Preface: Hobby loss rules are applicable to small activities, i.e. hobby farms. The following blog is pertinent to those who would like to deduct expenses on say small flock activities in the backyard.
Farm Hobby Losses Are an IRS Audit Risk
Credit: Jacob M. Dietz, CPA
Do you operate a small farm in addition to your main source of income? If so, does profit motivate your small farming operation? The answer to that question may determine how the farming operation is taxed. The question is not “is the farm profitable” but “is there a profit motive?” The tax law limits deductions for farms with no profit motive under the hobby loss rules. If you operate a small farm with a profit motive but no profit, then know what a hobby loss is, learn what the IRS factors into its decisions, and act to avoid the hobby loss classification.
Although the term hobby is frequently applied to the rules limiting deductions when there is no profit motive, the activity doesn’t need to be pleasurable. A taxpayer cannot escape the hobby loss rules by explaining that dealing with a frozen watering hose in winter is not pleasurable. The key is lack of a profit motive. Someone running a small farm on the side who never tries to turn a profit appears to lack a profit motive. On the other hand, a farmer sincerely motivated to make a profit but who suffers a loss due to crop failure is not a hobby loss farmer. The profit motive was there even if the profits weren’t.
So how does the IRS determine if there is a profit motive? The IRS lists some factors to determine if there is a profit motive. These factors are:
“You carry on the activity in a businesslike manner,
The time and effort you put into the activity indicate you intend to make it profitable,
You depend on the income for your livelihood,
Your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business),
You change your methods of operation in an attempt to improve profitability,
You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
You were successful in making a profit in similar activities in the past,
The activity makes a profit in some years, and
You can expect to make a future profit from the appreciation of the assets used in the activity.”
What can you do if you have a small unprofitable farming operation that is not your main source of income, but you have a sincere profit motive? First, continue to try making a profit. Second, demonstrate that you have a profit motive using factors listed by the IRS.
- Farm like it is a business. Track your income and expenses, and prepare reports showing how the operation performed.
- Track how much time you spend on the farming operation. It might surprise you, and the IRS, how much you work if you add up all those Saturdays and evenings.
- If you have another main source of income, then you might not be able to say that you depend on the farm for your livelihood. Losing on a single factor, however, doesn’t mean that there is no profit motive.
- If something beyond your control hurts your profitability, document it. You can’t help that a tornado ravished your corn right before harvest.
- If you are changing the crops you plant to increase profitability, document that change and your reason.
- If you have skill in farming, considering documenting it. Document attempts to gain farming skill, such as through reading, classes, talking with seasoned farmers, etc.
- If you made money farming in the past, keep tax returns or other records to substantiate that income.
- If the activity occasionally makes a profit, keep records of that. The IRS presumes an operation to have a profit motive if 3 out of 5 years, or 2 out of 7 years for some activities, it shows a profit. If you expect to make profits later in the 5 or 7-year period, but not at the beginning, you can file a form asking the IRS to wait until enough time has passed to apply the time test.
- If you expect to make profit by selling the farm, let the IRS know that if they question you. Perhaps you can show that the value has already appreciated since you bought it. Note that if you are planning to pass the farm to your descendants upon your death, then the appreciated value doesn’t help your case.
While the best way to demonstrate a profit motive is with profits, unfortunately that is not always possible. If you are trying unsuccessfully to make profits, then be familiar with the IRS factors, and try to document the ones that support your profit motive. If you have questions about your small farming operation and the hobby loss rules, talk to your accountant.