are not adequate, the IRS auditor may make his or her own determination of the net income which, of course, will not likely be to the taxpayer’s benefit.
Even if the maintenance of business financial records were not a requirement of the IRS, there are other benefits that a breeder (and every business owner for that matter) derive from keeping good records. Good records provide piece of mind in knowing that all transactions can be easily evaluated. Good records encourage operational effectiveness by making you more aware and knowledgeable about the economics of your business. And, they point directly to the profitability of your business operations and to those activities where corrective actions are required.
Bookkeeping can be a major source of annoyance to any breeder. However, inadequate accounting records will seriously jeopardize your breeding operation from being considered as a business. If upon examination the IRS auditor comes to realize that your sales records consist simply of a list, that your business expenses have been determined only by an end-of-year tabulation, and that the receipts and disbursements for your breeding activities have been co-mingled with the funds in your personal checking account, the justification for a business classification will be significantly difficult to establish. It is reasonable for the Internal Revenue Service to expect a breeder’s bookkeeping methods to include the use of:
1. All sales documented in numerical sequence
2. Proof of expenditures made by the business
3. Cash receipts and disbursements journals
4. A separate banking account
The use of numerical invoices for sales transactions is a much preferred procedure. The invoice should be in duplicate and include such information as: name and address of the purchaser, nature of the sale, sales price, and if any, the terms of the sale. One copy should be provided to your customer and the second copy placed in your business files.
Documented proof of your business expenses should be readily accessible. If an IRS Revenue Agent were to question an expenditure, you need to be able to produce a cancelled check or bank statement as proof of payment and an invoice as proof of deductibility. You should insist on receiving creditors’ statements made out in your kennel name, or doing business as.
I am a firm believer that there should be absolutely no mingling of business and personal funds. You really should have a business checking account that is totally separate from your personal checking account. It is a simple matter and it is one that is far too frequently ignored by individuals who operate their own small business. It may seem of minor concern, but it may lead to a determination that your breeding activities are a hobby and not a business.
BOOKKEEPING
Every breeder operating in a business-like manner will have an orderly bookkeeping system. Your books should be set up in a manner that easily facilitates the preparation of your profit and loss statement and your tax return. However, since most breeding operations are small scale they do not justify the additional expense of hiring a full time accountant, so the records must be maintained by the breeder. Therefore, I do recommend that breeders obtain some professional assistance in establishing a workable bookkeeping system. Once you have a bookkeeping system properly set up, it is relatively simple to work with and keep current.
When setting up your bookkeeping system, it is necessary to determine the accounting methods you will be using. For example, in the preparation of your yearly tax return, it will be necessary to give a detailed accounting of your revenues received and expenses paid. This can best be accomplished by utilizing a cash receipt journal and a cash disbursement journal. These journals are simply a chronological list of income received and the costs associated with the conduct of your breeding activities.
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Posted by ralbee
on Apr 12 2015. Filed under Current Articles, Editorial, Featured.
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