Those who are just beginning the farm operation or those who are slowly withdrawing from it would do well to familiarize themselves with the Internal Revenue Code § 183 "Activities Not Engaged in for Profit", occasionally referred The "Horse Shelter" or Hobby Loss Rules.
This code section is designed to prevent tax payers from claiming business losses (and thereby reducing income available for taxation) on activities that the tax payer 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 has historically found this a difficult area to litigate in, but has developed training manuals and policies to help examiners who may have no knowledge of farm operations, in order to ensure compliance with the Internal Revenue Code. A review of the training manual shows the IRS attempts to familiarize its agents with the world of competitive show animals, but also the distinction between registered herds of cattle and commercial herds of cattle. The manual advises 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, and each one is briefly examined below.
1. Books and Activities maintained. The examiner will review the level of sophistication of the records, notably if the enterprise has a separate check book from the personal living expense check book of the tax payer. The mere presence of records is not enough, the tax payer must show it 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 economic forecast for the enterprise, that 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 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 tax payer in order to achieve profitability. A good example of this is documentation of Iowa State service programs and publications consulted and demonstrable selection criteria for genotype of seed or breeding stock selected and retained. If the tax payer has failed to heed advise to change operations without a justification (like lack of funds to change), this will cause concern on the part of the examiner. Likewise, if the tax payer devotes little time to an activity but generates a large loss, it will attract scurnity.
4. Disguised expenses. Consider for example, over zealous advertising via "Vanity ads" will attract the attention of the examiner. Consider the true purpose of any advertising spent by the operation. An ad with a picture of a child and horse wishing luck to the tax payers children in the upcoming horse show is not viewed usually as a legitimate business expense.
5. Potential for increase in the value of assets. If a business is showing a loss, but can demonstrate that its assets (like land) will increase due to the business activity over time, it may help appease examiners concerns of hobby loss. The intent to capture the increase in value must be demonstrated as well.
6. Tax Payers success in other activities. A tax payer with high profitability in side line restaurant who yearly loses large amounts on cattle production because of high expenses will be scrutinized to determine if his best efforts are also being applied to the cattle operation. Additionally, a tax payer with substantial sources of income have not faired with the Tax court.
7. Pleasure element. The IRS training manuals warn its 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 the inputting of crop, attending to calving and foaling at all hours of the night and enduring the elements is not normally undertaken without a profit motive. And the internal revenue service does not mandate that tax payers cannot enjoy their income production. However, passion with out profit paints the picture of an enterprise not undertaken for profit.
Much of this can be avoided by showing a profit. A presumption in the law indicates that a profit once every certain number of years depending on the enterprise, shows the activity is engaged in for profit.
The bottom line is to ensure that business losses are legitimately related to the pursuit of profit. A court once noted, hogs get fat, pigs slaughtered. The message of the court has application in tax preparation as well.