There are various types of business entities utilized to conduct horse racing and breeding activities. It is important to understand the tax, legal and liability implications of each. As always, consult with your tax and/or legal advisor before choosing a type of business entity for your equine activity.
Considered the simplest form of ownership, a sole proprietorship is a business owned by a single individual. The owner reports her horse activity revenues and expenses on her individual income tax return and pays the related tax. While the owner enjoys the advantage of making decisions without regard to other investors, the owner is individually liable for all business expenses.
A general partnership is the most basic form of a partnership. Typically, two or more individuals join together to operate as a single business entity. Income tax returns are filed by the partnership, but all gains and losses pass through to the individual partners. Tax treatment of the partners is essentially the same as in a sole proprietorship. The major advantage is simplicity. However, there is no protection for the partners. In other words, all personal assets of each partner, including non-partnership assets, are exposed in order to satisfy liabilities of the partnership.
This form of partnership limits partners' liability to those assets contributed to the partnership. The general or managing partner's liability is not limited. Since the general partner's liability is not limited, he is afforded greater power and control over the partnership assets and responsibility for most decisions. By turning decision-making power over to the general partner, other partners are considered non-active or passive participants. This means your horse operation losses can be offset only against other passive income, i.e., non-earned income and non-investment income. With regard to the partnership, losses can offset future income or can offset any income during the year the limited partnership ceases operation.
As with a general partnership, income tax returns are filed by the partnership. Organizational expenses will be incurred and most states require filing a certificate.
Commonly defined as a co-ownership group, a syndicate is a hybrid form of business entity, similar to a partnership, that is created by contract among members of the syndicate. Syndicates are most often associated with breeding and racing ventures. They allow an investor to raise capital and sell interests in a specific asset. Each co-owner's or syndicate member's rights and obligations are defined by contract, with the syndicate manager appointed to exercise management duties.
There are no statutory requirements for such entities. Decisions may or may not be made in a democratic manner, and each syndicate member assumes responsibility for her income, expenses and tax consequences. Investors assume unlimited liability. It is important to note that a member's right to transfer her interest may be restricted. However, by carefully drafting the agreement, and allowing for operational flexibility and adjustments for changed circumstances, many potential pitfalls can be avoided and a syndicate can be a useful vehicle for ownership.
Generally speaking, a corporation is a separate legal entity. It is a separate taxpayer, filing separate returns and pays taxes at corporate rates. It can involve one or more investors or shareholders who, generally, are not at risk for corporate liabilities beyond their investment. Any corporate losses are "locked into" the corporation and cannot be used to offset other income of the individual shareholders.
This type of corporation represents a mix of corporate and general partnership characteristics. As with a C corporation, it can be comprised of one or more investors.
An S corporation generally offers three advantages: (1) shareholder liability is limited; (2) corporate income and losses pass through to the shareholders and are reported on their individual tax returns; and (3) investors can actively participate in the management decisions. S status is elected by the corporation and its shareholders by filing with the IRS. However, establishing the organization requires a professional's assistance and the associated costs could be significant in relation to the investment. Additionally, there are certain technical requirements for electing S status which cannot be met in every instance.
Limited Liability Company (LLC)
An LLC offers some of the desirable features of a corporation and a partnership, yet eliminates the normal restrictions. The LLC provides for pass-through tax treatment while maintaining limited liability, even for those who manage the business. Rules regarding allocation of gains and losses generally are more flexible than those pertaining to S corporations, and administrative requirements may be less burdensome.
LLCs are recognized in most, but not every, state. Rules regarding their operation and treatment vary. In some instances, it is possible for a limited liability company to be denied its pass-through tax treatment.
LLCs are becoming the entity of choice for many horse owners, but the decision to use this form should only be made after consulting your tax and legal advisors.
Limited Liability Partnership (LLP)
Although very similar to a general partnership, the LLP varies in that each partner is not vicariously liable for the wrongful acts of other partners. Only the partner or partners who performed the act that causes harm or incurs an expense are liable for its consequences. Furthermore, partners are able to actively participate in decisions if they so choose.
Pass-through tax treatment applies as it does with general partnerships. The main drawbacks are the administrative requirements and expense. Given that this form of business entity is a relatively new entity, it may not be recognized in all states. Therefore, the limitation of liability may or may not be effective when a limited liability partnership is operating outside the state in which it was created.