Test’ Helps Prove Farm is Profitable Rather Than a Hobby
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Tom McConnell
WVU Extension Service
Farm Management Specialist
Published in the Farm Bureau News
, February 2001

Farmers almost always underreport their expenses for tax purposes. One reason for this is that farmers don't keep accurate records. This is especially true when they mix their farm accounting with their personal/household checking account or use a personal credit card to pay for some inputs.

Another reason is fear. This idea is usually planted during a conversation, when one farmer proclaims to another: "I heard that you must show a profit three out of five years or the IRS will audit you."

The threat of an audit can get any businessperson to focus immediately on income tax management. So, with no more information than that, farmers will underreport their expenses so they can show a modest profit and not "draw attention" to their returns by staying within the profit guidelines of the Section 183, or "Hobby Loss" rule of the Internal Revenue Code.

This discussion is not about avoiding an audit or outmaneuvering the Internal Revenue Service (IRS); it is about sufficiently understanding the tax code and your operation so you can farm and report with confidence.

Generally, the Section 183 rule states that a business (farm or not) must show a profit three out of five years to continue to deduct expenses beyond income in the future. Horse farms enjoy an exception in that they must show a profit in two out of seven years. If the business fails to attain this performance, then from that point forward a businessperson will be able to claim expenses only to the point where they match income without exceeding it.

Although this explanation is oversimplified and overlooks the many options the taxpayer has, this is the section that scares many farmers into underreporting their expenses. The Section 183 rule needs further study on the part of the businessperson and his or her tax professional so the individual can manage income taxes from a position of information rather than fear and hearsay.

First the taxpayer/businessperson must know that if he or she meets the threshold of "three of five profitable years," the burden of determining whether an operation is "not for profit" or a "hobby farm" is placed on the IRS. The taxpayer not meeting the threshold of profitable years has the burden of proving that he or she entered into the farming operation with a profit motive. That does not mean that the case has to be proved at the very moment another tax year starts. It does mean that if loses are taken for more years than allowed in Section 183, the taxpayer has to be able to supply information (if the return is audited) to support the claim that he or she is trying to make a profit rather than enjoying huge expense deductions to avoid paying taxes on income earned in some way other than in that business.  

The IRS suggests a nine-point test that a taxpayer must consider when making that determination or defending his or her business practices and the worthiness of his  deductions.  This list has evolved in a "common law" fashion, meaning its origin is a simplification of the intent of many court decisions.

You should take into account all of the following points to help prove that you are farming for profit.

  1. You operate your farm in a businesslike manner. (As manager, do you have a business plan, have you set goals, do you keep records?)
  2. The time and effort you spend on farming indicate that you intend to make a profit. (Do you spend sufficient time and energy on attaining that goal?)
  3. You depend on income from farming for livelihood. (Here, full-time farmers have an advantage, but the income issue relates more to the farmer's need for deductions than his or her dependence on farm income.  Farmers having off-farm jobs to supplement their income depend on their farm income, too.)
  4. Your losses are due to circumstances beyond your control or are normal in the start-up phase of farming.
  5. You change your methods of operation. (You could begin to winter calves rather than sell them in the fall or finish cattle to slaughter weights; the income could be delayed several months.)
  6. You and your advisers have the knowledge to carry on the farming activity as a successful business. (Attending continuing education classes can offset perceived weaknesses in this area.)
  7. You made a profit in similar activities in the past.
  8. You made a profit farming in other years and can document how much you made.
  9. You can expect to make a future profit from appreciation of the assets used in the farming activity.

You need to make a decision to farm for profit rather than "just for fun." Floating between the profit and pleasure worlds can be expensive in terms of taxes if you allow the IRS to determine that the business is a hobby, and then it disallows a large deduction on a particular return. Lurking on the edge of deciding about the seriousness of your operation will just lead to frustration and, yes, to the underreporting of expenses.

There is not a part-time operator in the state who thinks he or she cannot make better use of his or her tax money than the federal government. It's not logical to forego expenses rather than defend the seriousness, dedication, and skill of the businessperson-farmer managing the operation.

There is no documentation suggesting that the IRS thinks two-income farm families are any more or less serious about their farming than their full-time on-farm counterparts. The operator should be confident about his or her mode of operation and should act accordingly With reporting and business practices. The tax code provides a precise way to report income, deduct expenses, and pay taxes.

I have observed that the IRS respects the hard work of West Virginia farmers and tends to be very open-minded about the narrow margins they earn and the cyclical nature of farm profits.

To get started, the small farmer must include a tax professional on his or her management team and then work hard to educate that person about the farm operation and his or her goals. Once the professional has an idea about the farm and the farmer, he or she can represent the farmer better than the farmer can.

To receive more information on this subject or to schedule an income tax session for your farm group, contact me by telephone (304-293-6131, ext. 4237) or e-mail tmeconne@wvu.edu .