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Tax Planning For Part-Time Farmers

The farmer looms large in the American imagination, but many Americans who have not experienced modern farming firsthand have a skewed perception of what the activity actually entails.

The Internal Revenue Service is not so small-minded.

The IRS casts a wide net when it comes to the definition of farming. In Publication 225, the “Farmer’s Tax Guide,” the agency takes the position that “You are in the business of farming if you cultivate, operate, or manage a farm for profit, either as owner or tenant.” Farmers are not only those who grow food crops, but also those who produce livestock, dairy, poultry, fish and fruit. Truck farms, ranches and orchards are all farms, too, as far as the IRS is concerned.

But what about part-time farmers? According to the 2012 Census of Agriculture, 38 percent of all U.S. farms were operated by individuals who had primary occupations other than farming. And many American farms, whether part time or full time, are also small; 88 percent of all farms had less than $350,000 in gross cash farm income, according to the same survey.

For tax purposes, the main question is not the size of your operation or how many hours you work, at least not in isolation. The most pertinent question is whether your farm is a business or a hobby.

Section 183 of the tax code details the rules on activities “not engaged in for profit.” The determination, often referred to as the “hobby-loss rule,” can make a big difference in how you handle your taxes. And part-time farmers are especially prone to IRS scrutiny because for-profit farms have access to a variety of helpful tax rules.

The simplest way to prove that your farm is a for-profit venture is to turn a profit. In most cases, the law creates the presumption that if an activity shows a profit in three out of the five most recent tax years, the taxpayer intends to make a profit from the activity. For horse-related activities, you need only show a profit every two out of seven years. Once you have established a profit motive, the burden of proof shifts to the IRS if it wishes to allege that your farm is not run with a profit motive.

Regrettably, farming can prove economically challenging, which is part of the reason so many small farmers have other primary occupations in the first place. This does not mean, however, that you cannot demonstrate a profit motive without meeting the profitability test. The facts and circumstances of your situation can also demonstrate to an IRS examiner that your farm is not simply meant for your own pleasure, but is truly intended as a business.

Some of the conditions you can indicate include:

You operate your farm like a business. You should be able to produce evidence to prove you are treating your farming in a businesslike way. Such evidence could include a realistic and concrete business plan, a separate checking account for farming activity, and clean and accurate accounting records. If you sell your products directly to the end consumer, spending time and money on marketing materials can also show profit motive.

You put a reasonable amount of time and effort into your farming activities. Even if you farm part time, keeping records of the hours you work will show that you treat it as a consistent business venture, not simply a leisure-time activity. In addition to the time you spend actually farming, you should also keep track of time you spend reading relevant publications, attending classes or seminars, and participating in any other activities meant to improve your skills. Many state cooperative extension services even offer workshops in partnership with the IRS specifically on farm taxation.

You demonstrate expertise or have consulted experts about your farm. How much experience do you have in your area of agriculture? If you are new to farming, have you discussed your plan with more experienced farmers and implemented their advice? A farmer who has spent decades in agriculture but chooses to work part time as she gets older is likely to have an easier time demonstrating profit motive than is a banker who takes up farming on a whim after retiring from his primary career.

You reasonably expect to turn a profit in the future. Have you been successful in similar ventures before? Is your “day job” related to your farming activity? Have you had your property appraised more than once, and if so, has its value increased over time? Even if you don’t meet the IRS’ profitability test, have you earned profits in the past? Proof of even occasional profitability will help your case.

Your financial status rests, at least in part, on the farm’s success. If you earn sufficient income at your primary occupation or have substantial financial resources independent of the farm, it may be harder to demonstrate the farm’s profit motive.

While none of these circumstances is indispensable on its own, the more of them you can document and demonstrate, the more likely the IRS will accept your position that your farm is a true business. It is also worth noting that when establishing a new farm, a taxpayer can put off the determination of whether the business is a for-profit venture. If it looks as though your farm will eventually turn a profit, you can postpone the determination until the end of the fourth tax year of farm operations.

Farmers who run their farms as a hobby simply report the income as they would income from any other hobby activity. Assuming that the taxpayer itemizes deductions, he or she can itemize miscellaneous hobby-related deductions on Schedule A, but not in excess of the gross hobby-related income. These deductions are also subject to the general 2 percent floor relative to adjusted gross income.

Farmers who run their farms as a business, in contrast, can deduct all allowable expenses. They will report their income from farming on Schedule F. (This form is also used to report a variety of other farm-related income, such as crop insurance proceeds or rent earned from farms.) This form is also where farmers will report deductible expenses. Many of these are the same as those available to any other business, but farmers have access to additional specific deductions on things such as seed, chemicals and fertilizer. Farmers will also often benefit from depreciating property such as machinery and other technological improvements to their operations.

Since many farmers live on their farms, it is also important to keep excellent records of deductible expenses that may be partly personal and partly business related. For instance, water, rent, insurance and gasoline all may need to be allocated between business and personal use, since the portion for personal use is generally not deductible. You may wish to involve a tax professional in making this determination, but either way, it will be important to document how you divided expenses in case the IRS audits your return.

For farms that are organized as sole proprietorships, partnerships or S corporations, farmers may have the option to engage in “farm income averaging.” This method allows you to average all or some of the current year’s farm income by allocating it to the three prior tax years. This option is not open to farmers whose enterprise is organized as a C corporation, however.

In addition to filing Schedule F, farmers who treat their farms as a business will need to be aware of their other tax obligations. Even part-time farmers who operate for-profit farms will generally need to stay mindful of self-employment taxes. If they hire employees, they must withhold Social Security and Medicare taxes for them as well; on the other hand, employees’ wages are usually a deductible expense.

Given the wide range of activities the IRS includes under the umbrella of “farming,” it is important to note that the tax code sometimes has special rules for certain agricultural pursuits. For instance, many of the rules discussed in this article are slightly different for those raising horses or for farmers primarily producing timber. When in doubt, it is wise to consult an expert with experience in your particular area.

Farmers should also stay aware of their state tax obligations. For most farmers, property tax will represent a major portion of their overall tax burdens. However, sales tax and state-specific permits and fees may also come into play. Some states, too, exempt specific agriculture-related sales from tax. Therefore, it is important to fully understand the rules in your state in order to meet your obligations and to take advantage of any available benefits.

Many farms are family affairs, and some part-time farmers are former full-time farmers who have scaled back their involvement as they approach retirement. Like any small business, if you plan for your farm to survive after you are gone, it is important to create a formal succession plan as part of your wider estate plan. While many, if not most, part-time farms will fall below the threshold for federal estate tax, careful planning ahead of time can reduce the likelihood that your heirs will need to sell some of your property to meet such tax obligations.

Part-time farming can be a rewarding pursuit, whether it has been a longstanding part of your family’s lifestyle or is a new endeavor. Taking the time to fully understand the nature of your farming activity, as well as the tax obligations and benefits it presents, can make it a rewarding part of your financial life, too.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.