Horse racing in the Commonwealth
November 1, 2023
By Miranda L. Simpson, CPA
Louisville, Kentucky, is known for many landmarks and distinctions, namely the Kentucky Derby.
Natives of the area are proud of the notoriety and the international spotlight; for two minutes in early May, practically the entire world has their eyes on Churchill Downs to witness which horse wins the Run for the Roses. Seventy miles east of Louisville in Lexington, you will find yourself in “The Horse Capital of the World.” In Lexington, Keeneland attracts the masses for several weeks during the spring and fall meet.
There is no denying that the state of Kentucky holds its own in the horse industry. Kentucky CPAs have little choice when it comes to understanding tax laws that affect many of theirequine-owning clients. Fall is here, and horses are running again, let’s visit a few federal tax laws common to clients who dabble in or make their living racing horses.
Keeneland, Lexington Kentucky
Meals and entertainment
Modifications to the meals and entertainment deduction, as part of the Tax Cuts and Jobs Act of 2017 (TCJA), was a widely unpopular decision by lawmakers. Entertainment expenses were permanently scratched from the Internal Revenue Code (IRC) and deductions for meals became a bit more limited. Many business owners spend a fair amount of money investing in client relations and prospects, primarily through meals and entertainment.
Understandably, they were upset to learn that some of these expenses would no longer help come tax time. A day at the races is a common way Kentuckians entertain and gather with business associates. Most of these expenses continue to be non-deductible; do not discount all Keeneland or Churchill Downs outings just yet as a freebie to Uncle Sam.
The following are some of the exceptions listed in IRC §274(e), as it relates to entertainment that continue to be fully deductible:
- Food and beverages for employees
- Expenses treated as compensation
- Reimbursed expenses
- Recreational expenses for employees
- Employees, stockholders, etc., business meetings
In addition to the exceptions above, ordinary, and necessary expenses of a trade or business are fully deductible. For example, a horse trainer may need to pay fees to gain entrance to an event, but because this expense is directly related to the business (and not for entertainment purposes), it would be fully deductible.
Under the current tax laws, meals are still generally 50 percent deductible, but meals included with entertainment are not deductible. If mint juleps, burgoo stew, and Derby pie are part of the price of tickets, box seats, or event facilities, they are not tax-deductible. If the cost of the food and beverage can be listed separately on the invoice, a 50 percent deduction for meals is allowable.
*Note that this is not an in-depth discussion on the meals and entertainment deduction/disallowance*
Depreciation of racehorses
Unlike professional gamblers, the few times I have found myself at the races, I usually bet on a horse with an interesting name. A few years ago, I found a contender for the blanket of roses, Tiz the Law. Tiz was born (foaled) in March of 2017 and would have been eligible for a depreciation deduction once sold and placed into service. In 2017, racehorses could be depreciated over a three-year period, but this provision expired at the beginning of 2018.
The Tax Cuts and Jobs Act of 2017 (TCJA) did not extend this and racehorses were scheduled to revert to a seven-year depreciable life. TCJA did provide for more generous bonus depreciation and Section 179 deductions. On December 20, 2019, the extenders bill was signed into law, which prolonged the three-year life for racehorses through 2020 and made it retroactive to 2018.
Since 2020, Congress has enacted similar extender bills each year to continue to allow the three-year depreciable life for racehorses. In April of this year, Congressman Andy Barr introduced “The Racehorse Cost Recovery Act of 2023” to make the more favorable depreciable life a permanent change to the tax law. Much like many tax provisions that are consistently extended each year, a permanent change might make year-end planning a bit easier for tax professionals.
May the odds be in his favor, and perhaps become “Tiz the Law.”
Gambling losses and deductions
For every gambler who rolls the dice, takes a shot in the dark, or picks a horse by the name, there is another who has a system.
The system could be an algorithm that calculates probability or a spreadsheet with graphs and pie charts that analyze historical data. Either way, lady luck is no respecter of persons (or their system) and so for every winner, there are quite a few losers.
Before TCJA, gambling losses could be deducted up to the amount of gambling winnings, as an itemized deduction. Thankfully lawmakers decided not to anger gambling taxpayers and as such, gambling losses are still deductible on Schedule A as an itemized deduction. The caveat here is that a large percentage of taxpayers are not able to itemize any longer.
Since the standard deduction doubled and the cap of $10,000 on state and local taxes, itemizers are fewer and farther between. However, these tax law changes are set to sunset on December 31, 2025, if lawmakers do not act. For now, though, most gambling taxpayers may be subject to tax on their earnings without a corresponding deduction for their losses.
Tax reform enacted in 2017 also put an end to so-called “professional gamblers’” ability to write off other expenses, such as travel, meals, and office expenses, against their gambling winning.
In tax years before 2018, these taxpayers could report their gambling winnings and losses and other expenses on Schedule C, Profit or Loss from Business. By reporting gambling winnings in this manner, professional gamblers could potentially create trade or business losses, which would offset other taxable income, or even create a net operating loss. Nevertheless, lawmakers shut this down by limiting deductions and losses to the amount of income.
Speaking of losses, the Internal Revenue Service has a long history of battling taxpayers over the issue of Hobby Losses. Taxpayers in the horse racing industry usually spend an enormous amount of money funding their endeavors each year. Of course, many of these taxpayers are wealthy individuals who have other sources of income and do not mind the extra write-offs. But the IRS does mind and will pounce on the opportunity to challenge whether an activity is a bona fide business when they can. Many factors are used to determine whether an activity is a business or a hobby, but the overwhelming factor that waves a red flag, is losses, year after year!
Taxpayers who repeatedly report losses, especially large numbers, should be aware of the likelihood that an audit may be on the horizon. There are nine factors that the IRS considers in determining whether a business might be a hobby, although not all factors need to be met. Keep in mind that the burden of proof is on the shoulders of the taxpayer to prove the business is not a hobby. Think guilty until proven innocent. Below are the nine factors, summarized by the IRS, per §1.183-2(b) of the Federal Tax Regulations:
- Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
- Whether the time and effort you put into the activity indicates you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
199A and horse racing
One of the more popular, and complicated, tax laws that was birthed out of TCJA, is the 199A pass-through deduction. Although this provision is also set to sunset on December 31, 2025, a couple more years are still available to utilize this deduction. In general, the 199A deduction is equal to 20 percent of qualified business income from a pass-through trade or business. If the business is a hobby, as discussed in the preceding section, it is not a trade or business for purposes of the 199A deduction. The next consideration, after clearing the trade or business hurdle, is whether the business is a Specified Service Trade or Business (SSTB). The reason this matters is that if a business falls in the clutches of an SSTB, the 199A deduction could be limited or disallowed completely if the taxpayer’s income reaches above certain thresholds. An SSTB, for purposes of the 199A deduction, is defined as any trade or business involving the performance of services. The various fields listed in the definition include the field of Athletics.
The performance of services in the field of athletics means the performance of services by individuals who participate in athletic competition such as athletes, coaches, and team managers in baseball, basketball…, track and field, billiards, and racing. Horse racing businesses, including jockeys, trainers, and managers may be subject to this limitation. There is still a huge amount of opportunity to maximize this deduction for business owners and those in the horse industry. Many planning considerations, including whether the business is properly classified as an SSTB, are available to benefit from this deduction.
Horse racing in the Commonwealth of Kentucky is a nostalgic occasion for its citizens and others from around the globe. Kentucky's long history of popular racing events solidifies its dominance in the horse industry.
Although tax laws can be complex and are ever-changing, CPAs in the Bluegrass state are the experts to turn to for guidance. Now that the busy season is over for most, hopefully, CPAs can trade their beige outfits for an array of pastels, green visors for a fascinator, and florescent lighting for sunshine at the track.
About the author: Miranda L. Simpson, CPA, can be reached at email@example.com. Simpson is a self-employed CPA with extensive experience in tax. She has authored many federal tax articles for The Kentucky CPA Journal.