By June Henderson, CPA

The IRS “Hobby Loss” provision applies to individuals, partnerships, LLCs filing as a partnership and
S-corporations. If you are a farmer or rancher, you should learn more about how this provision may affect you. The tax code provides that Hobby entities are not allowed to deduct expenses in excess of income from an activity which is not engaged in for profit.

Whether an activity is a business or a hobby depends upon whether or not the taxpayer entered into the activity with the objective of “making a profit”. For farmers and ranchers who have other income sources not related to your farming activity, building a case that you are in the cattle or horse business with the intent of making a profit is very important.

Should your farm or ranch fall into the category of being profitable for two out of seven years, your business would be presumed to be a business and not a hobby. But, keep in mind that the “two profit years out of seven” rule is a presumption and not a safe harbor. Without proper planning and recordkeeping, the IRS could still reach the conclusion that your activity is a hobby rather than a business.

For example, the horse industry has suffered declines over the past 6 to 8 years. If you invested in putting together a good band of brood mares and selected prime breedings for those mares, there has been little opportunity to recover those costs or to “profit” from these activities. There are no rules related to how many horses an entity should own in order to qualify as a business. But, in order to preserve the objective of making a profit, you should be wary about investing so much that you have little hope of recovering your investment through winnings, services revenues or sale of horses. Fuel prices, costs of feed and hay have risen over the past few years while the average sale price of the horse has fallen. Due to these conditions, many horse-related businesses are experiencing losses spanning several years. How do you best insure that your losses will not be looked upon as “Hobby Losses” by our taxing authorities?

There are nine important factors to consider in determining whether the owner of an activity intends to make a profit.
1. The manner in which you carry on the activity
2. Your expertise or that of your advisors
3. The time and effort you spend in carrying on the activity
4. Your expectation that the assets used in the activity will appreciate in value
5. Your success in other similar or dissimilar activities
6. Your history of income or losses with respect to the activity
7. The amount of occasional profits, if any, which you have earned
8. Your financial status
9. Any personal pleasure or recreation you may have experienced

What are the best practices to establishing proof that your farming/ranching undertaking is “for profit”?
Planning for profit years is important. You might shift revenue and expenses from one year to another, such as paying two years of property taxes within one reporting year, or holding onto livestock for sale and grouping the sales within one reporting year which may make the “sale” year more profitable.
Selling horses, cattle or breeding rights, leasing broodmares or purchasing cattle embryos are tactics to shift revenue and expenses in order to plan for a “profit year”.

Consistently using straight line depreciation is also a good practice that can be used when planning for profit years. This does not affect the overall profitability of your business activity, but could help you qualify for the two out of seven year profit conditions.

Farmers and ranchers should always try to operate in a manner which indicates there is a profit motive. The creation of a business plan is one of the top recommendations along with the development of an annual budget. Also recommended is that owners keeps a daily, weekly log or “diary” in which issues that affect profitability can be recorded. Documenting issues such as livestock related accidents, failed breedings, illness, disease or changes in the way you do business can prove to be important should there be an audit. It is also difficult to remember these issues years later if not documented.

Record keeping is key.
Keeping a good set of books and operating with businesslike methods is one of the most important steps that you can take. In the past IRS evaluations have had positive outcomes if the farmer had prepared budgets and operating procedures which forecasted that the operation would be profitable even if the profits did not come to pass.

For farming/ranching operations, a lack of a business plan, a budget or projections for future profits can be damaging. It is a good practice to have a written plan. It is also easier to follow your plan if it is written and it is also much easier to explain your plan should the IRS evaluate your business.

Your business plan should provide details such as anticipated profits from future sales of animals, crops or leases as well as plans, for the purchase of future income producing assets such as replacement heifers or herd bulls.

Another thing to keep in mind is the concept that farming and ranching assets may be expected to appreciate. The term “profit” includes appreciation in the value of assets, including your land.
If little profit is realized from your ranching operation, perhaps an overall profit might occur from the increase in value of the land, livestock or other assets used in the business.

Failure to meet the “for profit” requirements are often related to investigations or audits in which case the taxpayer did not have counsel. As with any business undertaking, you should seek legal and financial advice about the economics of your activity. Even though you may be quite experienced with the aspects and undertakings of your ranching operation, seeking and following the advice of a professional is valid documentation that your intent is to improve the financial outcome of your business.

###