Micro Horse Owners Are in It to Win It, but What About the Tax Burden?
By: Dean Dorton | May 5, 2022
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Micro share ownership of horses is making it more affordable for the average person to own a part of a horse. However, most people probably do not consider the tax implications of owning shares of a horse. Below we discuss the various ownership types and related taxes.
Equine | Tax
This article was first published in the May 2022 edition of the Blood Horse Magazine
Written by: Jen Shah, CPA
Over the past few years, we have seen an increase in large ownership groups participating in our sport, particularly on the racing side. It makes sense to encourage fans to learn more about the industry and convert some into horse owners themselves. It has inspired people like my husband who owns a hair in a few horses (including a Derby winner!) but is not otherwise directly involved in the industry (besides attending and watching the races) to invest.
For many, particularly those who are just dipping their toe into horse investment and not making a significant initial cash investment, the tax implications of this investment may be minor. According to my husband, he did not even consider the tax implications (gasp!) when he decided to invest but, as the family CPA, taxes are always a consideration for me. With differing options available to potential horse owners, I thought it may be worthwhile to give an overview of some of the more common ways to structure horse ownership for larger owner groups and address the key tax and cash implications. For our purpose here, the article focuses on the income tax impact to individual investors, none of whom are otherwise actively involved in the horse business.
The most common ways to operate are as a non-profit social club or as a for-profit entity, either a flow-through entity (typically a partnership) or a C corporation. Likely, if you have made a small investment in horses with others, the manager of the group makes the choice on how to structure the investment before you are given the opportunity to invest. There are certainly non-tax items to consider when structuring these investments, as well. A comparison chart is also included to highlight the key tax differences between the options discussed below.
Some of the racing clubs operate as non-profit social clubs organized for pleasure, recreation and enjoyment. These non-profits are supported by annual membership dues from members who are interested in learning more about the Thoroughbred industry via their participation in the social club. In return, the social club provides members with access to horse ownership and educational opportunities like learning about the Thoroughbred business.
Membership dues paid by the members to the social club are not deductible on the member’s income tax return. The social club is not subject to income taxes if its activities fall under the social club designation but the members may not receive any of the gross profits generated by the non-profit. Conversely, any net losses generated by the non-profit do not flow to the individual owners nor is there any tax benefit obtained by the non-profit since the social club is generally not subject to income tax. Therefore, for individual owners who participate in these non-profit clubs, there are little to no income tax implications of the investment. The non-profit’s annual tax filing is a public document so both members and non-members may view the non-profit’s tax return and related financial results included with the return.
These non-profit social clubs work best when the primary goal is to educate members about horse ownership without offering participants a share in the profits generated. Many horse owners, alternatively, choose to invest in horses via a for-profit entity, either a flow-through entity (for example, a single-member LLC, partnership or S corporation) or a C corporation. Investing in these for-profit entities has a greater income tax impact to investors versus the non-profit option discussed above. Flow-through entities have typically been most commonly used in the horse industry primarily due to the flexibility they provide. However, with large ownership groups, flow-through entities may create an administrative burden if operating in multiple states with many owners.
Multi-member flow-through entities (partnerships and S corporations) file a tax return, but there is generally not a company-level Federal income tax imposed. Partnerships provide more flexibility versus S corporations, which may be useful for service providers (like trainers and bloodstock agents) but do not typically work well for companies that hold assets that may appreciate like horses. Therefore, this article focuses on partnerships. Most partnerships require additional cash contributions after the initial cash contribution is paid so this option is probably the most realistic regarding the benefits and burdens of horse ownership.
Partnerships issue a Schedule K1 to partners on an annual basis and each partner reports their share of net income or loss generated by the partnership. Most income generated by racing partnerships is taxed at ordinary Federal income rates of up to 37%. If the partnership is currently generating tax losses, which may occur particularly with current tax incentives like 100% bonus depreciation, partners are allocated their respective share of these losses which may be currently used to offset the partner’s other income. There are some limitations for currently claiming these losses which are beyond the scope of this article. Any losses that have been suspended may be fully written off by partners as ordinary losses in the year the partnership ceases operations. If the partnership is operating in multiple states, then each partner may have an annual filing requirement in multiple states.
C corporations, on the other hand, are subject to company-level Federal income tax at 21% if net income is earned. Operating losses generated by the C corporation stay in the C corporation. If shareholders receive cash from the corporation out of net profits, then this may also be taxed as dividends to the shareholder and subject to 20% Federal income tax. If the C corporation does not have “earnings and profits” (calculated by the C corporation) when cash is paid to the shareholders, this is treated as a nontaxable return of capital by the shareholders.
When a C corporation is closed, if a shareholder has invested more cash than what is received, this is typically a capital loss versus ordinary loss. Capital losses are limited to $3,000 per year so these are generally not as tax-efficient as ordinary losses. However, there is a special rule for small business C corporations if certain criteria are met which may convert these capital losses into ordinary losses for shareholders. If this situation applies, you should check with the C corporation to verify if you may claim an ordinary versus capital loss.
On the surface, it sounds like partnerships may be more tax-efficient because C corporations subject owners to double-taxation. However, as the chart reports, the combined top Federal tax rates to the company and owners, even when considering the two layers of potential tax in the C corporation structure, are roughly the same on ordinary income or loss generated by partnerships (37%) and C corporations (36.8%). To demonstrate the blended C corporation Federal income tax rate, let’s use a basic example of $100 of corporate taxable income. After paying the $21 corporate tax, there is $79 left to distribute to the shareholders. The tax to the shareholders on the $79 of dividend received is $15.80 (20% tax rate on qualified dividends multiplied by $79). A total of $36.80 of tax (or 36.8%) has been paid by both the C corporation and the shareholders on $100 of income, returning $63.20 to the shareholders after taxes.
If ordinary income is generated and you are in the top income tax bracket, the above example may indicate there is little difference between investing in horses in a partnership or a C corporation. However, this ignores the impact of state income taxes, the potential for a 20% qualified business deduction on partnership income, the 3.8% net investment income tax on passive and investment income, and a reduction in the Federal individual income tax rate if you are not in the highest tax bracket. So, I always recommend checking with your own family CPA and analyzing based on your specific facts before making any investment decisions.
As we all know, investing in horses is a risky business and more often than not, losses will be generated by the investment. Typically, a capital loss in C corporation stock is less valuable than ordinary losses reported annually by a partnership. However, the small business stock exception converts what would normally be a capital loss in C corporation stock to an ordinary loss so, except for the potential for timing differences in recognizing the loss, the income tax impact if an overall tax loss is generated should be neutral between investments in partnerships versus C corporations.
One scenario where using a partnership would produce less tax versus a C corporation is if a long-term capital gain is generated. In order to qualify for long-term capital gain treatment, horses have to be held over 24 months (versus the usual 12-month holding period). If a horse meets the long-term holding period, then the portion of the gain that exceeds the depreciation claimed before sale may be taxed at the favorable 20% long-term capital gain tax rate to members if held in a partnership. C corporations do not have a different Federal income tax rate for long-term capital gains – the same 21% rate applies and then the net profits distributed may be taxable to shareholders in addition to the corporate tax. However, for many of these ownership groups, horses are often sold before the 24-month holding period is met.
A typical example is a yearling purchase in September 2020, where training commences in the fall of 2020 and into the two-year-old year, and the horse may start racing in 2021, followed by the Derby trail as the three-year-old year progresses in 2022. If these 2022 Derby prospects are sold around Derby 2022, then the 24-month holding period will not be met and any sale would be ordinary income. There is some planning which may be done here to meet the 24-month holding period, but that comes with the continued benefits and burdens of ownership. Often, the decision is made to take to money and run.
Admittedly, the tax consequences of these investments do not play a big role for most micro horse owners. The primary benefit of participating as an owner in this industry far outweighs the tax cost of doing so for most, although as this investment increases, the related tax implications may become a bigger priority. I hope this article provides some useful information as you consider your horse ownership options. Most importantly, have fun and enjoy the ride!
Individual Passive Investors – Tax Comparison Chart
|Type||Partnership||C Corporation||Social Club*|
|Cash Contributions – Owners||Capital contribution to entity||Purchase of stock in corporation||Non-deductible membership dues|
|Cash Distributions – Owners||Typically a nontaxable return of capital (exceptions apply)||Taxes as a dividend or non-taxable return of capital||Only eligible to receive a refund of dues paid – non-taxable|
|Federal Tax Form||Form 1065 with Schedule K1s to Members||Form 1120 with Form 1099-DIV to shareholders if cash distributions made||Form 990|
|Level of Federal and Multistate Income Tax on Operating Income or Loss||Members||Corporation||N/A|
|Top Federal Income Tax Rate – Company||N/A||21% on corporate taxable income||N/A|
|Top Federal Income Tax Rate – Owners||37% on ordinary operating profits/20% on long-term capital gains||20% on qualified dividends||N/A|
|Combined Top Federal Income Tax Rate – Company + Owners||37%||36.80%||N/A|
|Exposure to 3.8% Net Investment Income Tax – Owners||Yes, on operating profits and long-term capital gains||Yes, on dividends and capital gains from sales of stock in corporation||N/A|
|May be eligible for 20% Qualified Business Income Deduction through 2025 – Owners||Yes||No||No|
|Excess Business Loss Limitation may apply through 2026 – Owners||Yes||No||No|
|Subject to Hobby Loss Rules||Yes, both entity and owners||No||No|
|Subject to the Passive Loss Rules||Yes, owners are subject||No||No|
|Type of Gain for Sale of Horse held 24 months or less||Ordinary||Ordinary||N/A|
|Type of Gain for Sale of Horse held more than 24 months||Long-term Capital (in excess of depreciation claimed)||Long-term Capital (but same 21% corporate rate as ordinary)||N/A|
|Type of Gain upon Liquidation of Entity – Owners||Typically allocated via operating profits as ordinary or capital||Capital – Short-term if stock held 12 months or less; long-term otherwise||N/A|
|Type of Loss upon Liquidation of Entity – Owners||Typically allocated via operating losses as ordinary||Typically Capital (but see small business stock exception which coverts loss to ordinary)||N/A|
*Above assumes the non-profit’s activities fall within its tax-exempt purpose. If any unrelated business income (UBI) is generated, then the non-profit is subject to the 21% corporate tax rate on net profits of such activity.
Jen Shah, in addition to owning a hair of a Derby winner via her husband, is a CPA for Dean Dorton in Lexington, KY where she leads the firm’s equine practice. Dean Dorton works together with thoroughbred and sport horse and farm owners around the world on U.S. tax planning, tax compliance and business operational matters.
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