Since 2000, the IRS has nearly tripled the number of audits of tax returns filed by people making $25,000 to $100,000. Kevin Brown, the IRS deputy commissioner, stated that this is an effort to run a “balanced audit program.” Last year the number of audits in this category was approximately 436,000, up from about 147,000 returns in 2000.
However, for people with incomes above $100,000 the odds of being audited are about 1 in 59, and for people earning $1 million or more the odds of getting audited are about 1 in 16.
For people who operate farms or ranches that generate tax write-offs continue to be audited fairly often because the IRS regards these taxpayers as “vulnerable.” Any endeavor that has some elements of a “hobby” but which the taxpayer reports as a business, poses a red flag under the IRS hobby loss rule.
Recently, a new client wanted a tax opinion letter in connection with a newly formed farm venture. The husband told me that he and his wife have full time jobs as physicians, and that they decided to launch a farming venture--in this case cattle and some citrus trees--so as to provide them with a “tax shelter.” I told them that in order to pass IRS scrutiny, and in order for me to provide them with a worthwhile tax opinion letter, they would have to change their approach. The IRS looks to the “intention” of the taxpayer, as shown through various categories of evidence, and if the taxpayer says that the primary motive is to provide a “tax shelter” rather than a bona fide business, this will make things difficult.
If you embark on a new farming or ranching venture without prior experience, and without consulting with any experts on the business end of the activity, this tends to suggest that you are more concerned about tax avoidance than operating a profit-making activity. As one Tax Court case said, “While a formal market study is not required, a basic investigation of the factors that would affect profit is.”
In starting a new venture it is important to have some concept of what your ultimate costs might be, how you might operate at the greatest cost efficiency, how much revenues you could expect, and what risks could impair the generation of revenues.
Not long ago, the famous boxer, Joseph Frazier, bought a 365-acre farm near his childhood home, and moved his mother and other relatives there. He hired two full-time managers as well as several field hands. Mr. Frazier's mother worked on the property and assisted in most aspects of the farm operations. Mr. Frazier had an oral agreement whereby he would share any farm profits equally with his mother, but that he alone would be entitled to tax deductions for farm losses.
Mr. Frazier visited the farm only a few weeks each year, during which time he mended fences, repaired barns and corrals, fixed up the houses on the property, and worked in the fields.
A bookkeeper maintained financial and payroll records. Crops consisted of tomatoes, cucumbers, corn, peas, beans, squash, wheat, and soybeans. However, the soil was mostly clay, covered by a thin layer of top soil, and this resulted in low yields. The farm managers were unable to market the crops successfully, and the farm realized only $9,000 of income in a five-year period.
Mr. Frazier decided that, due to rising beef prices, it might be profitable to raise cattle in addition to planting crops, so he bought about 60 head of cattle. A setback soon occurred when a rare parasite disease took the lives of most of the herd.
The IRS said the farm was a hobby and denied his deductions. The Tax Court reversed the IRS and said that Mr. Frazier conducted the farm in a “relatively” businesslike manner. He made efforts to change methods of operation by planting different crops, and he attempted to raise cattle. The court said that much of the losses were due to events beyond Mr. Frazier's control. The court said that Mr. Frazier and other witnesses were highly credible and forthright in their testimony. There was no evidence of the farm being used for recreational or resort purposes.
The court said that clearly Mr. Frazier wanted to improve his mother's life by having her live on the farm, and wanted to give her an opportunity to share in farm profits. “Profit motive is not negated simply because a taxpayer derives a sense of satisfaction in providing for relatives, friends, or loved ones. The fact that petitioner's mother and some of his other relatives lived on the farm doesn't establish that the farm was not operated with an intent to make a profit.”
The court concluded that “the losses more accurately are explained in terms of an inefficient farming operation, and hindsight should not cause us to substitute our judgment for that of a taxpayer who, with his funds, ‘gave it a try.'”
In that case, the court was apparently convinced that the taxpayer had an honest intention of engaging in a business rather than a hobby, despite the fact that there was a significant history of losses.
[John Alan Cohan is a lawyer who has served the livestock, horse and farming 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.]