Internal Revenue Service Code 183(d) presumes the taxpayer enters into an activity for a profit if the activity shows a profit for three out of five consecutive years. If the activity shows a profit in three out of five years (or two of seven consecutive years for horse breeding, training, showing, or racing), the taxpayer can treat the activity as a business and deduct all of the usual business expenses. Thus, the burden of determining whether an operation is "not for profit" or a "hobby farm" is placed on the IRS and not on the taxpayer. However, the taxpayer not meeting the threshold of profitable years has the burden of proving that he or she entered into the farming operation with a profit motive.
In addition, the IRS has set out nine factors that can be used as evidence that the activity is a business even though it is losing money.
- You carry on the activity in a business-like manner,
- The time and effort you put into the activity indicate you intend to make it profitable,
- You depend on income from the activity for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
- You change your methods of operation in an attempt to improve profitability,
- You, or your advisers, have the knowledge needed to carry on the activity as a successful business,
- You were successful in making a profit in similar activities in the past,
- The activity makes a profit in some years, and
- You can expect to make a future profit from the appreciation of the assets used in the activity.
If the taxpayer does not make a profit as described above, he or she may still be able to show the activity is a business even though it is losing money. In addition to the nine factors, there are other areas to consider including the Deductibility Ordering Rules for hobby losses.
You need to make a decision to farm for profit rather than "just for fun." To get started, the small farmer should include a tax professional on his or her management team and then work hard to educate that person about the farm operation and his or her goals. For more information, contact a professional tax preparer, or consult the IRS publication at Publication 535 (2005), Business Expenses
or IRS Tax Tips for Farmers