With an abundance of change within the Internal Revenue Code, many individuals are turning towards part-time farming (or at least owning a farm) to claim some additional business deductions and minimize his or her tax burdens. While this seems like a miraculous solution to many individuals, it can end up being a burden on the taxpayer if the farm is considered a “hobby farm,” contrary to a business farm.
Farming, like any other business, is simply that: a business. Technically, a farm is a business that undertakes farming activities and produces income, of which is reported on the farmer’s Schedule F of Form 1040. Tread lightly, however, because the farm may lose its business flavor if certain steps are not taken to ensure that the farm is not simply a “hobby.” Under section 183 of the Internal Revenue Code, if the individual’s activity is not engaged in for profit, deductions, other than the ones specified within section 183(b), shall not be allowed. Taxpayers that may have significant income from other sources have the potential to reduce his or her taxable income by reporting losses from activities that may or may not be engaged for profit. Therefore, the IRS may use section 183 to change the activity from a business to a not-for-profit hobby and disallow many deductions (as would otherwise be deductible for businesses under section 162 trade or business expenses).
Section 183(d) lays out a presumption: if the farming activity shows a profit for three out of five consecutive years (or two out of seven consecutive years for horse breeding, training, showing, or racing), the IRS will presume that the farm is a business and the taxpayer is allowed to take the appropriate deductions. If the taxpayer meets these strict profit requirements, the burden is on the IRS to prove that the taxpayer is not running a hobby farm. So, it is still possible, even if you clearly meet the presumption, for a taxpayer to be audited by the IRS for hobby farming: but the burden is on the IRS.
Although this is a rather black and white presumption, if the taxpayer lacks the requisite profits, the burden shifts to the taxpayer to use nine factors, provided by the regulations, to show that the activity is a business. Whether or not the activity is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. These nine factors described from Reg. § 1.183-2(b) are:
The taxpayer should carry on the activity in a businesslike manner and maintain complete and accurate books and records indicating that the activity is engaged in for profit. Although the presence of books and records does not automatically indicate that the business is for profit, an examiner needs to document how these records are used by the taxpayer. The examiner will look at whether the taxpayer created any business plan, and if the taxpayer followed such plan.
A taxpayer should prepare for such an activity by extensively studying its business, economic, and scientific practices, or at least consult with an individual that is well prepared. If a taxpayer has such preparation, but does not carry on the activity with such practices, however, a lack of intent to derive profit may be indicated. The examiner may document the expertise and knowledge of the taxpayer with regard to the activity.
If the taxpayer devotes much of his or her personal time to the activity, especially if the activity does not have substantial personal or recreational aspects, there is more evidence of an intention to derive a profit. Should the taxpayer withdraw from another occupation to devote time towards the activity is evidence towards a for profit business. On the other hand, if the taxpayer only devotes a small amount of time towards the activity, it is not necessarily a lack of profit motive if the taxpayer employs competent qualified people to carry on such a business.
A taxpayer may intend to derive such a profit from the operation of the business or from the overall result in the value of the land is realized during a sale of the actual land at the end of the activity. This factor is the most difficult to determine, but taxpayers are generally successful because of the potential for land appreciation. Be cautious, however, because receipts and evidence should indicate the purpose behind offsetting any current losses against future asset gain potential.
If the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate a desire for this activity to be a for profit activity, even if it is not currently profitable. An examiner will focus on the financial successes that the taxpayer had with other activities and a statement should address specific instances if the taxpayer has previously abandoned any activities.
If there are a series of losses during the initial stages of an activity does not necessarily indicate that the activity is a hobby. However, if the losses are sustained beyond the period for which are customarily necessary, and if such losses are not explained, it may be indicative of an activity that is not for profit. Should the activity sustain multiple losses due to unforeseen circumstances, there is not such an indication. If there are a series of years in which net income was realized, it creates strong evidence that the activity is a for-profit activity.
The amount of profits in relation to the amount of losses incurred, and in relation to the initial investment and value of assets used in the activity, may provide the criteria needed for the taxpayer’s intent. Occasional substantial profit will possibly indicate that the activity is engaged in for profit, even if there are continuous losses. An examiner will consider the amount of occasional profits the activity will generate.
If the taxpayer does not have substantial income or capital from sources other than the activity, the activity will indicate more of a for-profit activity. Should the taxpayer have substantial income from other sources, the activity may indicate a type of shelter, especially if there are personal or recreational elements to the activity. Overall, taxpayers that have substantial income have the financial wherewithal to sustain a history of losses with respect to not for profit activities.
An examiner will address any pleasurable and recreational aspects of the activity after developing an understanding of the taxpayer’s activity. The presence of any personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit. However, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if many of the other factors are met.
No single factor controls, however, many courts give more weight to objective factors rather than the taxpayer’s intent. These factors may be used as evidence that the farming operations are not mere hobbies, even if it is consistently creating a loss. This determination can not only affect the taxpayer’s deductions, but also: self-employment tax, deductions for health insurance premiums, alternative minimum tax, itemized deductions, adjusted gross income, and Roth IRA contributions.
If an examiner believes that the activity is possibly not engaged in for profit, the examiner is required to adequately address each of these nine factors. Therefore, a taxpayer that plans on keeping his or her farm a business, should consistently keep records and evidence providing for each factor.