This is not a substitute for legal or financial advice. See here for the site’s reposting policy.
Most farmers and ranchers and their accountants are familiar with “farm” income and expenses and the “Schedule F” tax form for “farmers” only. But what if you are a new or beginning farmer or this is your first time filing taxes with farm-related income? How do you know whether or not you can count your income and expenses as “farm” income?
There are some benefits of being a “farmer” and having “farm” income under federal tax laws. This post will provide a general overview of what is and is not considered farm income and a farm business for profit under federal tax law. It will not discuss the specific benefits of filing as a farmer and having farm income. Tax season is the perfect time to discuss these benefits with your accountant.
What is and is Not Farm Income
First, it is important to determine what can be counted as “farm” income. A “farm” is defined under federal tax law as “stock, dairy, poultry, fruit, furbearing animal, and truck farms, plantations, ranches, nurseries, ranges, greenhouses or other similar structures used primarily for the raising of agricultural or horticultural commodities, and orchards and woodlands.” Farm income and expenses reportable on a Schedule F must include farm business activities such as cultivating, operating, or managing a farm for profit.
Although this definition covers a wide range of activities, there are still some activities related to agricultural production that may not be considered “farm” activities under federal tax law. For federal income tax purposes, farm and ranch business activities usually end when the product is processed beyond its unmanufactured state; but, unmanufactured products can go through handling, drying, packing, grading, and storing stages and still be classified as farm activities.
A commonly used example is the difference between a vineyard vs. a winery. A vineyard that cleans and packs grapes, and then sells those grapes, is partaking in farm activity under federal tax law. A winery that makes and sells wine is not partaking in a farm activity under federal tax law because the grapes have been processed beyond their unmanufactured state. If the vineyard operation processed the grapes into jam and then sold it as a final product, the operation would also not be able to classify the income from the jam as farm income under federal income tax law. If your business sells both manufactured and unmanufactured products, you should separate your farming and non-farming activities, and consider using an accountant’s help.
Other examples showing how specific federal income tax law can be when it comes to determining whether or not an activity falls under farming or ranching include:
- Farming Fish vs. Fishing: Income from operating a fish farm is considered reportable farm income on a Schedule F. The Internal Revenue Service (IRS) regulations do not consider an area where aquatic life is merely caught or harvested to fall under fish farming, and therefore, these sales are not considered farm income. For example, oyster growers who either own or lease oyster beds where they develop and breed oysters would fall under the definition of a farm activity for federal income tax purposes. In contrast, individuals who simply go out to harvest oysters in the wild would not have farm income.
- The sale of farm assets like land, buildings, breeding, working, or sport livestock, and farm machinery and equipment is NOT reportable farm income on a Schedule F.
- Rent is considered farm income only if your rental agreement states you will materially participate in production or manage farm products on that land, and you actually participate.
A Farm Business or a Hobby Farm?
Next, consider the “for profit” requirements of federal tax law before counting your income and expenses as farm business activities on a Schedule F. A hobby farm is not considered a business for profit. A hobby farm will probably have more limited deduction options for the taxpayer. A farm operation showing a loss for several years may start to worry about whether the IRS will classify them as a hobby farm. Luckily, there are factors the IRS and tax courts use to determine whether or not a farm is either a hobby or a business for profit.
Under federal tax law, if a business is not able to show a profit for three of five consecutive years, the IRS will consider whether or not the farm operation is a hobby or a business for profit. To show a profit, the farm’s annual income must exceed allowable deductions.
The IRS uses nine factors when investigating a business that has triggered the profit rule, but no one factor or combination of factors will determine a farm’s for profit status. Farmers should consider how complying with the profit rule and these nine factors can increase their chances of keeping the “business for profit” label by the IRS. Strong recordkeeping can help prove a farm meets these requirements.
1. Is it clear that the activity is intended to make a profit? Are you keeping records and books? Do you have a written business plan? Consider filling out the University of Maryland Extension Farm Business Planning Workbook located here.
2. Is the activity what the taxpayer depends on for income? If you have a large amount of income from another job, then the IRS might think that your farm is a hobby your regular job is simply supporting.
3. Are losses beyond the taxpayer’s control or at the beginning phases of the business? Consider whether weather, market conditions, etc. created abnormal losses, and if your farm operation is still in its beginning phases.
4. Has the taxpayer changed anything to make the business more profitable? Have you spent time considering how you can make the business more profitable? How much effort are you putting into the business to make it profitable?
5. Does the taxpayer have the knowledge to make the business successful? For example, can you show that you have taken classes, paid advisers to provide ideas, or attended Extension workshops about your area of farming?
6. Has the activity made a profit in the past? Has the farm made a profit in the past with similar activities?
7. Has the activity made a profit at any point?
8. Will the activity make a profit in the future from the appreciation of assets? Are there assets that will increase in value over time, such as livestock?
9. Is this just a hobby? Are you participating in the activity for personal pleasure or recreation? While the tax court’s decisions are not saying farming cannot be enjoyable and fun, if you struggle to prove the other factors mentioned above, the court will also consider this to determine whether or not this is simply a hobby.
The federal tax code can save money and even time for farm businesses filing their taxes this spring. It may be extremely beneficial to your pocketbook to discuss your “farm” income with your accountant.
Rev. Rul. 76-241, 1976-1 C.B. 131 (I.R.S. January 01, 1976).