For most people their encounter with the IRS ends at the audit phase: Taxpayers will often agree to pay whatever the IRS says they owe.
In situations where the auditor claims your activity is a hobby, not a business, this can have long-lasting and adverse consequences because deductions against outside income would be disallowed.
If you choose, you can appeal an audit determination to IRS Appeals and, if that is not successful, to Tax Court. The IRS is a large bureaucracy, but the procedures are fairly clear in that taxpayers are given ample opportunity, if you follow the procedures, to contest determinations made at the audit level.
The “philosophy” in IRS appeals, for the most part, is to seek a fair settlement of cases. Often, if you have strong evidence on your behalf, the appeals officer will end up conceding the case in its entirety, and you walk away owing nothing. In other instances, a settlement might be based on a percentage that you agree to pay. If a large amount of money is at stake, the appeals proceeding usually requires representation by a tax attorney.
The U.S. Tax Court is a Federal court established by Congress to provide a forum in which taxpayers can dispute IRS tax deficiencies assessed against them. This is a court, as it were, of last resort for taxpayers, if the matter has not been settled in IRS Appeals.
In order to file a petition in Tax Court, you must await receipt from the IRS of a “90-day letter,” also known as a deficiency notice. This triggers a 90-day period in which you must file a petition or else the IRS assessment will become final and unappealable.
The Tax Court is composed of presidentially appointed judges who are well versed in tax law. Although the Court is physically located in Washington, D.C., court sessions are held throughout the country, so that the lawyer who files your case can designate a city convenient to you.
The advantage of Tax Court is that you have the opportunity, once again, to settle your case. Your representative must be familiar with the extensive Tax Court rules and procedures. If the case is not settled with IRS counsel, the judge will hear your case. No juries are involved. Depending on the judge, and depending on the strengths of your case, you may or may not win.
You will have the opportunity to present witnesses on your behalf, including expert witnesses. The taxpayer usually will be a key witness to testify as to your intentions and expectations in carrying on the activity. You will need to explain your method of recordkeeping, articulate what the business plan was, what efforts were made to cut down on costs and increase revenue, who was employed as trainers, how decisions were made on acquisition of horses, breeding, racing, showing and selling. If there were setbacks, such as casualty losses or economic downturns, these also will need to be narrated.
Some Tax Court judges are more sympathetic than others on the trials and difficulties horse owners face – whether in racing or breeding – to make a profit.
Not everyone is audited in the first place. But most of audits of horse owners involve those who have a history of losses with large tax deductions taken against large principal sources of income.
Although the horse and ranching industries are big forces in the American economy because they help fund many related industries and workers, the IRS takes a skeptical view towards taxpayers who have a history of losses in these areas. But at the same time, taxpayers who go to the effort of pursuing their cases in IRS Appeals or Tax Court usually can get a better opportunity to have a satisfactory result. It will still be necessary to have strong evidence that your activity is conducted in a businesslike manner, and plenty of documentation and witnesses, in order to determine just how you could make a profit in this activity over time.
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. He can be reached at: (310) 278-0203, or email at firstname.lastname@example.org. His website is JohnAlanCohan.com.