When a farm operation is in its early stages, its owners often treat it as a side-business, to supplement income from their primary occupation.
While this is almost certainly a smart decision for the financial affairs of the family, it’s important that the farmer understand a few tax rules to ensure proper income tax reporting. The rules we’ll discuss here deal with Passive Activity Losses.
A passive activity is any business or farm activity in which the taxpayer owns an interest, but doesn’t materially participate.
In order to ensure that a farm loss is deductible and not suspended as passive, farmers need to materially participate in the farm operation by regularly working, planning, providing resources, and making decisions.
To determine whether an individual materially participates or not, the IRS examines the farmer’s role using seven tests. If any one test is passed, the activity is not considered passive, and losses are deductible.
1) Does the farmer participate for more than 500 hours? The participation of both spouses can be added together; if more than 500, participation is material.
2) Is the farmer the sole participant in the activity? If the taxpayer does substantially all the work in the activity, there is no requirement for hours, and participation is material.
3) Does the farmer participate for more than 100 hours in the activity, with no one else participating more? If the farmer logs more than 100 hours, and no other party, including employees, works more than the farmer, participation is material.
4) Is the 500-hours test from No. 1 met via participation in multiple activities the taxpayer participates in? This test is complicated and warrants discussion with a tax professional; if the farmer has several activities in the 100-hour range with similar functions, they might be aggregated together to achieve material participation.
5) Has the farmer materially participated for five of the last 10 years? If so, participation is material.
6) The sixth test deals with personal service corporations where material participation for three years locks in material participation in the future. This test is not likely to impact farmers.
7) Do the facts and circumstances show that the taxpayer materially participates? This test allows for a close examination of the individual case and allows for consideration of log books and other information in determining participation.
While a full-time farmer won’t find it difficult to pass one of the tests, any farmer involved in other activities should understand the importance of substantiating farm participation.
