by: John Alan Cohan
Attorney at Law

Many years ago a federal court defined the word “profit” as “the advantage or gain resulting from the investment of capital, or the acquisition of money beyond the amount expended; a pecuniary gain.” The meaning of “profit” is important not only in computing tax liability, but in determining a taxpayer's motive for entering into a transaction, or establishing a livestock or other farming business.

In determining whether a taxpayer enters a livestock activity for profit, the focus of the inquiry by the IRS is whether the taxpayer's primary or principal motive is to derive a profit. More so now than in the past, the IRS and the Tax Court looks for objective facts and documentary evidence in addition to self-serving statements of the taxpayer.

Among other things, objective evidence consists of the expression of the taxpayer's intent to third parties. This may be in the form of consultations with other livestock owners, farmers, legal advisers, and so forth. Proving this may be difficult. Therefore, it is always recommended to keep copies of e-mail and other correspondence for possible future use in the event of an audit.

A surprising number of people who seek to make a profit in the livestock industry, and who deduct losses in the years when they occur, fail to maintain proper records. Many of them are lucky and do not get audited, but if the activity lacks businesslike records, this could be a red flag should the IRS scrutinize the situation.

Often a livestock activity will start due to a change of motive. A taxpayer will first carry on a farming activity as a hobby, and then decide that circumstances or other considerations make it the case that the activity could be transformed into a business. The difficulty here is documenting the shift from a hobby to a business. It is important to show that the taxpayer conducted research and investigated the feasibility of making this change. Often a taxpayer will get expert guidance from financial advisers, or obtain a tax opinion letter from a tax attorney. The best evidence is a tax opinion letter, as this documents the history of the situation, narrates the facts of the taxpayer's situation, and outlines the taxpayer's business plan.

If a taxpayer sustains ongoing losses from a farming activity over a period of years, particularly if it is more than five consecutive years, it becomes very difficult to prove that the activity is engaged in as a trade or business. Many taxpayers are being audited in the early, or startup, phase of the activity. These taxpayers encounter difficulty, often enough, because they are caught unaware. They did not expect to be audited so early, and their business records are not really “in place.”

In addition to business plan, nowadays taxpayers are advised to keep records of cost accounting details as evidence of a profit objective. Closely connected to such records is some type of marketing plan. Also, taxpayers need to have evidence, where appropriate, of a change of operating methods, adoption of new techniques or abandonment of unprofitable methods. For instance, there should be evidence that unprofitable animals used in the activity are culled, usually by selling them at a reduced price or donating them to a college livestock program. There should be use of advertising in trade magazines, and copies of the magazines should be kept as evidence. The IRS will often argue that if a taxpayer does not advertise in print ads, or other types of advertisement (such as on the Internet or other modern modes of advertising) this is evidence that the activity is not engaged in for profit. Some taxpayers try to save money on this, since admittedly advertising costs can be significant, particularly since ads usually need to be repeated, and rely instead on “word of mouth” advertising. However, “word of mouth” advertising is difficult to prove or to quantify. Maintaining a reasonably professional web site, in which animals are advertised, is also a useful business strategy.

Finally, there should be evidence that the taxpayer is investing further monies in the venture with the purpose of increasing the profitability of the operation. This usually means making improvements to barns, fences, pastures, and machinery.

[John Alan Cohan is an attorney who has worked in the livestock, farming and horse industries since 1981. He can be reached at 310-278-0203, or by e-mail at [email protected] His website is]


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