Let’s answer this question by using the example of Ray, who has decided to leave the corporate world behind and change careers to become a corn farmer in Iowa. As can be imagined, Ray has a lot of expenses relating to starting up this new venture. He needs to buy land, equipment, seed, fertilizer, and a whole host of other items before he can plant his first crop. He will also likely run into further expenses as he looks for a market for that first crop – then he will have to figure out how to harvest the crop and get it to its buyers. I think we can be pretty sure that Ray’s expenses for his first year as a farmer will exceed any income he may receive for his corn crop. But the good news for Ray and other farmers is that, under certain conditions, the tax code allows for the deduction of farm expenses even if they are greater than income.
The main issue when it comes to being able to deduct his losses in this way is whether Ray is operating his farm as a business or as a hobby. This is a very important distinction; the final word belongs to the IRS but is based on the facts and circumstances.
Suppose the IRS determines that Ray’s activity is a business. In that case, he can deduct his ordinary and necessary expenses of carrying on the business of farming even if they exceed his income. On the other hand, if the IRS regards the operation as a hobby, he must declare any income he receives, but he cannot deduct his farm-related expenses.
When making its decision on whether an enterprise is a business or a hobby; the IRS takes 9 (nine) different factors into account relating to the management of the farm. If the IRS ever doubts Ray’s assertion that his farm is indeed a business, an auditor would ask the following questions.
- Is Ray operating the farm in a businesslike manner? Does he have a business plan? Are there separate bank accounts for farm and personal use?
- Is an adequate amount of time and effort being spent on operating the farm in the hope of making it profitable? This time and effort can be invested by Ray and/or his employees, but the main point is that the business is being actively operated with the goal of making it profitable.
- To what extent does Ray depend on income from the farm? Ray is likely to need other sources of income during the early days of the farm operation. Thus, the IRS would like to know that the farm is intended to be a reliable source of income for Ray in the longer-term rather than simply a way for him to avoid his other tax obligations.
- Were any of Ray’s annual losses caused by circumstances beyond his control or for start-up reasons? The IRS realizes that Ray will have losses during his start-up phase and also potentially during later years due to random events such as floods, drought, and fluctuations in the sale price of corn. However, the IRS also wants to be reassured that Ray is not creating farming losses intentionally.
- Has Ray made adjustments or changes in his operation to improve profitability? Questions such as this are intended to measure how closely Ray monitored and managed operations and to what extent he refined activities on the farm to meet his profitability goals better.
- Does Ray have advisors to help him operate his farming business? Access to professionals, such as a CPA, a University of Iowa farm management specialist, or a grain marketer would not only help Ray run his farming operations but also demonstrate to the IRS that he is running his farm like a business.
- Has Ray made a profit in any other businesses or farms before now? Any prior profit-making experience, especially in farming, would help demonstrate that Ray understands the principles of running a business and has succeeded in the past.
- Has Ray made a profit on the farm in some years? How much? The IRS has a general guideline that farm operations should show some kind of profit at least 3 (three) years out of every 5 (five). This is not a strict rule, but the IRS may regard continual losses as a sign that Ray’s operation is a hobby rather than a business.
- Does Ray have an expectation of profit in the long term? What is the projected cash flow? If cash-flow is not positive, does Ray have a plan to address it? The IRS does not necessarily expect to see enormous profits, but it does want to see evidence of the intent to be profitable.
Although none of the individual 9 (nine) factors listed carry more weight than any of the others, it would be Ray’s responsibility to show proof of meeting as many of the above guidelines as possible. Keeping comprehensive records of his income, purchases, and other activities related to operating the farm would be key to proving his case that he is indeed running a business and not a hobby.
And so long as Ray keeps good records for his business, there is nothing to stop him later on if he decides to create a not-for-profit hobby enterprise based around a baseball diamond he has built in a corner of his cornfield. Everyone needs a break sometimes from the hard work of farming, and you never know who might come out to play on this “field of dreams”!