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Horse Sense Applied to Startup

BY CHARLES J. REICHERT

Please note: This item is from our archives and was published in 2007. It is provided for historical reference. The content may be out of date and links may no longer function.

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In its first ruling of 2007, the Tax Court concluded that a woman could deduct expenses of for-profit horse boarding and training that later grew into a business. Had the IRS prevailed, taxpayers who engaged in a for-profit activity with the hope it would grow into a full-fledged trade or business would have been required to capitalize expenditures incurred during the for-profit activity period.

Individual taxpayers may deduct expenditures related to a for-profit activity (an itemized deduction) as well as expenditures related to an active trade or business (a deduction for AGI). A trade or business is distinguished from a for-profit activity by the regularity and continuity of its economic activity. Previous courts have held that the same standards to distinguish capital expenditures from ordinary expenses should apply to both types of activities. Costs incurred by a taxpayer in anticipation of the start of an active trade or business ordinarily have been required to be capitalized. Taxpayers may elect to deduct up to $5,000 of startup expenditures in the year a trade or business begins.

In 1998, Julie Toth opened a horse breeding and training facility near Portland, Ore. From 1998 to 2001, she made numerous improvements to the facility and hired additional staff. By 2004 she treated it as a business. That year, Toth filed tax returns for 1998 and 2001, reporting all amounts for those years on Schedule C. Later in 2004, the IRS sent her a notice of deficiency for both years, and Toth petitioned the court.

Toth argued that her claimed expenses were deductible under section 212, while the IRS said they were nondeductible startup expenditures under section 195(a). The court said whether a for-profit activity later becomes a trade or business is immaterial when classifying its expenditures as currently deductible or as capital expenditures. The key to deductibility is the start of the for-profit activity—once it has begun, any ordinary and necessary expenses are deductible. Moreover, forcing Toth to capitalize the expenses would cause them to be treated differently than similar expenses of a trade or business, the court said.

Toth v. Commissioner , 128 T.C. No.1.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.