is published by Dean, Dorton & Ford's Equine Industry Group. We hope you find the information we are presenting to be interesting and helpful. We welcome any feedback in this regard. Located in the heart of central Kentucky, known for its world-class horse farms, racing, and sales, Dean, Dorton & Ford has provided accounting, tax, and business consulting services to the horse industry since our inception in 1979. Our clients cover a broad spectrum of organizations involved in the horse industry, from small boarding farms to large multi-departmental farms involved in boarding, breeding, selling, stallion management, and crop production; from racing stables to a racetrack; from bloodstock agents to equine veterinary firms to equine insurance agencies; and from industry associations to industry publications. Not all of our clients are based in central Kentucky; horse industry clients from other parts of the country and from outside the United States also gain comfort by having our industry specialists work with them. As a firm, we endeavor to know the business of horses, not just accounting and tax rules relating to the industry. We accomplish this in a number of ways, including meeting periodically, often with outside experts, to discuss business topics of interest in the industry; by reading industry periodicals; by studying the abundance of statistical data available regarding different measures of industry performance; and most usefully, by working with our clients in the industry on their business matters. We perform a variety of services for our clients involved in the equine industry and welcome inquiries, whether from new participants in the industry who want assistance in properly structuring and administering their stables or farms, or from long-time industry participants seeking to improve the performance and administration of their equine operations. Members of our Equine Industry Group will be pleased to answer any questions you may have. Please call any of the following: Doug Dean, Richard Dorton, Martha Jones, Leigh McKee, or Steve Schnettler. ADDRESS: 106 West Vine Street, Suite 600 Lexington, Kentucky 40507 TELEPHONE: (859) 255-2341 FAX: (859) 255-0125 WEB SITE: www.deandortonford.com E-MAIL: ddean@deandortonford.com Dean, Dorton & Ford, P.S.C. Page 1
Dean, Dorton & Ford, P.S.C. - Equine Industry Group Accounting For smaller enterprises, directly performing many accounting, payroll, and clerical functions. Designing and implementing farm accounting and management information systems. Business Consulting Developing strategies to use the optimum forms of organization in which to conduct horse and farm businesses. Developing financial and business plans for farms, breeding operations, and racing stables. Financial analysis of stallion prospects. Organizing, staffing, training, and management consulting in connection with farm office operations. Designing and implementing retirement plan and other employee benefit programs. Tax Developing strategies to make maximum use of potential tax losses. Avoiding exposure to the hobby loss rules. Structuring transactions to avoid or minimize sales and use taxes. Avoiding or managing the potential impact of the passive activity loss rules. Using current and deferred trades of horses and farms to avoid or postpone income taxes. Using the involuntary conversion tax rules to defer income taxes on insurance recoveries related to horse and farm casualties. Estate planning designed to use special use valuation and family farm conservation incentives, family limited partnership strategies, and deferred tax payments. Handling multi-state tax allocations. Helping foreign owners and breeders to minimize exposure to U.S. taxes and comply with filing requirements. Developing tax accounting systems to comply, where required, with rules requiring capitalization of preproductive period costs. Representing clients with federal and state tax audits. Taking advantage of unique tax depreciation rules. Dean, Dorton & Ford, P.S.C. Page 2
Table of Contents Information and Commentary on Thoroughbred Public Auction Markets 4-7 Information and Commentary on Thoroughbred Breeders' Costs and Profits 8-11 Information and Commentary on Changes in Production Costs and Yearling Selling Prices for Thoroughbred Breeders 12-14 Information and Commentary on Racing Purses 15-16 Trends and Changes in Tax Rules and Planning for Equine Businesses 17-18 A Primer on Tax Depreciation Rules for Horses 19-23 Summary of Survey on Equine Industry Compensation and Employee Benefits - 2000 24-25 Dean, Dorton & Ford, P.S.C. Page 3
$1,200 Graph I Size and Composition of the Public Auction Market in Dollars 1987 to 2000 Data from The Blood-Horse $1,200 In millions of dollars $1,000 $800 $600 $400 $200 $1,000 $800 $600 $400 $200 1987 1988 1989 1990 1991 1992 1993 1994 1995 Yearlings Weanlings Two-Year-Olds Broodmares Inflation Adjustment 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Graph II Number of Horses Sold at Public Auction by Type of Horse 1987 to 2000 Weanlings Yearlings Broodmares Two-Year-Olds 1987 1988 1989 1990 1991 1992 1993 1994 1995 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Data from The Blood-Horse Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 4
Commentary on Graphs I and II Due to increases in dollars invested in 2000 and low inflation, the auction markets in 2000 surpassed the dollar volume (in nominal and inflation-adjusted amounts) of each of the periods covered. The nominal volume exceeded $1 billion for the first time, as depicted in Graph I. This graph also shows that total dollars invested in auction markets in 2000 is 3.2 times the level of 1992, the lowest of those depicted. Inflation-adjusted, the size of the 2000 market is 2.6 times the size of the 1992 market. After making up about 55% of the auction market (in dollars), in the years from 1987 to 1992, yearling sales, as a percentage of the total auction market, declined steadily through 1998, then experienced an increase in 1999 from 43% to 45%, and increased again in 2000 to 49%. Two-year-olds, which accounted for 19% of the auction market in 1996, have dropped steadily since then to 15% in 2000. In 1998, weanlings accounted for their largest share of the auction market in the period covered (11%), but decreased by 2000 to 8%. Broodmares accounted for about 30% of auction sale dollars in 1987-89, dropped to about 20% in 1990-93, increased consistently from 1993 to 30% in 1999, but decreased slightly to 29% in 2000. The increased level of pinhooking in the generally growing market of recent years tends to increase the auction numbers (volume and dollars) as these horses are resold. The total number of horses sold at auction in 2000 reached its highest level for the years shown, with each category increasing compared to 1999. The bigger increases in numbers sold in 2000 are in the yearling (9%) and broodmare (4%) categories. Weanlings and two-year-olds each increased 2%. In 2000 and in 1999, 29% and 27%, respectively, of the prior year foal crops were sold at public auction as yearlings. In 2000 and in 1999, 7.0% and 6.8%, respectively, of the same year foal crops were sold at public auction as weanlings. Dean, Dorton & Ford, P.S.C. Page 5
$65,000 Graph III Average Price at Public Auction by Type of Horse 1987 to 2000 Yearlings Weanlings Two-Year-Olds Broodmares $65,000 $55,000 $55,000 $45,000 $45,000 $35,000 $35,000 $25,000 $25,000 $15,000 1987 1988 1989 1990 1991 1992 1993 1994 1995 $15,000 Data from The Blood-Horse Graph IV Average Price by Type of Horse by Decile 1996 to 2000 $350,000 Yearlings $350,000 Weanlings $350,000 Two-Year-Olds $250,000 $250,000 $250,000 $150,000 $150,000 $150,000 $50,000 Top 10% 2nd 10% Upper20-50% $50,000 Top 10% 2nd 10% Upper 20-50% $50,000 Top 10% 2nd 10% Upper 20-50% Data from The Blood-Horse Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 6
Commentary on Graphs III and IV Two-year-old average prices, which had increased every year since 1991, including an 18% increase from 1998 to 1999, decreased by 3% in 2000. Since 1998, broodmares have had the highest average price of all categories. As recently as 1995, average broodmare prices were the lowest of all categories. Average weanling prices were quite volatile through 1994, then were on a consistent upward trend through 1999, but decreased 17% in 2000. Average yearling prices experienced steady growth from 1995 to 1998 of approximately 11-12% each year. In 1999, average yearling prices jumped 18%, and in 2000 they increased 8%. Graph IV examines the top 50% (by price) of each market segment yearlings, weanlings, and two-year olds - over the last five years. As the yearling graph indicates, the gap between average prices for the top decile of yearlings has widened consistently in the period covered. The average price for the top 10% of yearlings in 2000 exceeds the average for the next 10% by 5.2 times (4.5 times in 1999). For weanlings, the average 2000 price for the top 10% is about 3.5 times the average price for the next 10%, which is the same as 1999. For two-year-olds, the ratio of average prices of the top decile to the second decile has been fairly stable in the range of 2.9 to 3.3 (3.1 in 2000). While 2000 average yearling prices in the top decile increased substantially (15%), the average prices even in the top deciles for weanlings and two-year-olds declined (13% and 4%, respectively). For yearlings, 2000 average prices in the second decile and combined third through fifth deciles actually declined (.1% and 5%, respectively). Although not shown, each of the sixth through tenth deciles also dropped in average from 1999 to 2000, so all of the overall increase of 8% in average yearling prices can be attributed to the top 10%. For weanlings, the overall 17% decline in average prices was represented by declines in each decile. Dean, Dorton & Ford, P.S.C. Page 7
Graph V Breakdown of Price of Yearling Sales into Cost Components - Stud Fees, Sales Commissions, and Mare and Foal Board and Incidental Expenses -- Balance Available to Cover Cost of Mare and Profit YEARLINGS -- By Stud Fee Range 1996 to 2000 $800,000 $700,000 Stud Fees and Up $499,500 $556,392 $567,224 $800,000 $700,000 Stud Fees $50,000 to $99,999 $800,000 $700,000 Stud Fees $30,000 to $49,999 $600,000 $500,000 $320,834 $600,000 $500,000 $600,000 $500,000 $129,211 $164,954 $143,725 $144,980 $161,133 $146,015 $78,825 $82,222 $84,715 $67,157 $76,061 $800,000 Stud Fees $20,000 to $29,999 $800,000 Stud Fees $10,000 to $19,999 $700,000 $600,000 $500,000 $700,000 $600,000 $500,000 Balance After Other Costs to Cover Cost of Mare and Profit Sales Commissions Mare and Foal Board and Other Incidental Expenses Stud Fees $22,488 $34,929 $52,531 $24,302 $37,906 $3,999 $7,965 $11,183 $15,732 $5,984 Dollar figures are amounts remaining after other costs to cover mare & profit. Underlying Data from Auction Review, The Thoroughbred Times Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 8
Graph VI Breakdown of Price of Weanling Sales into Cost Components -- Stud Fees, Sales Commissions, and Mare and Foal Board and Incidental Expenses -- Balance Available to Cover Cost of Mare and Profit WEANLINGS -- By Stud Fee Range 1996 to 2000 $800,000 Stud Fees and Up $800,000 Stud Fees $50,000 to $99,999 $800,000 Stud Fees $30,000 to $49,999 $700,000 $456,510 $700,000 $700,000 $600,000 $600,000 $600,000 $500,000 $302,244 $293,610 $500,000 $500,000 $192,941 $231,049 $82,306 $100,564 $95,551 $92,355 $31,335 $71,674 $48,045 $54,076 $48,784 $31,741 $800,000 Stud Fees $20,000 to $29,999 $800,000 Stud Fees $10,000 to $19,999 $700,000 $600,000 $700,000 $600,000 Balance After Other Costs to Cover Cost of Mare and Profit $500,000 $500,000 Sales Commissions Mare and Foal Board and Other Incidental Expenses Stud Fees $34,182 $27,869 $21,975 $14,622 $12,193 $6,929 $7,163 $6,502 $9,137 $1,377 Dollar figures are amounts remaining after other costs to cover mare & profit. Underlying Data from Auction Review, The Thoroughbred Times Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 9
Commentary on Graphs V and VI We have analyzed data which shows the relationship of yearling (Graph V) and weanling (Graph VI) sales results to stud fee costs over 1996-2000, segmented by stud fee ranges (for the breeding year). These graphs show the portion of average sales price consumed by related stud fees, and add two other significant components of cost, a 5% sales commission and the cost of boarding and otherwise caring for the foal from an approximate weaning date until sold and the dam for a year. For this latter cost, primarily board and veterinary, we used $20,000 and $13,000 for yearlings and weanlings, respectively. The balance of average sales prices not consumed by the specific costs outlined above is available principally to cover the cost of using the mare for a year to produce the foal and, hopefully, to provide a profit to the breeder. The ratio of the amount available for mare costs and profit-to-stud fee for the last five years are: Stud Fee Range and up Yearlings 0.9:1 2.4:1 4.0:1 4.5:1 4.4:1 Weanlings 1.5:1 2.0:1 3.7:1 2.2:1 2.0:1 $50,000 - $99,999 Yearlings 2.5:1 2.4:1 2.9:1 2.6:1 2.5:1 Weanlings 1.4:1 1.7:1 1.5:1 1.6:1 0.6:1 $30,000 - $49,999 Yearlings 2.2:1 2.3:1 1.9:1 2.5:1 2.2:1 Weanlings 1.4:1 2.0:1 1.6:1 0.9:1 1.4:1 $20,000 - $29,999 Yearlings 1.0:1 1.6:1 2.3:1 1.1:1 1.8:1 Weanlings 1.5:1 1.2:1 0.7:1 1.0:1 0.6:1 $10,000 - $19,999 Yearlings 0.3:1 0.6:1 0.9:1 1.3:1 0.5:1 Weanlings 0.6:1 0.6:1 0.5:1 0.8:1 0.1:1 Dean, Dorton & Ford, P.S.C. Page 10
For yearling sellers, breeders to the highest priced stallions received approximately the same amounts to cover mare cost and profit in 2000 as they did in 1999. The growth in margin for these yearlings bred to top stallions was outstanding over 1996-99 (0.9:1 to 4.5:1), but declined slightly in 2000. However, in this segment, weanling sellers experienced a reduction in profitability again in 2000. In the $50,000 to $99,999 stud fee range, the margin to cover mare cost and profit has been very consistent for yearling sellers over 1996-2000, ranging from 2.4:1 to 2.9:1. The margin for weanling sellers in this stud fee category dropped significantly from 1999 to 2000 (1.6:1 to 0.6:1). Sellers of yearlings in the $30,000 to $49,999 stud fee range experienced reduced profitability in 2000 compared to 1999. However, the prices for weanling sellers in this category recovered from 1999 s decline. In the $20,000 to $29,999 stud fee range, the margin to cover mare cost and profit increased for yearlings sold in 2000, as contrasted with a decrease in the margin to cover mare cost and profit for weanlings in this category. In the $10,000 to $19,999 stud fee range, the margins dropped significantly in 2000 for sellers of both yearlings and weanlings. Dean, Dorton & Ford, P.S.C. Page 11
Graph VII Changes in Production Costs and Yearling Selling Prices for Breeders by Stud Fee Range and Decile 1998-99 and 1999-00 Tier 1 Tier 2 Tier 3 Tier 4 Tier 5 Overall & up $50,000 to $99,999 $30,000 to $49,999 $20,000 to $29,999 $10,000 to $19,999 Average / 1st decile / 2nd decile / 3rd decile / 4th decile / 5th decile All Ranges Shown 1999 to 2000 Change in Price 60% 40% 20% 0% -20% -40% 30% 15% 20% 19% 14% 16% 11% 7% 2% -2% -9% -7% -6% -13% -19% -20% -26% 5% Change in Price 60% 40% 20% 0% -20% -40% 1998 to 1999 32% 23% 26% 17% 22% 18% 16% 19% 14% 17% 18% 9% 9% 16% 6% 0% 3% -31% Change in Average Broodmare Price by Decile Change in Average Stud Fees by Stud Fee Range Change in Average Yearling Selling Price by Stud Fee Range Data from Racing Update & Auction Review, Thoroughbred Times Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 12
Commentary on Graph VII In Graph VII, we try to provide insight into a critical question for breeders: Are your production costs increasing at a higher or lower rate than the prices you re receiving for your products? The analysis covers changes in prices from 1999 to 2000 and from 1998 to 1999. For costs of production, we focus on the two major elements: (1) broodmare costs based on public auction prices and (2) stud fees. For sales prices of breeders products, we examine auction prices of yearlings. The analysis is based on current production costs and current sales prices and does not attempt to correlate sales prices with the costs of producing these foal crops. In other words, we are focusing on current costs replacement costs and current sales prices. We segment our analysis into five tiers: Tier Stallion cost stud fees of: Mare cost prices for reported sales at public auction: Sales prices yearlings sold at public auction and produced from stallions with these fees: 1 + Top 10% + 2 $50,000-99,999 2 nd 10% $50,000-99,999 3 $30,000-49,999 3 rd 10% $30,000-49,999 4 $20,000-29,999 4 th 10% $20,000-29,999 5 $10,000-$19,999 5 th 10% $10,000-19,999 Dean, Dorton & Ford, P.S.C. Page 13
These tiers can be considered to represent approximately the top one-half of the thoroughbred breeders market. We also show the overall changing cost and price levels for all the tiers we analyzed. Even at the very top of the market clearly the segment experiencing the best overall financial performance production cost increases continue to significantly outpace sales prices, not a healthy trend for breeders. In several of the other tiers, declines in average broodmare costs should help breeders, but generally increasing stud fees are not helpful. General economic principles suggest that breeders are recognizing the pressure on their margins and are limiting the prices they are willing to pay for broodmares. In this context, we note that in the 2nd through 5th deciles of broodmare costs, significant decreases in averages occurred (9% to 26%) from 1999 to 2000, quite a change from the trend from 1998 to 1999 when sizeable increases were experienced in each of these deciles (18% to 32%). Overall, from 1999 to 2000, our data shows 5% higher yearling prices, but 7% higher broodmare costs and 16% higher stud fees, leading to an expectation of generally smaller profit margins. Dean, Dorton & Ford, P.S.C. Page 14
Graph VIII Racing Purses and Numbers of Horses Racing 1990 to 2000 $1,200 Gross U.S. & Canadian Purses 100,000 Number of U.S. & Canadian Runners $1,100 90,000 In millions of dollars $1,000 $900 $800 $700 $600 80,000 70,000 60,000 $500 1990 1991 1992 1993 1994 1995 50,000 1990 1991 1992 1993 1994 1995 $17,000 Average U.S. & Canadian Purses per Runner 8.50 Starts per U.S. & Canadian Runner $16,000 $15,000 8.00 $14,000 $13,000 7.50 $12,000 $11,000 7.00 $10,000 6.50 $9,000 $8,000 1990 1991 1992 1993 1994 1995 6.00 1990 1991 1992 1993 1994 1995 Data from The Jockey Club Fact Book Equine Business Year in Review - 2000 Dean, Dorton & Ford, P.S.C. Page 15
Commentary on Graph VIII From 1990 to 2000 average purses per runner have increased from $8,700 to $16,500-89%. From 1990 to 1994, the increase in purses per runner was due primarily to a decrease in the number of runners (by 17%) gross purses changed only negligibly from 1990 to 1994 and were slightly lower in 1994 than in 1990. From 1994 to 2000, on the other hand, the increase in purses per runner was due primarily to an increase in gross purses available to owners (by 46%). The number of runners continued to decline during that period (by 7%). While average purses per runner increased an impressive 89% between 1990 and 2000, the costs of maintaining a horse in training still substantially exceed average winnings per runner. We also note that the increase in average purses per runner from 1990 to 2000 89% - has kept pace generally with the increase in the average cost of purchasing yearlings and weanings over the same period 97% and 86%, respectively, but is below increases in the cost of purchasing two year-olds 151%. After consistent decreases in the number of runners from 1990 through 1998, the number leveled out in 1999 and increased modestly in 2000. Dean, Dorton & Ford, P.S.C. Page 16
Trends and Changes in Tax Rules and Planning for Equine Businesses Little changed in 2000 in the tax environment for equine businesses, but substantial changes may occur in 2001 based on initiatives expected from President George W. Bush s new administration. The discussion which follows summarizes changes from recent years that may impact tax planning and results for 2000 and 2001. The discussion is necessarily brief, so we encourage you to seek professional advice before undertaking any specific action relating to these ideas. Alternative Minimum Tax Rules Now Friendlier for Horse Owners. While increasingly more taxpayers are being caught in the complex web of the alternative minimum tax (AMT), horse owners are less likely to experience this problem as a result of a change first effective in 1999. Depreciation periods and methods for horses now are the same for regular tax and AMT purposes, where before (for horses placed in service pre-1999), they were different to a substantial degree. The differences for horses placed in service under prior law must continue to be computed until the cost of the affected horses is fully recovered. Based on expressions of concern that the AMT s reach is much broader than it ever was intended to be, there seems to be a reasonable prospect that the AMT will be reformed in a major way to be less of a concern or perhaps even will be repealed. Farm Income Averaging - A Favorable Development. The ability of individuals to average their taxable income and avoid some of the impact of the progressive tax rate structure was eliminated many years ago. However, a limited opportunity for individuals engaged in a farming business was reinstated in 1998. These provisions allow qualifying individuals to elect to treat all or a portion of their current year farm income as if it had been earned ratably over the prior three years. During 2000, the IRS changed its interpretation of the proper treatment when someone has a net loss in a prior year. IRS now agrees that a negative taxable income in a prior year is treated as negative, not as zero, their previous position. This is a favorable development for those whose tax circumstances cause them to be impacted by it. Dean, Dorton & Ford, P.S.C. Page 17
Limited Liability Companies Remain the Structure of Choice. Limited liability companies (LLCs), due to their mix of noncorporate tax and corporate liability shelter characteristics, continue to be the entity of choice for many equine businesses. Many states, including Kentucky, allow single-owner businesses to be LLCs, increasing their utility. Single-owner LLCs are disregarded for income tax purposes their income and expenses are reported directly on the owner s returns, so they tend to be inexpensive to administer. Estate and Gift Tax Developments. The biggest news in this area is the apparent increasing momentum to repeal the Federal estate tax. While it is too soon to predict the outcome of the political process as it relates to estate tax repeal, we ll all be interested in watching the process occur. The prospect of estate tax repeal seems to have slowed estate planning activity, but it is noteworthy that IRS challenges to valuation discounts resulting from the use of family limited partnerships (FLPs) generally have been unsuccessful in the courts. Families using this technique are well-advised to observe all the formalities involved and to treat the entities created as real; otherwise, the intended benefits may not be realized. Well-documented appraisal reports also are an important part of successful implementation of FLP planning. In central Kentucky, we re seeing more grants of conservation easements. The potential tax savings of qualifying conservation easements in perpetuity are threefold: a charitable deduction for income tax purposes for the decline in the property s fair market value as a result of the easement; an estate or gift tax benefit resulting from the decline in the property s fair market value resulting from the easement; and an additional estate tax benefit, a value exclusion of up to ($500,000 after 2001) from the already reduced post-easement value. When property on which a qualifying conservation easement has been granted is held in a family limited partnership or limited liability company, the valuation benefits can be very impressive. Dean, Dorton & Ford, P.S.C. Page 18
A Primer on Tax Depreciation Rules for Horses Congress has prescribed very specific rules for computing horse depreciation deductions. In this article, we ll describe the rules applicable to most horse owners. When to Begin Depreciation - Depreciation begins when a horse is placed in service. Exactly when a racehorse or breeding stock is considered to be placed in service has not been clearly defined. Racehorses may be considered to be placed in service when training begins or when the horse first races. Breeding stock may be considered to be placed in service when the horse is held for breeding or when the horse is actually first bred. Once an owner has used the same method of determining when a horse is placed in service for 2 years in a row, the owner is considered to have adopted that method of accounting, which cannot be changed without IRS permission. How to Compute Depreciation - Three main factors come into play: the period over which the horse will be depreciated, the depreciation method, and the depreciation convention. (1) Depreciation Period If a racehorse is 2 years old or less when it is placed in service, it is considered to be 7-year property and is depreciated over an 8-year period (partial years of depreciation are taken in the first and last years). If a racehorse is more than 2 years old when it is placed in service, it is considered to be 3-year property and is depreciated over a 4-year period. Likewise, if breeding stock is 12 years old or less when placed in service, it is depreciated over an 8-year period; if it is more than 12 years old when placed in service, it is depreciated over a 4-year period. For tax purposes, a horse is aged based on its actual foaling date. So, a racehorse is more than 2 years old (and thus eligible for the shorter depreciation period) on the day after the second anniversary of its foaling date. For example, a horse that was foaled on February 1, 1998 and placed in service on February 1, 2000 would be depreciated over 8 years, but that same horse placed in service on February 2, 2000 would be depreciated over 4 years. Dean, Dorton & Ford, P.S.C. Page 19
TAX TIP - Starting Depreciation of Some Horses Later Will Defer Taxes Ordinarily, taxpayers want to begin depreciation as early as possible to reduce taxable income as soon as possible. However, due to the vastly different depreciation periods for (1) racehorses that are 2 years old or less and breeding horses that are 12 years old or less (8 years), versus (2) racehorses that are more than 2 years old and breeding horses that are more than 12 years old (4 years), it can be beneficial to defer placing a horse in service until after it reaches the cut-off age, if possible. For example, a yearling buyer who considers his racehorses to be placed in service when they begin training as yearlings will deduct just over 57% of the cost of the racehorse by the end of its 4-yearold year, while an owner who considers them to be placed in service when they begin racing as 2- year-olds usually will deduct over 87% of the cost by the end of the 4-year-old year even though no deduction for depreciation is taken in the first year of ownership. (2) Depreciation Method - The depreciation method for horses used predominantly in the U.S. is 150% of the declining balance of the asset (cost less accumulated depreciation), switching to straight-line when it provides a higher deduction. (3) Depreciation Convention - Generally, one-half year s depreciation is allowed in the year a horse is placed in service. This general rule is called the mid-year convention and is designed to simplify the depreciation computation. However, if more than 40% of the cost of all qualifying property (generally tangible personal property) placed in service during the year is placed in service in the last 3 months of the year, each new item that year will be considered to be placed in service in the middle of the quarter of the year in which it is actually placed in service. This is called the mid-quarter convention, and it is designed to keep taxpayers who have a disproportionately high amount of acquisitions late in the year from getting too large a depreciation deduction in the first year. TAX TIP Be Aware of the Mid-Quarter Convention If you place in service more than 40% of your current year personal property additions during the last quarter of the year, you must use the mid-quarter convention in computing depreciation for that year s additions. Last quarter acquisitions, which may have been expected to increase depreciation deductions, may instead decrease them, if the 40% threshold is exceeded. Dean, Dorton & Ford, P.S.C. Page 20
Fortunately, the IRS has provided the percentages of the cost of a horse that can be deducted as depreciation for each year for each depreciation period and convention. See the accompanying table for these percentages. Special Rules - Special rules apply for computing depreciation in the year a horse is sold. If the mid-year convention applied in the year the horse was placed in service, it also applies to the horse in the year it is sold (unless the year of sale is also the final year on the depreciation schedule, in which case all the depreciation is allowable). If the mid-quarter convention applied in the year the horse was placed in service, it also applies to the horse in the year it is sold. Special rules also apply for computing depreciation in the first and final tax years of a business if those periods are not for a full 12 months. These rules are designed to pro-rate depreciation based on the number of months that the business was operating. How is depreciation computed when a horse s use is changed from racing to breeding? If the racehorse had been depreciated as 7-year property, no change in the schedule is required if the conversion would be to a breeding horse falling in the 7-year property category. However, if the racehorse had been depreciated as 3-year property and is converted to a breeding horse falling in the 7-year property category, the undepreciated cost as of the beginning of the year of change is recovered over the remaining period for 7-year property. For example, if a racehorse placed in service in 1999 at age 2 (at a time when it was more than 2 years old in relation to its foaling date) is retired for breeding in 2001 as a 4-year old, it will have been depreciated as a racehorse for 1999 and 2000 and then will be depreciated as a breeding horse for the next 6 years, 2001-2006, using the remaining basis at the time of the switch. Additionally, there are special rules for computing depreciation if a horse is used predominantly outside the U.S. According to the IRS, predominantly means 50% of the year or 50% of the time during the year that the horse was considered to be placed in service. For example, a 3-year old racehorse purchased and placed in service in Europe on March 1 returns to the U.S. to continue its racing career on August 2. The racehorse is in service a total of 306 days of the year 154 outside the U.S. and 152 in the U.S. This racehorse is used predominantly outside the U.S. and must be depreciated over a 13-year period using the straight-line method. Breeding horses used predominantly outside the U.S. must be depreciated over an 11-year period, also using the straight-line method. Dean, Dorton & Ford, P.S.C. Page 21
Election to Expense Certain Depreciable Property - Under Section 179 of the Internal Revenue Code, some horse owners can deduct, rather than capitalize and depreciate, some of the cost of horses placed in service in the year. The maximum amount allowed as a deduction in 2000 was $20,000. The amount is scheduled to increase to $24,000 in 2001 and 2002, and to $25,000 after 2002. In order to qualify for this deduction, the horse owner must meet the following requirements: The owner must have aggregate taxable business income. It is not necessary that the horse business itself produce taxable income. To the extent that the allowable deduction exceeds taxable business income for the year, the deduction, if elected, can be carried over to future years. The cost of all tangible personal property placed in service during the tax year must not exceed. To the extent that it does, the amount of the deduction is reduced on a dollar-for-dollar basis. For example, if an owner places horses and other tangible personal property costing $210,000 in service in 2000, the allowable deduction for 2000 would be $10,000 [$20,000 ($210,000 - )]. TAX TIP Select Section 179 Deduction Property with Care Owners who qualify for the Section 179 deduction can maximize their tax benefits by applying the deduction to horses with longer depreciation periods. If some acquisitions qualify as 7-year property and others as 3-year property and the total exceeds the amount allowable under Section 179, first use Section 179 for the horses qualifying as 7-year property. Depreciation Under the Alternative Minimum Tax System - For horses placed in service before 1999, depreciation periods were longer for purposes of alternative minimum tax ( AMT ) than for regular tax. However, for horses placed in service in 1999 and after, depreciation periods for AMT are shortened to coincide with the applicable periods for regular tax. In addition to making computations simpler, this change provides significant tax relief to owners who are investing increasing amounts in bloodstock. Dean, Dorton & Ford, P.S.C. Page 22
The table below shows the percentages of cost which normally can be deducted each year for horses falling in the 3-year or 7-year property categories: MID-YEAR, MID-QUARTER CONVENTIONS RACEHORSE 2 years old or less; and BREEDING STOCK 12 years old or less MID-YEAR CONVENTION MID-QUARTER CONVENTION 1 st Quarter 2 nd Quarter 3 rd Quarter 4 th Quarter Year 1 10.715% 18.751% 13.394% 8.036% 2.679% Year 2 19.134% 17.412% 18.560% 19.708% 20.856% Year 3 15.033% 13.680% 14.582% 15.484% 16.386% Year 4 12.248% 12.159% 12.220% 12.275% 12.875% Years 5 through 7 12.248% 12.159% 12.220% 12.275% 12.182% Year 8 6.126% 1.521% 4.584% 7.672% 10.658% RACEHORSE more than 2 years old; and BREEDING STOCK more than 12 years old MID-YEAR CONVENTION MID-QUARTER CONVENTION 1 st Quarter 2 nd Quarter 3 rd Quarter 4 th Quarter Year 1 25.000% 43.750% 31.250% 18.750% 6.250% Year 2 37.500% 28.125% 34.375% 40.625% 46.875% Year 3 25.000% 25.000% 25.000% 27.083% 31.250% Year 4 12.500% 3.125% 9.375% 13.542% 15.625% Leigh McKee and Doug Dean Dean, Dorton & Ford, P.S.C. Page 23
Summary of Survey on Equine Industry Compensation and Employee Benefits - 2000 As a service to the equine industry, Dean, Dorton & Ford conducted a survey in late 2000 of Kentucky horse farms regarding compensation rates and employee benefit practices. We sent 419 surveys and received 65 responses, about a 16% response rate. By size (based on number of full-time employees), the respondents break down as follows: Full-time Employees Respondents 1-5 31 6-15 13 16-25 8 26-50 8 51+ 5 Compensation Rates. We reported compensation rates for all size farms and also for the larger farms (more than 25 full-time employees) for these job categories: Salary Farm manager Division manager Office Manager Stallion manager Business/financial manager Hourly Groom Watchman Skilled laborer Agricultural worker Bookkeeper Office clerk Seasonal worker sales Seasonal worker agricultural Foreman Dean, Dorton & Ford, P.S.C. Page 24
Employee Benefits. Our survey also examined the following benefit plans and practices sponsored by farm employers: Retirement plans Medical insurance Disability insurance Group term life insurance Holidays, vacations and sick leave policies Uniforms Housing Vehicles Cafeteria plans We noted a substantial increase in employers use of many of these plans, in comparison with a similar survey we conducted in 1997. Considering the tight labor markets prevalent in recent years, the increase in employee benefits is not surprising. Our survey enabled us to develop a composite workforce by nationality from among the respondents: U.S. 58.22% Hispanic 38.99% Irish 1.42% Other foreign 1.37% We also obtained data regarding instances of being audited in the last 3 years in the following areas: Wage and hour laws Employee vs. independent contractor Foreign worker status Sales tax Workers compensation Income tax If you did not receive a copy of our survey results report, but would like to receive one, please contact Sharon Davis or Lesley Howard of our office, and we will be glad to send you one. Dean, Dorton & Ford, P.S.C. Page 25