Excessive business deductions by livestock or general farmers, or horse owners— or for that matter, most any other business—trigger IRS audits. If you are audited in connection with any farming, livestock or horse activity, the IRS will usually start with one tax year and then look back or forward for other years to see the history of losses or profits.
If audited, it’s crucial to have documentary evidence, not only to substantiate the deductions, but to show how they relate to your venture and how the records help prove that you are operating in a businesslike manner.
For most people, the IRS will want to know how you have the time to operate the activity alongside your principal occupation. Most people have day jobs that provide their principal source of income, and they attend to farm activities in the evenings, weekends and in other free time. It is helpful if you maintain a time log that shows, week by week, the amount of time you put into the venture and what you did.
There are several practical points that one should observe in connection with an audit of any kind:
1. First you should have your representative (an accountant, CPA, or sometimes if the stakes are large, a tax attorney) find out what the IRS agent is looking for. Sometimes there may simply be some minor discrepancies that are in issue. Often, the IRS will issue a Document Information Request that details what needs to be gathered together.
2. If your business records are not quite in order, be sure to straighten them out so they are in a presentable format. If you have a corporate minute book, for instance, make sure it has been updated. Make sure that any licenses and permits are in order.
3. Only provide those documents specifically requested.
4. If the IRS agent wants you to “waive” the statute of limitations, this is usually not advisable. There is no benefit to giving the IRS more time or opening up further opportunities for them to make a fishing expedition out of your tax returns.
5. Assuming you have a representative, it is usually better to let him or her meet with the auditor alone. Your presence is not required and could give the agent an opportunity to try and trip you up with difficult questions that really need to be analyzed before responding.
6. The agent might want to know if you have an “exit strategy” in the event you experience continuing losses. It will be helpful to have a written business plan that shows how and when you expect to turn a profit.
7. It is helpful if you can show that you have done things to develop the farmland, rehabilitated dilapidated structures, installed new fencing, refurbished or built new barns, enhanced irrigation and water access, and so forth. If the property had appreciated in value, it is helpful to provide a formal appraisal.
8. The agent will probably look for “recreational elements” to try and show that the activity is really something of a pleasure farm rather than a real effort to make money.
9. Keep in mind that the agent is not exactly an enemy, but at the same time, he or she has the overriding purpose of raising revenue and looking for any opportunity to deny tax deductions. If your deductions are denied, the agent will issue a written report detailing that the activity is “not con ducted for profit.”
Often it is necessary to educate the IRS agent on your particular area of farming, livestock or horse breeding to help him or her understand how money can be made in this field and the challenges to overcome.
If you do not prevail in the year selected for audit, the IRS will almost always proceed to audit further years that are still within the statute of limitations (three years from date of filing).
As previously discussed in this column, it is never advisable to concede an audit, but to fight it in IRS Appeals or Tax Court where you are likely to get a better outcome. — John Alan Cohan