Those who are just beginning a farm operation or food business, those who work off-farm or those who are slowly withdrawing from farming would do well to familiarize themselves with the Internal Revenue Code § 183, “Activities Not Engaged in for Profit,” occasionally referred to as “The Horse Shelter” or “Hobby Loss Rules.”
IRC § 183 is designed to prevent taxpayers from claiming business losses (and thereby reducing income available for taxation) on activities the taxpayer primarily engages in for recreation, entertainment and personal enjoyment, rather than a legitimate business purpose. Specifically, horse farms and cattle operations of small sizes are eyed with greater scrutiny.
The IRS trains its Section 183 examiners (who may have no prior knowledge of farm operations), to use manuals and policies to familiarize its agents with everything from the world of competitive show animals, to the distinction between registered and commercial herds of cattle. Several factors are considered by these examiners, and knowing what agents look at can help you make important decisions about your farm’s business activity and record-keeping.
The IRS agent-training manual advises Section 183 examiners to consider calculating the volume of feed purchased versus animals sold, to ensure no under-reporting of income, such as cash sales.
Several factors are reviewed by the IRS, each briefly examined below:
1. Books and Activities Maintained: The examiner will review the level of sophistication of the records, namely if the enterprise has a separate checkbook from the personal living expense checkbook of the taxpayer. The mere presence of records is not enough; the taxpayer must show that he or she is relying on the records to make decisions and changes to the operation to make it profitable, not just to satisfy, for example, a breed association records-keeping requirement.
2. Business Plan: The examiners want to review a formal, written business plan, demonstrating realistic growth and an economic forecast for the enterprise, which, if successful, would result in a viable operation. Relying on occasional profits or windfall activities, such as only being profitable in the event of twin colts, for example, fails to meet the concept of a solid business plan.
3. Methods and Efficiency of the Operation: The IRS will review the use of experts or specialists by the taxpayer in order to achieve profitability. A good example of this is documentation of Cornell Cooperative Extension programs, publications consulted, and demonstrable selection criteria for genotype of seed or breeding stock selected and retained. If the taxpayer has failed to heed advice to change operations without a justification (such as lack of funds to change), this will cause concern on the part of the examiner. Likewise, if the taxpayer devotes little time to an activity but generates a large loss, it will attract scrutiny.
4. Disguised Expenses: An example of this might include overzealous advertising via “vanity ads.” This will attract an examiner’s attention. Consider the true purpose of any advertising spent by the operation. For example, an ad with a picture of a child and horse, wishing luck to the taxpayer’s children in the upcoming horse show is not usually viewed as a legitimate business expense. On the other hand, advertising an upcoming cattle sale be an legitimate advertising expense.
5. Potential for Increase in the Value of Assets: If a business is showing a loss, but can demonstrate that its assets (e.g., land) will increase due to the business activity over time, it may help appease an examiner’s concerns of hobby loss. The intent to capture the increase in value must be demonstrated as well.
6. Taxpayer’s Success in Other Activities: A taxpayer with a high profit margin in a sideline restaurant, who annually loses large amounts on cattle production because of high expenses, will be scrutinized to determine whether his best efforts are also being applied to the cattle operation. Additionally, taxpayers with substantial sources of income have generally not fared well in tax court.
7. Pleasure Element: IRS training manuals warn examiners not to be lulled by the argument that farming is a drudgery, though case law supports the concept that devoting hours upon hours to crop input, attending to calving and foaling at all times of the night, and enduring the elements is not normally undertaken without a profit motive. And the IRS does not mandate that taxpayers cannot enjoy their income production. However, passion without profit paints the picture of an enterprise not undertaken for purposes of profit.
Showing a profit can help you avoid much of this kind of searching IRS analysis of your business deductions. A presumption in the law indicates that a profit once every few years, depending on the enterprise, shows the activity is engaged in for-profit enterprise. Consider this example:
The lesson to take home for part-time farmers is to:
- Make sure you have a separate checking account;
- Visit a Cornell Cooperative Extension seminar or a field day (and make a record of attending);
- Make a record of your consultations with herd improvement, crop consultants or area managers of service providers regarding your enterprise;
- Have a written business plan on how you intend to make profit at your endeavor; and
- Consider how you can manage your taxes to show a profit approximately once every five years.
This is an excerpt from my book that I co-authored with Pat Dillon, an Iowa food and agriculture lawyer. You can purchase a copy of the book “Field Guide: Legal Guide for New York Farmers and Food Entrepreneurs” on Amazon.com.