Your tax return has been selected for examination by our office." These are words no taxpayer wants to read from either the IRS or the Alabama Department of Revenue (ADOR). Recently, a farm spouse told the story of their ongoing state tax audit. It was a familiar one with a sad ending.
• Husband and wife owned and operated a small cattle farm.
• They both had full-time, off-farm employment.
• Worked hard, but lost money for the last 10 years on their Schedule F - Farm Tax Return as a sole proprietor.
Initial Finding by Auditor: Farm not business, but hobby. Hobby tax losses not allowable on all tax years under examination. Taxable income increased by the amount of tax losses. Additional prior year taxes and possible interest and penalties due upon completion of the audit.
The auditor’s findings could have been avoided if the farmer was knowledgeable of the guidelines published by the IRS and Alabama Department of Revenue for all small businesses (which includes small farmers and ranchers).
The IRS Code 183 (d) deems the taxpayer enters into an activity for a profit and can deduct all business-related expenses if the business makes a profit three out of five consecutive years. If breeding, training, showing or racing horses, it is considered a for-profit business if a profit is made in two out of seven consecutive years. When this threshold of profitable years is not met, the taxpayer has the burden of proving he/she entered into the farming activity with a profit motive. Taxpayers should not single out one factor to determine whether the business is for profit, because the IRS takes all of the following points into consideration.
The 2010 edition of IRS Publications 535 – Business Expenses and 225 – Farmers Tax Guide list the following nine items as determining factors in whether a business is a "Not-for-Profit Activity."
1. You carry on the activity in a businesslike manner.
2. The time and effort you put into the activity indicate you intend to make it profitable.
3. You depend on the income for your livelihood.
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type business).
5. You change your methods of operation in an attempt to improve profitability.
6. You (or your advisors) have the knowledge needed to carry on the activity as a successful business.
7. You were successful in making a profit in similar activities in the past.
8. The activity makes a profit in some years.
9. You can expect to make a future profit from the appreciation of the assets used in the activity.
The ADOR has similar criteria for determining whether a farming activity is engaged in for-profit. Their nine factors are shown in the chart on the next page, along with the situation for the audited farm.
This small farmer and rancher would sound very familiar to any Extension professional in agriculture. After reading these guidelines, here are some suggestions for any farmer or rancher you work with.
• Get the facts – read the appropriate tax publications.
• Understand the state financial and political environment – if taxes cannot go up, one option to increase revenue is to more stringently enforce existing tax regulations.
• Sole Proprietor farmers and ranchers are considered self-employed, with significant opportunities to under-report taxable income and use the farm as a tax-write-off to avoid tax on non-farm income.
• The farmer should strongly consider seeing their tax-preparer prior to each year-end to review year-to-date sales and expenses for tax planning purposes, particularly if they have not reported any Schedule F profits in the last four years.
Finally, as Extension professionals, we all can ask two questions: Mr. & Mrs. Farmer (or Rancher), does this article sound like you? What can I do to help?
· IRS Farmers’ Tax Guide (IRS Publication 225) explains how federal tax laws apply to farming, www.irs.gov/pub/irs-pdf/p225.pdf
· IRS Business Expenses (IRS Publication 535), www.irs.gov/pub/irs-pdf/p535.pdf
· Alabama Cooperative Extension System Farm Management and Agricultural Enterprise Analysis Program can provide technical assistance with complying with state and federal guidelines,
The items covered in this article are informational only and are not meant as tax, legal or financial advice; consult with your tax professional, lawyer or financial consultant for guidance on issues specific to your situation. The authors do not endorse any websites, companies or applications, and cannot attest to the accuracy of the information provided by third-party sites or any other linked site.
The authors are Extension Economists with the Alabama Cooperative Extension System. For more information about farm management and financial analysis, please contact your County Extension Coordinator or an Extension Specialist: North Alabama: Holt Hardin, (256) 574-2143 or Robert Page, (256) 528-7133; Central Alabama: Jamie Yeager, (334) 624-4016; Southwest Alabama: Steve Brown, (251) 867-7760; Southeast Alabama: Thomas Hall, (334) 693-2010.