A great number of companies do not make a profit, but instead have operating losses for an extended period of years. Of companies that have decided to start selling stock to the public in initial public offerings (IPOs), about 75 percent of them have never made a profit. Their newly issued stock is being bought in droves--and is somewhat akin to buying lottery tickets, in my opinion.
Many people do not make a profit in their farming ventures -- and the IRS is well aware of this fact. For most farmers and ranchers, the activity is not the taxpayers' primary occupation. One Tax Court case said that it would be “foolish” for a taxpayer to give up other employment until he was sure he could support himself with the proceeds from farming or livestock.
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 people 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 such as trainers or farm managers.
However, even the most considerate and compassionate IRS agent will still want to see evidence that your farm or ranch is operated “with the intention” of making a profit if profits are not forthcoming. Livestock and other farming ventures should be operated basically in the same way as other businesses, utilizing business principles and judgment in decision-making, and maintaining appropriate books and records. More so now than in the past, the IRS looks for objective facts and documentary evidence in addition to self-serving statements of the taxpayer.
The IRS is particularly interested in how you keep books and records of the activity. One case described the importance of proper books and records this way: “The purpose of maintaining books and records is more than to memorialize for tax purposes the existence of the subject transactions; it is to facilitate a means of periodically determining profitability and analyzing expenses such that proper cost saving measures might be implemented in a timely and efficient manner.”
Often a livestock or other farming activity will start out as a hobby, and then the taxpayer will decide to transform the activity into a business. The difficulty here is documenting the shift from a hobby to a business. It is important to show that the taxpayer conducted research and investigated the feasibility of making this change.
Attorneys who specialize in tax law frequently issue what we call tax opinion letters to people in various activities--to help the client go into a venture, or continue operating a venture, in accordance with tax law.
A tax opinion letter is like an insurance policy, but more than that it also helps guide you in how you go about conducting your livestock or other farming activity. If you are audited, the tax opinion letter is documentary evidence that you have sought out expert advice on how to operate the venture in a more profitable manner, consistent with tax guidelines.
Under tax law for farming and ranching activities, the taxpayer has the burden of proof to show that the activity is engaged in for profit, unless it can be shown that there are two profit years in a five-year period. Since many audits are conducted in the early part of the startup phase, it is not yet possible to show a profit, but the IRS will still try and find reason to declare that the venture is a hobby.
Many of my clients obtain a tax opinion letter from me in order to help withstand IRS scrutiny in the event they are audited. Of course, it is never possible to predict how a situation will turn out in the event of an audit, but a properly drafted tax opinion letter can be a credible source of evidence that you sought out expert advice and that you followed the advice given. Also, in cases where tax opinions are rendered by a tax attorney, the IRS will be reluctant to impose penalties should the taxpayer end up being denied the tax deductions sought.
Other issues addressed in the tax opinion letter may pertain to whether the client ought to change the manner of doing business, whether the business entity structure is appropriate for the situation, whether there can be cost-savings methods generated, and whether the business documents used by the taxpayer are in proper form.
[John Alan Cohan is a lawyer who has served the livestock and farming industries since 1981. He serves clients in all 50 states, and can be reached by telephone at (310) 278-0203 or via e-mail at email@example.com.]