While it is possible to negotiate with the IRS over past due taxes – to get an installment agreement, for instance – the best strategy is to be prepared in the event of an audit in the first place by proper tax planning. The U.S. Tax Court has stated many times – and this is also reiterated in the IRS Audit Manual – that a business plan is evidence that a taxpayer is operating a farm, ranch or horse activity in a businesslike manner. The absence of a business plan will almost certainly result in an adverse determination by the IRS, unless you can show profit years.
A business plan should be formalized in writing, and should contain realistic projections of income and expenses that will point towards a profit year down the line.
It is impossible to avoid getting audited. Even if you have the best professionally prepared tax returns, if you have sustained losses over a period of years and you are deducting losses against your main source of income – you should be prepared for an audit.
Fortunately, you can withstand IRS scrutiny if you are prepared (hopefully well in advance). It takes a significant amount of effort to put together a business plan, and this is one of the reasons why the IRS views this as a positive indicator of your intention to be engaged in a business rather than a hobby.
As you know, if your farming, ranching or horse activity has sustained a history of losses – which includes a significant percentage of owners – the IRS may claim that this activity is simply a “tax shelter” by which you deduct costs against your principal source of income.
Years ago it was much easier to withstand IRS scrutiny, but I can assure you those days have passed. I grew up with horses and my family never had problems with the IRS even though we never made a profit. But today a more modern IRS is capable of focusing on specific areas of commerce and selecting people for audits that fit certain profiles that seem like candidates for paying more taxes than they have claimed.
It is important to obtain professional guidance in formulating a business plan, so that the person who prepared it can sign off on it, just as CPAs sign off on profit reports of large companies.
Even a brief evaluation of your activity can be helpful in pointing out ways that you can improve the profit picture – by way of reducing costs, or at least helping to articulate why certain costs are there that can’t go away, and how it is you can achieve a profitable year at some point in the near future.
Avoid IRS problems by advance planning.
John Alan Cohan is an attorney who has served the farming, ranching and horse industries since 1981.
