The IRS has been cracking down on individuals and small businesses-- including farmers, ranchers and horse owners--with increased tax audits and aggressive tactics to collect taxes. The tactics include an increased volume of audits, and more bank levies and liens on real property.
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. Most of my clients are physicians, architects, industrialists, and other wealthy individuals who have plenty of money that they hope to utilize in one way or another to generate more income and to help shelter them from taxes. Farming is not only an extremely vital segment of the economy, but for many it is a worthwhile endeavor to engage in while enjoying tax benefits. But in order to “enjoy” tax benefits it is ultimately necessary to comply with IRS Regulations.
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.
In my book, Turn Your Hobby Into a Business--The Right Way (available at Amazon.com and book stores), I have several chapters pertaining to farmers and ranchers and how to avoid IRS problems, but ultimately 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 profit year at some point in the near future.
What the IRS wants is to collect revenue, especially since the Federal Government is in financial straits. So, under the circumstances it behooves people to do what they can to avoid IRS problems by advance planning. The main point is that is important is to prove that it is your intention to be engaged in a profit-making venture, not a tax shelter or a means of taking significant tax deductions from your main source of income.
[John Alan Cohan is an attorney who has served the farming, ranching and horse industries since 1981. He can be reached at 310-278-0203 or by e-mail at [email protected] . His website is www.JohnAlanCohan.com .]