Understanding tax laws and guidelines can help you avoid unexpected tax consequences on your small farm or ranch.
“Your tax return has been selected for examination by our office.”
These are words that no taxpayer wants to read from either the Internal Revenue Service (IRS) or the Alabama Department of Revenue (ADOR). The following scenario involves a state tax audit. It was a familiar one with a sad ending.
- Husband and wife owned and operated a small cattle farm.
- They both had full-time off-farm employment.
- Their state and local tax returns showed the farm losing money for each of the last ten years, as reported on their sole proprietor Form 1040, Schedule F, Farm Tax Return.
Initial Finding by Auditor: Farm is not business, but hobby. Hobby tax losses are not allowable on all tax years under examination. Taxable income increased by the amount of tax losses. Additional prior year taxes and possible interest and penalties are due upon completion of the audit.
The auditor’s findings could have been avoided if the farmer was knowledgeable of the guidelines published by the IRS and the Alabama Department of Revenue for all small businesses, which includes small farmers and ranchers.
The Internal Revenue Service Code Section183 (d) deems that the taxpayer enters into an farming activity for a profit and can deduct all related business expenses if the business makes a profit three out of five consecutive years. If breeding, training, showing, or racing horses, it is considered a for-profit business if a profit is made in two out of seven consecutive years. When this threshold of profitable years is not met, the taxpayer has the burden of proving that he or she entered the farming activity with a profit motive. Taxpayers should not single out one factor to determine whether the business is for profit, because the IRS takes all of the following points into consideration.
The 2018 edition of IRS Publication 535, Business Expenses and IRS Publication 225, Farmer’s Tax Guide list the following nine items as determining factors in whether a business is a not-for-profit activity.
- You operate your farm in a businesslike manner.
- The time and effort you spend on farming indicate you intend to make it profitable.
- You depend on income from farming for your livelihood.
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of farming).
- You change your methods of operation in an attempt to improve profitability.
- You (or your advisors) have the knowledge needed to carry on the farming activity as a successful business.
- You were successful in making a profit in similar activities in the past.
- The farm makes a profit in some years.
- You can expect to make a future profit from the appreciation of the assets used in farming.
The Alabama Department of Revenue has similar criteria for determining whether a farming activity is engaged in for a profit. The ADOR nine factors to consider are shown in the left column of the following table. The facts or answers given by the farmer to the auditor during the audit are shown in the right column of the table.
|ADOR Guidelines Used by the Auditor||Farmer’s Answers to Auditor|
|1. Manner in which the activity is conducted.|
• Maintenance of checking accounts separate from personal accounts.
• Presentation of a formal written business plan.
• Preparation of budgets.
• Maintenance of business books and records.
|• Farmer had no separate checking account for farm (personal and farm funds intermingled) |
• No business plan.
• No annual budget.
• No books and records other than checkbook and bank statements with sack of receipts and expenses for tax preparer use at end of year.
• No financial statements other than tax return.
• Established business based on extended study of similar businesses and consultation with experts, which indicates a profit motive.
• Personal background in activity.
|• Member of state cattlemen association. |
• Regularly read and studied cattle publications.
• Had not consulted with Extension cattle specialist or other cattle consultant on improving operations since mid-1990s.
|3. Time and effort expended in carrying on the activity.|
• Significant percentage of time devoted to activity.
|• Farmer and spouse both had full-time off-farm employment. |
• Farmer was required to document the amount of time they spent in ranch business to establish how active they were in farming.
|4. Expectation that assets used in activity may appreciate in value.|
• The taxpayer may intend to derive profit from the increase in value of assets even though there may not be a short-term annual profit.
|• Initial land was inherited. |
• More land had been rented to expand herd.
|5. Success in carrying on other similar or dissimilar activities.|
• Financial success in other activities.
|• Husband and spouse nonfarm jobs were not in agriculture. |
• Neither had any experience owning any other successful small business.
|6. History of income or losses with respect to the activity.|
• Series of losses indicates lack of profit motive.
• Is there any indication of a trend toward profitability?
|• Farmer had ten years of losses in farming with no reported profits. |
• Farmer could not satisfactorily answer question: Why would a reasonable person stay in business for ten years with continuing losses?
|7. Amount of occasional profits, if any, which are earned.|
• Occasional substantial profit indicates profit motive.
• Profits should be in line with time and financial investment in the activity.
|• No profits reported by farmer in ten years. |
• Farmer’s and spouse’s W-2 reported wages from off-farm jobs subsidized farm losses.
|8. Financial status of the taxpayer.|
• Substantial income from other sources may suggest that the activity is not engaged in for profit especially if there are personal or recreational elements involved.
|• W-2 nonfarm earnings had subsidized cattle operations for multiple years with no reported profits. |
• Taxpayer and spouse reported that they enjoyed raising cattle and living in a farm environment for themselves and their children.
|9. Elements of personal pleasure or recreation.|
• Presence of personal motives other than profit.
• Potential to continue the activity without ever making a profit.
|• Farm lifestyle was preferred by both taxpayer and spouse. |
• Farmer had ten-year history of no profits and no plans before the audit of discontinuing raising cattle.
In comparing the ADOR guidelines used to determine whether this farm was operated as a business or as a hobby, the auditor determined that this farm was a hobby with no profit motive and that farm losses on the tax returns were disallowed for all years under examination.
The IRS and ADOR guidelines for business activities compared to the facts presented by the farmer during the audit clearly failed to meet most of these guidelines. This situation is not uncommon. Following are suggestions for any farmer or rancher to consider.
- Get the facts. Read the appropriate tax publications.
- Understand the state financial and political environment. If taxes cannot go up, one option to increase revenues is to more stringently enforce existing tax regulations.
- Recognize that sole proprietor farmers and ranchers are considered self-employed small business owners, with significant opportunities to underreport taxable income and use farms as a tax write-off to reduce or avoid tax on nonfarm income.
- Strongly consider seeing a tax preparer before each year-end to review year-to-date sales and expenses for tax planning purposes, particularly if you have not reported any Schedule F profits in the last four years.
Consider whether this scenario sounds like you and your situation. If so, contact Alabama Extension educators who can provide resources and assistance.
Useful IRS Publications
IRS Farmer’s Tax Guide (IRS Publication 225) explains how federal tax laws apply to farming. https://www.irs. gov/pub/irs-pdf/p225.pdf
IRS Business Expenses (IRS Publication 535) discusses common business expenses and explains what is and what is not deductible. https://www.irs.gov/pub/irs-pdf/ p535.pdf