Is your farm operation a bona fide business or more of a hobby? There is a difference in the eyes of the IRS and knowing how to classify your entity is crucial when it comes to your taxes. It affects the way taxes are filed and what can be deducted.
Determining if an activity is engaged in for profit is based on the facts and circumstances of each case. However, IRS regulations provide nine factors to consider. These factors are frequently applied in relevant case law. Although certain activities are more susceptible to the hobby loss taint, no activities are immune.
Section 183 of the tax code governs “hobby losses.” This section of the tax code was passed so Congress could close down what it perceived as inappropriate farm and horse shelters. The “Safe Harbor” law sets up a presumption that if an activity shows a profit in three out of five tax years, then the taxpayer is engaged in it to make a profit. In the case of horse operations, the business must show a profit in two out of seven tax years. There are nine factors the IRS uses to determine hobby farm losses. Let’s take a look at just a few of them here.
Factor: The manner in which the taxpayer carries on the activity
The IRS will look at your intentions when it comes to your farming operation. Are you doing what you love in the hopes of making a profit? If so, you are probably keeping a separate set of books, have a separate checking account, etc. If you take part in the operations that are necessary to run a successful and profitable business, you most likely won’t fall into the hobby category.
Factor: The expertise of the taxpayer or his or her advisor
If you have expert level knowledge pertaining to your field, this will be taken into consideration. If your skillset and background speaks to the nature of your operation, you could be looking at a business classification as opposed to hobby. For example, if you run a horse farm and you are an accomplished rider or a veterinarian, you could be considered an expert in your field. If knowledge and the arenas that it allows you to be a part of position you to run an operation that grows and makes money, business might be your classification.
Factor: The time and effort expended by the taxpayer in carrying on the activity
Whether or not you hold another job outside your farm operation is a factor that the IRS uses when weighing in on if you are business or hobby. If you are working a full-time position and farming here and there on the side and bringing in minimal if any cash flow from your efforts, that is much different than devoting much of your time to the operation and bringing in a large profit.
Factor: The amount of occasional profits, if any, which are earned
Maybe you didn’t enter into your farming operation with the intent to make money, but over time, it’s happened. Your potential to make increased income and the amount of money you actually make will matter to the IRS when deciding if you have crossed over the hobby threshold into business territory.
Again, these are just a few of the factors that are evaluated for tax purposes. None of the nine factors controls the profit motive determination, and meeting a preponderance of those factors doesn’t indicate whether or not the necessary actual and honest profit motive is present in a particular activity.
Keep in mind, even if your income is small and determined to be hobby, it cannot be ignored because IRC Sec. 61(a) provides that gross income includes income from whatever source derived unless there is a specific exclusion. There is no exclusion for hobby income. Hobby income is reported on page 1, line 21, of Form 1040. It is not subject to self-employment taxes because a hobby is not considered a trade or business.
For more information or for assistance in business or hobby farming, please contact Holbrook & Manter, CPAs. We’ve been assisting farmers of all types for over nine decades and have four locations to serve you,
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through the firm website at:www.HolbrookManter.com