The farming, livestock and horse industries are facing challenges in hard economic times. These industries serve the economic lifeblood of millions of Americans, not only owners, but related industries and services as well. Casualties and setbacks from economic forces are recurring problems making it difficult to make a profit on a consistent basis.
The IRS has asserted the idea that owners are expected to “show how” you intend to profit monetarily from the activity if there are sustained losses. In other words, how are you going to be able to demonstrate that a profit will eventually be made from the activity? What sort of documentary evidence will you need to assemble? The IRS feels that taxpayers involved in farming, ranching or horses should have a definite idea as to how they are going to generate a profit, and this in turn will show that the activity is conducted with an “actual and honest objective of making a profit.” The IRS tends to grant greater weight to objective evidence than to the taxpayer's mere statement of intent.
It is often extremely difficult to prove a profit objective when the activity is part-time and where deductions are taken to offset income from other sources.
A higher standard of compliance has emerged in audits conducted by the IRS, particularly with regards to standards of recordkeeping and the formulation of a written business plan. For horse owners, for instance, the IRS will view the venture with skepticism when the owner has only a small group of animals with a bleak sales or racing record. If specific horses are developed for breeding or racing, the evidence must show that the animals in question have some “realistic potential” to prove themselves. It is not enough to prove that you took great care in selecting the particular breed or the specific bloodlines involved, or that you read about and researched the breed extensively, though these ingredients are presumed to exist. These same principles apply to livestock farming and agricultural farming.
In starting a new farming venture it is important to establish that you not only “discussed” the activity with experts in the field, but that these discussions dwelled on “how to profit from such an operation.” It is important to show that you conducted an “extensive study” of the business prior to entering into the activity, and developed a business plan. If the activity involves horses it is important to show a “regular training program conducted by qualified trainers.”
Often I hear from taxpayers who say that they are not operating a hobby, and that they keep receipts, invoices and canceled checks to verify the extent of their costs. This, however, is nothing more nor less than what any taxpayer is expected to maintain to help prepare tax returns. What is more important is to prepare monthly or quarterly financial statements with respect to the activity.
Any projections that indicate when you expect to turn a profit should be totally substantiated. The source of revenues must be based on objective planning rather than something in the nature of “wishful thinking.” If animals or crops are expected to earn you a profit this must be substantiated by objective evidence.
The activity need not be the taxpayer's primary occupation and rarely is. It has been called “foolish” for a taxpayer to give up other employment until he was sure he could support himself with the proceeds from farming or livestock. The fact that someone works full time outside of the activity does not imply that there is insufficient time to put into the farming venture. And the fact that a taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive, especially if the taxpayer employs competent and qualified persons to carry on the activity. Usually one can show that a limited amount of time devoted to the activity is supplemented by work done by experienced employees.
The IRS and the Tax Court will also consider whether taxpayers exhibit desirable business qualities in other endeavors. Thus, for example, in Daugherty v. Commissioner, TC Memo 1983-188, the Tax Court noted that the taxpayer possessed diligence, initiative, foresight, and other qualities that often lead to business success in concluding that he had reason to expect eventual success with the activity.
Often enough, the IRS or the Tax Courts will find “negative” facts and these will work against the taxpayer. Negative facts include the failure to consult experts in the field, failure to prepare any profit projections prior to commencing the activity, failure to keep logs of time expended, failure to maintain a separate bank account the activity, and records that appear to be shoddily prepared or prepared in “anticipation” of an audit or a Tax Court trial.
One of the best ways of showing that you are genuinely operating as a business is to have a professionally prepared business plan or to have a tax opinion letter from a tax attorney familiar with the industry to analyze your particular situation. This can assist in directing your activity away from its weaknesses and onto the right track in terms of complying with the strict standards discussed in the Tax Court cases. and IRS Regulations.
[John Alan Cohan is a lawyer who has served the farming, livestock and horse industries since l98l. He serves clients in all 50 states, and can be reached by telephone at (3l0) 278-0203 or via e-mail at JohnAlanCohan@aol.com. His website is at www.JohnAlanCohan.com.]