The IRS is focusing more on audits in the farming, livestock and horse industries in which taxpayers are claiming six figures or more in tax deductions. This often pertains to taxpayers who are employed full time in a profession, and operate the farm or other activity on a part-time basis, often relying on managers and contract employees.
These industries are quite varied in the methods of bookkeeping within each operation. IRS agents are required to use its internal manual, the Audit Technique Guide, in auditing taxpayers engaged in farming and in the breeding, raising, buying, and selling of livestock or horses. There are so many hurdles that, particularly in larger audits it is crucial to have experienced tax counsel or accountants participate in the audit. And as previously mentioned, the IRS will always want to know if you have a business plan or a tax opinion letter that helps support your intention to be engaged in an activity for profit.
As we know, these are volatile and dynamic industries. Domestic and international markets, weather conditions and disasters, medical and health considerations, and the interrelationship between livestock and its feed market are all contributing factors.
IRS agents in these audits are supposed to familiarize themselves with the industry so that they can analyze the information encountered during an audit. IRS agents are asked to search articles of interest in magazines and journals, and they are referred to the service offered by the Lubbock County Library in Texas, which provides articles from 12,000 industry publications.
What the IRS looks to first and foremost are financial records.
IRS employees are advised to look for clues on underreporting of income. According to the manual, “The most successful rancher may fail to disclose all income because of the accompanying income tax benefits. Farmers having a very good year with a sudden turnaround just before filing time may be dealing with a cash flow crunch.”
Auditors are told that the “use of multiple bank accounts with reliance on the bank records for reporting purposes lends itself to misreporting due to exclusion of some records. Watch for transfers to/from savings, money market, and investment accounts or certificates of deposit. Any deposits from non-taxable sources, e.g. return of previous investment, should be traced to the source of the originally invested funds.”
Auditors are asked to watch out for “atypical” sales of livestock, particularly sales with no documentation.
The IRS suspects, in general, that farmers and ranchers commonly report personal expenses as business expenses. “All aspects of a farmer's life is centered around the crop or animal and is therefore easily considered to be financially related to the business. Customarily, you will find personal expenses in insurance, gasoline, interest, taxes, utilities, and repairs.”
Another concern involves contract labor. The farming industry is labor intensive throughout its production cycle. Farm Labor Contractors are required to be licensed by some states (check with your local state requirements).
The auditor will compare the wage expense to gross receipts. The taxpayer is expected to meet the Social Security Taxes, Medicare Taxes, FUTA Taxes, SUI Reserve Fund, and Worker's Compensation. The auditor will want to verify that the wages and payroll taxes were paid. The auditor will see if you filed Form 943 “Employer's Annual Tax Return for Agricultural Employees” and Form 940 “Employer's Annual Federal Unemployment (FUTA).” The auditor will want to verify that all payroll taxes have been paid.
There are numerous federal and state laws requiring the registration of farm labor contractors. This is a complex subject beyond the scope of this brief article. But the IRS will interpret any defect as implying you are not operating in a businesslike manner.
Farmers often write a number of checks in the last few days of the tax year to pay expenses. The IRS tends to focus on large disbursements, and decides if these are a payment or a deposit. In general, a deposit to be applied against a future expense is not deductible. Although a check is written, no deduction is allowed until the expense is actually incurred. The issue arises when the seller treats the farmer's payment as a deposit and does not report the amount paid by the farmer as income. However, the farmer takes the amount paid as an expense. This is common in the farming industry for fertilizer, feed, grain, etc. The IRS also looks for excessive deductions for prepaid farm supplies.
Advance planning is the best way of getting through an IRS audit without incurring a deficiency notice. Unfortunately, the majority of taxpayers do not take adequate steps to protect themselves, and this is of increasing concern in light of more aggressive approaches by the IRS.
[John Alan Cohan is an attorney who has served the farming, livestock and horse industries since 1981. He can be reached at 310-278-0203 or via e-mail at JohnAlanCohan@ aol.com. His website is John AlanCohan.com.]