Updated: Jul 7, 2020
This post should not be construed as legal advice or tax advice.
I do not set myself out to be a tax expert, but at times I attempt to explain some aspects of tax law. Today we are going to discuss when you can take a business expense deduction on your taxes for your farm businesses. On the other hand, hobby losses and expenses from hobbies cannot be deducted from your income taxes (wouldn’t we all like to deduct expenses from our favorite pastimes on our taxes?). But when a business is considered a business and when it is considered a hobby is an issue the U.S. Tax Court has dealt with repeatedly.
According to the 2012 Census of Agriculture, 61.5 percent of all Maryland farm operators (and 62.2 percent of all U.S. farm operators) work off the farm in some capacity. Many agricultural producers may have full time off-farm jobs and only farm on the weekends or use vacation days to manage the farm. Having a full time off-farm job does not automatically qualify your farm as a hobby (although to many of you it may be both a business and a hobby). The Internal Revenue Service (IRS) has developed factors to determine if the activity is a business or a hobby.
To aid you in understanding the factors, let’s look at a recent Tax Court decision in Metz v. Commissioner of Internal Revenue (T.C. Memo. 2015-54). In Metz, the Metzes had started an Arabian horse farm in 1991 in Sioux City, Iowa, then moving to Naples, Florida, and finally to Santa Ynez Valley in California. Each move was designed to put the Metzes in a better market to sell their horses. In its years of existence, however, the Metzes’ farm was never profitable. Because of the annual losses, the IRS determined the farm was a hobby and not a business and disallowed numerous deductions. This decision was overruled, however, by the U.S. Tax Court, and we will look at why.
Before we list the Tax Court’s determining factors, it’s important to note that numerous Tax Court and Federal court decisions point out that the business does not have to make a profit, only that the taxpayer run the business in an honest way to potentially make a profit. Factors to consider that the business was being run to potentially make a profit are:
manner in which the taxpayers carry on the activity;
expertise of the taxpayers or of their advisers;
time and effort expended on the activity;
expectation that assets used in the activity may appreciate in value;
success of the taxpayers in carrying out other similar or dissimilar activities;
history of income or losses with respect to the activity;
amount of occasional profits, if any, from the activity;
financial status of the taxpayers; and
any elements of personal pleasure or recreation. (Metz, 1-2).
These nine factors are applied focusing on the taxpayer’s subjective intent, and IRS does not substitute a reasonable person standard or their own business judgment in evaluating the factors.
Looking at factor 1, the tax court found that the Metzes kept business records and hired an accountant to help with the financials. The accountant also helped reconcile potential comingling of personal and business expenses. The Metzes hired a law firm with experience in the Arabian horse market to help with sales, had a well-developed business plan, had professional advertising and marketing materials, horse-by-horse tracking, and regularly adopted new techniques to help improve the business. The court saw all these factors weighing in the Metzes’ favor.
Looking at the Metzes own and their advisors’ expertise, both parties had developed an understanding of the Arabian horse industry, were in positions of leadership with Arabian horse associations, and prior to that had mentored other experienced Arabian horse stable operators. The Metzes also hired numerous experts to help them in running the business. The tax court saw all this weighing in the Metzes favor. Looking at the time and effort expended on the activity, the Metzes were basically fully employed by the operation and the tax court also agreed this weighed in their favor.
Other factors which weighed in the Metzes’ favor were the expectation that assets used in the operation may appreciate in value; the record showed the Metzes did believe this. Mr. Metz had a history of turning around a previously unprofitable company and that experience was well suited here. The yearly losses were understandable based on the world Arabian horse market.
Looking at the financial status of the Metzes, before 2008 it could be argued they were using the farm to shelter gains in other investments, but after 2008 the Metzes had been wiped out. The Metzes continued the farm despite losing all their money, and ended up investing a large portion of their income in the farm. This factor weighed in the Metzes’ favor according to the Tax Court.
The final factor is “personal pleasure or recreation.” Here, the court points out, the more pleasure you get in activity the more likely it is to be a hobby and not for profit. This does not mean you have to loathe an activity for it to count as for profit. Here the IRS thought that since the Metzes attended numerous horse shows and riding horses the activity was more for pleasure than for profit. The court found that horse farms owners do regularly attend horse shows and ride horses. There were enough non-pleasurable activities in operating the farm which did not render the farm a hobby. To sum up, the Tax Court disagreed with the IRS and ruled the Metzes’ horse farm was not a hobby and was intended to make a profit.
Why Should You Care?
There is no exact formula as to when a business will be found a hobby or for-profit. For the vast majority of you, this will not be an issue and your farm will clearly be a for-profit business. But issues arise when you have an off-farm job with a high salary and a farm which consistently losses money, making it appear you are only using the farm to hide income from other sources. If you have concerns, remember to talk with your accountant to make sure you are keeping the necessary records to ensure that your farm will be considered for-profit and not a hobby.
26 C.F.R. §§ 1.183-1 to 1.183-2 (2015).
26 U.S.C. § 183 (2015).
Metz v. Comm’r of Internal Revenue, T.C. Memo 2015-54 (T.C. 2015).