Enforcement action by the Internal Revenue Service (IRS) has actually increased in recent months in the farming, horse and livestock fields, partly due to the need for the government to raise revenue, and partly due to an increase in taxpayers failing to file tax returns or failure to pay taxes owed. One of the principal problems with getting audited is that the IRS considers losses to be a red flag for the idea that you are operating a hobby rather than a business in the farming, horse and livestock industries, particularly if you have a principal occupation other than farming.
Some people have contacted me because they have been assessed substantial deficiencies by the IRS after years of losses, despite the fact that they had never been audited in the past. Eventually, the IRS will want to take a look at your operations if there is a significant history of losses.
Despite losses, the tax laws entitle you to engage in any field of endeavor, however speculative, as long as it is your intention to be engaged in a business. Without the tax writeoffs, many people would not be able to carry on certain ventures, particularly farming, horses and livestock. I find that most people do have the intention to eventually make a profit, but from the IRS standpoint, it is the taxpayer’s burden of proof to dispel the idea that the main motivation is to generate tax benefits or to engage in a hobby.
IRS regulations state that if you don’t have two profit years out of five for farming and livestock, or two profit years in seven for horses, your activity is presumed to be engaged in as a hobby, not a trade or business.
One of the main hurdles new clients tell me about is that they have no business plan and that the IRS thinks their records are not kept in proper form. I usually prepare a tax opinion letter for clients, almost all of whom have done well with IRS audits, so as to help them show a profit motive according to tax regulations.
Where a taxpayer with no prior experience enters into an activity, that taxpayer must show not only that advice was obtained in the particular area of endeavor, but also that general business advice was obtained.
In the Tax Court case Filios v. IRS, the Tax Court said that Louis Filios of Springfield, MA, “did not have budgets, income statements, balance sheets, income projections, or financial statements for the activity,” other than those compiled annually by his accountant to prepare annual federal tax returns, and that he was not engaged in his activity for profit. The lack of these kinds of records could be a problem for many ranchers whose overall business records often fall short of this standard.
The IRS is looking for better records that indicate a profit motive, such as records used for the purpose of cutting expenses, or those that can be used to help increase profits and evaluate the overall performance of the business on an ongoing basis.
Another frequent concern of the IRS is whether the taxpayer’s method of operations continues unchanged despite a long period of losses.
Also, the IRS wants to see evidence that favorably compares your activity to a profitable livestock, horse or other farming venture, which means more careful strategic planning. The IRS looks favorably on changes in procedure or looking for other ways to make profits to attempt to override losses.
Finally, the IRS is now emphasizing that you should prove that you yourself possess the requisite expertise regarding the business end of the activity, or that you have relied on the advice of others who possessed that type of expertise. Although you may study and consult experts regarding the technical and scientific aspects of farming, that is not enough. It’s further necessary to seek expert advice regarding the economic or business aspects of the activity. If you have developed economic expertise of your own, it’s important to be able to prove this. Mr. Filios spent between 10 and 20 hours per week engaged in ranch operations.
He subscribed to various industry publications, and read numerous books on breeding strategy. He was a pioneer in using vitamin and mineral supplements as part of the diet for his animals. He personally decided which vitamins and minerals to use, and mixed them himself. But the Tax Court agreed with what the IRS had pointed out, that he did not keep records show in which vitamins or minerals went to which particular animal. In cases where the IRS is against you, there are invariably many issues, some which come across as trivial, that the IRS asserts to attack your position.
The taxpayer signed all checks relating to the activity. A bookkeeper kept his records. She prepared annual summaries and spreadsheets showing disbursements by category, and verified the accuracy of charges and statements charged to the taxpayer.
Despite all this, the Tax Court found fault with almost everything, including the fact that expenses should have been kept on each animal individually, and that Mr. Filios, to quote the court, “never conducted written business studies” for his activity.
Similarly, he never prepared a written business plan or budget for the activity. The court concluded that “the sheer magnitude of petitioner’s losses, the consistency with which they were incurred, and their steady and dramatic increase over an extended period of time provided compelling evidence” that he was not engaged in the activity for the purpose of earning a profit. “A record of continued losses over an extended period of time is plainly relevant in discerning a taxpayer’s true motivation.”
— John Alan Cohan [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, or visit his Web site at JohnAlanCohan.com.]