You have a horse business, a stable most likely, and hopefully an eventual profit to show for your effort. What happens next? Uncle Sam wants his cut! Actually, even if you have been operating at a loss (not unusual in a start-up operation), taxes have been a large part of your business finances anyway.
Taxes can make or break any business. You've got bigger things to worry about than taxes? On April 15 you may have a rude awakening. Now's the time to assess 2005.
Let's assume you and your spouse have $60,000 of taxable income, besides the profit from your horse business. Your federal income tax rate on any extra income would be 25 percent. If your state income tax rate is seven percent and social security/ Medicare taxes are 15.3 percent, taxes would eat up 47.3 percent of every dollar the horse business makes. You knew the tax collector was your partner, didn't you?
Any business needs a tax strategy. By managing your cash flow you can have some control over taxes. All business decisions have tax consequence. Following are a number of factors that will strongly influence the amount of taxes you pay in any year.
Tax deferred retirement savings
As the owner of a business you are allowed to defer some of your profit into retirement accounts. There is a Simplified Employee Pension Individual Retirement Account (SEP IRA) that allows you to deduct 20 percent of your income. Or Simple IRAs and Solo 401(k)s just for the self-employed, which allow you to deduct the first $14,000 in 2005 (or $18,000 if you are age 50 over) and then 20 percent of additional income on top of that.
You can even set up a defined benefit pension just like the big corporations offer, just for yourself, with very high contribution limits. You'd still owe the 15.3 percent for social security and Medicare in our example (often called self-employment tax), but you could defer the extra 32 percent income tax until you retire and you are likely in a lower tax bracket.
Say your profit for the year is $20,000 and you have set up a solo 401(k). You elect to defer the maximum amount for someone over 50 years of age. You still owe the 15.3 percent self-employment tax on the $20,000, or $3,060. But if you defer the maximum $18,400 of income, your income tax is reduced by $5,888. Of course, Uncle Sam will eventually get his cut, but it was nice of him to throw in $5,888 toward your retirement.
Depreciation is usually charged over the life of a capital asset. It does serve to reduce your taxes, but the IRS limits the options available, so you have limited control over this expense. But there is one kind of depreciation that has a huge impact that you can control. Section 179 depreciation is also called expensing because you expense the entire amount of a capital expenditure in the year incurred.
Certain capital assets can be 100 percent expensed in the year of the purchase, up to a $105,000 limit in 2005. Qualified assets include single purpose livestock structures, machinery and equipment, and livestock, including horses. This tax law provision provides a golden opportunity to reduce taxes in a given year.
Capital asset investments can be timed to have the most beneficial impact on cash flows and to minimize taxes. So, if you buy a qualified asset for $50,000 in 2005, your taxes go down $23,650.
Home office deduction
The home office deduction is a sure way to get audited, right? The IRS has liberalized its rules and interpretations. They are now much more reasonable.
The office still must be exclusively used for business and there must be a legitimate business purpose. Say the business office occupies 10 percent of the square footage of the residence. All of a sudden you can expense 10 percent of the depreciation (as opposed to zero percent for a regular house), 10 percent of the utility and insurance bills, and 100 percent of any maintenance or repairs that relate solely to the business purpose (like book shelves for the office). Also, 10 percent of the mortgage and property taxes are now business expenses.
Big deal, they were already deductible weren't they? True, but now they reduce your business profit and you don't have to pay self-employment tax on that money.
Two out of seven year rule
Any farmer or rancher (or any businessperson) is expected to show a profit in two of the last seven years. If not, a profit motive is not presumed. This scares many potential business owners. What if I don't show the profit; what will the IRS say?
Actually, tax courts have held the start-up period for some agricultural enterprises like a horse operation might well take longer than seven years and a profit might not reasonably be expected in two of seven of the first years.
There is the presumptive rule, but it does not work in both directions. If you make a profit in two of the last seven years, it will be presumed you have a profit motive and you are presumed to be a legitimate business. However, if you do not make that profit in two of the last seven years, it is not presumed you do not have a profit motive.
All this means is that you are subject to the IRS questioning your profit motive. If your records show a reasonable intent to make a profit, your business can have a loss for any length of time.
Ordinary and necessary business expenses
Business expenses need to be ordinary, necessary, and directly connected to your business purpose. In addition, they may not be lavish or extravagant. Those are the rules.
Who decides what is ordinary and necessary? You do! Many small businesses fail to claim allowable deductions simply out of fear of increased audit chances. Like the items mentioned above, reasonable business expenses ought to be claimed and an audit not feared. If the expenses are customary in your business community, you should easily survive an audit.
If you attend a horse show with the purpose of making business contacts, attracting new boarders, and getting increased awareness of your stable, that is a business purpose. Your travel and show expenses would be deductible business expenses.
Your stable needs a new truck and horse trailer to transport boarders' horses to shows. Maybe, deep down, you wanted a new truck and horse trailer for yourself. But there is no place on Schedule C, where you account for your profit or loss from a business, for what you felt deep down. You have an obvious business purpose and a deductible business expense.
How often can you buy a new truck for the business? That is up to you, not the IRS, as long as you are within the industry norms.
Say I owned and managed a stable and I wanted to make a trip to Las Vegas this year. If I were aggressive with my taxes I might tie this trip in with a convention or other stable/ horse-related activity. If I did that, the travel expense to and from Las Vegas would be fully deductible and so would the expenses directly related to the event. I need not prorate the travel as long as my primary business purpose is the stable/horse event.
Taxes are one of the most important aspects of business management. They can make or break a business. All owners and managers need to be conscious of the tax consequences of business decisions. The only profit that counts is the one after taxes.
Thomas J. Straka is a forest economics professor at Clemson University in South Carolina. He feeds his old bay mare, Belle, nothing but Southern States horse feed, purchased at Oakway Farm and Garden, as it is less taxing on her system (pun intended). He and his wife, Pat, own two horses.