I know, personally; some clients have informed me. One of the principal problems with getting audited is that the IRS considers losses to be a red flag for the idea that you are operating a hobby rather than a business in the livestock industry.
For livestock owners who do not have two profit years in a five-year period, the IRS is still going to want to take a look at your activity sooner or later.
An opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate the activity is engaged in for profit, even though losses or only occasional small profits are actually generated.
This often motivates people to continue in their ranching activity despite losses over an extended period of time.
At the same time, IRS regulations state that if you don’t have two profit years out of five, your activity is presumed to be engaged in as a hobby, not a trade or business.
One of the main hurdles new clients tell me about is that they have no business plan and that the IRS thinks their records are not kept in proper form.
A business plan should show, among other things, a profit motive according to tax regulations.
Where a taxpayer with no prior experience enters into an activity, that taxpayer must show not only that advice was obtained in the particular area of endeavor, but also that general business advice was obtained.
In the Tax Court case Filios v. IRS, Louis Filios of Springfield, Massachusetts, lost. The Tax Court found that Mr. Filios “did not have budgets, income statements, balance sheets, income projections or financial statements for the activity,” other than those compiled annually by his accountant to prepare annual federal tax returns, and that he was not engaged in his activity for profit.
The lack of these kind of records could be a problem for many ranchers, whose overall business records often fall short of this standard.
The IRS is looking for better records that indicate a profit motive, such as records used for the purpose of cutting expenses or those that can be used to help increase profits and evaluate the overall performance of the business on an ongoing basis.
Another frequent concern of the IRS is whether the taxpayer’s method of operations generally continues unchanged (despite a long period of losses) or whether you change your practices in significant ways.
Also, the IRS wants to see evidence that favorably compares your activity to a profitable cattle or other livestock operation, which means more careful strategic planning.
Finally, the IRS is now emphasizing that you should prove you, yourself, possess the requisite expertise regarding the business end of the activity or that you have relied on the advice of others who possessed that type of expertise.
Although you may study and consult experts regarding the technical and scientific aspects of livestock raising, that is not enough.
It is further necessary to seek expert advice regarding the economic or business aspects of the activity. If you have developed economic expertise of your own, it’s important to be able to prove this.
Mr. Filios spent between 10 and 20 hours per week engaged in ranch operations. He subscribed to various industry publications and read numerous books on breeding strategy.
He was a pioneer in using vitamin and mineral supplements as part of the diet for his animals. He personally decided which vitamins and minerals to use and mixed them himself.
But the Tax Court complained that he did not keep records showing which vitamins or minerals went to which particular animal.
The taxpayer signed all checks relating to the activity. A bookkeeper kept his records. She prepared annual summaries and spreadsheets showing disbursements by category and verified the accuracy of charges and statements charged to the taxpayer.
Despite all this, the Tax Court found fault with almost everything, including the fact that expenses should have been kept on each animal individually and that he “never conducted written business studies” for his activity. Similarly, he never prepared a written business plan or budget for the activity.
Mr. Filios never hired business advisers or consulted with experts on the economic aspects of his breeding operation. He personally arranged for his livestock to be bred, and he personally reviewed and executed breeding agreements.
The court concluded that “the sheer magnitude of petitioner’s losses, the consistency with which they were incurred and their steady and dramatic increase over an extended period of time provided compelling evidence” that he was not engaged in the activity for the purpose of earning a profit.
“A record of continued losses over an extended period of time is plainly relevant in discerning a taxpayer’s true motivation.”
John Alan Cohan is a lawyer who has served the livestock, horse and farming industry since 1981.
