The IRS raised a record of $48.7 billion in revenue in fiscal year 2006 – revenue generated from audits of individuals, small businesses and corporations. There are about 115,000 IRS employees. This translates into a significant net profit to the Government. There was a 7 percent increase that year in individual audits, and an 8 percent increase in small business audits.
Most of the increased revenue pertains to taxpayers who underreported income – the main area that seems to arise in audits. The IRS plans on still increasing the number of audits, particularly on people who work for themselves. The number of individual income tax returns audited reached a 10-year high in 2007. This comes as the IRS faces heavy pressure from Congress to raise additional revenue to help shrink the nation’s deficit. Also, the IRS has increased audits of taxpayers involved in partnerships and S corporations, as well as “abusive” tax shelters.
Most farmers, ranchers and horse breeders invariably have “day jobs” that constitute their main source of income. The ranch or farming activity usually incurs losses for a number of years, and these losses are used to offset taxable income. Of course, most people want to ultimately make a profit in their venture, but in the meantime they are entitled to take tax deductions so long as the horse or other livestock or farming activity is operated “for profit,” that is, the taxpayer has the “intention” of making a profit despite the fact that there are losses. A significant segment of audits will continue to be in the hobby loss area. It is interesting to note that a large proportion of audits of physicians who operate cattle or horse farms on the side. For some reason, the IRS seems to target that particular segment, perhaps because they tend to have high incomes and little time to manage a farm or ranch, and they take large tax deductions. It is not fair to generalize, but physicians seem to be targeted quite often. The only way to convince the IRS that your cattle or horse – or for that matter any other farming venture – is operated as a business, not a hobby, is to have good documentary evidence. If you are audited it is advisable not to attend the audit, but to have a qualified representative, such as an experienced accountant, interact with the revenue agent. In larger or more complex cases you should hire a tax attorney, who will work together with the accountant.
Often the IRS agent will illicit damaging information directly from the taxpayer, or the taxpayer will not provide solid enough answers to the questions raised. In most instances where the taxpayer represents himself, the IRS rules against him and denies the tax deductions. That is why it is best to have a tax practitioner represent you. The IRS has an institutional bias against taxpayers who claim to be operating a ranch, farm or horse activity “for profit” when there are no profits, only write-offs. Still, in a number of instances, lawyers have been successful at the audit phase; when the taxpayer contacts their lawyer early enough so that he or she can get a fresh start, and where there are some decent facts to work with. It often also entails “educating” the revenue agent as to the particular aspects of the cattle industry, horse industry or other farming operations, and presenting appropriate legal points and authorities.
John Alan Cohan is a lawyer who has served the farming, livestock and horse industries since 1981.
