Many years ago a federal court defined the word “profit” as “the advantage or gain resulting from the investment of capital, or the acquisition of money beyond the amount expended; a pecuniary gain.” The meaning of “profit” is important not only in computing tax liability, but in determining a taxpayer’s motive for entering into a transaction, or establishing a livestock or other farming business.
In determining whether a taxpayer enters a livestock activity for profit, the focus of the inquiry by the IRS is whether the taxpayer’s primary or principal motive is to derive a profit.
Among other things, objective evidence consists of the expression of the taxpayer’s intent to third parties. This may be in the form of consultations with other livestock owners, farmers, legal advisers and so forth. It is always recommended to keep copies of e-mail and other correspondence for possible future use in the event of an audit.
A surprising number of people who seek to make a profit in the livestock industry, and who deduct losses in the years when they occur, fail to maintain proper records.
Often a livestock activity will start due to a change of motive. A taxpayer will first carry on a farming activity as a hobby, and then decide the activity could be transformed into a business. The difficulty here is documenting the shift from a hobby to a business. It is important to show that the taxpayer conducted research and investigated the feasibility of making this change. Often a taxpayer will get expert guidance from financial advisers, or obtain a tax opinion letter from a tax attorney, which documents the history of the situation, narrates the facts of the taxpayer’s situation and outlines the taxpayer’s business plan.
If a taxpayer sustains ongoing losses from a farming activity over a period of years, particularly if it is more than five consecutive years, it becomes very difficult to prove that the activity is engaged in as a trade or business. Many taxpayers are being audited in the early, or startup, phase of the activity. These taxpayers encounter difficulty, often enough, because they did not expect to be audited so early, and their business records are not really “in place.”
Taxpayers are advised to keep records of cost accounting details as evidence of a profit objective. Closely connected to such records is some type of marketing plan. Also, taxpayers need to have evidence, where appropriate, of a change of operating methods, adoption of new techniques or abandonment of unprofitable methods. For instance, there should be evidence that unprofitable animals used in the activity are culled, usually by selling them at a reduced price or donating them to a college livestock program. There should be use of advertising in trade magazines, and copies of the magazines should be kept as evidence. The IRS will often argue that if a taxpayer does not advertise in print ads, or other types of advertisement this is evidence that the activity is not engaged in for profit.
John Alan Cohan is a lawyer who has served the farming, ranching and horse industries since 1981.
