The Internal Revenue Service (IRS) defines a farmer as someone who operates a farming business with the intent of making a profit. You can find the definition of farmer on the cover of the Farmer's Tax Guide, IRS Publication 225. If you don’t have it, you may find the Farmer's Tax Guide by following this link.
The definition says: "You are in the business of farming if you cultivate, operate, or manage a farm for profit, either as owner or tenant. A farm includes livestock, dairy, poultry, fish, fruit, and truck farms. It also includes plantations, ranches, ranges, and orchards and groves." Note that farming does not include service providers such as veterinarians or custom harvesters, nor does it include landscaping operations or pet kennels. Processing is considered part of farming only to the extent that it's normally incidental to the growing, raising, or harvesting of commodities. So for example, cleaning, grading, and packaging fruit prior to sale is considered part of the farming activity of an orchard, whereas a winery, even if owned by the grape producers, is considered to be a separate business.
On another hand, an activity is a hobby if it's primarily for fun, recreation, or sport without any intention of making a profit. The IRS will presume a farming activity is being conducted for profit if it produced a profit in at least three out of the past five tax years, including the current year. Equine operations are the exception, with a presumption of profits in at least two out of seven years. If the years-of-profit test is not met, it doesn't automatically mean the activity is a hobby. Instead, the IRS will consider other criteria, including:
- The extent to which the activity is conducted in a businesslike manner
- The expertise of the taxpayer or his advisors related to the activity
- The time and effort spent on the activity
- The expectation there may be of assets used in the activity appreciating in value
- The success of the taxpayer in carrying on other similar activities
- The taxpayer’s history of income or losses with respect to the activity
- The amount of occasional profits, if any
- The financial status of the taxpayer, who may be interested in offsetting other sources of income
- The elements of personal pleasure or recreation
Any income from a hobby farm is reported on the first page of the U.S. Individual Income Tax Return or Form 1040, under "Other income", and it is taxable. You used to be able to deduct hobby farm expenses to the extent of the farm’s income, but that is not the case anymore, so you will be taxed on your hobby farm’s gross income independently from any expenses. On the other hand, income from a commercial farm is reported on Schedule F, which is an attachment to Form 1040, and its expenses are deductible, even if they go above income. So if your farm operates at a loss in some years, those losses can be used to offset your overall income tax liability.
Of course this makes it convenient for you to call your farm a commercial farm, but can you prove your farm is a business? If you are audited, the IRS will look at whether there are large expenses and little or no farm income, or if your farm’s losses are offsetting off-farm income. These things could make your activity seem as something you do only for a tax benefit. Many times farming is something we do for love more than for the profit, especially in the first few years when you are spending a lot of money and not making much in return. You have to be able to prove that your goal is to make money from farming.
The good news is that the practices needed to show the IRS that you are in farming for its potential profit, are the same good practices that will make your business a successful one. Some of them are:
- Keep your farm’s bank accounts separate from personal accounts
- Have a formal written business plan
- Have an annual budget
- Keep business books and records
- Make year-end financial statements and analyses
- Attend Extension meetings related to your farming activity
- Read Extension or other activity-related educational materials
- Consult with professionals
- Get a membership to a producer association
- Keep track of the time spent in carrying on the activity
Being a hobby farmer or homesteader are great lifestyle choices too, and they may fit your specific situation better. We hope that these tips will help you prepare for tax season whatever your income sources or lifestyle choices are.
Michigan State University Extension has many resources available, including bookkeeping and financial analysis tools to help you with the important decisions you have to make as a farm manager. Many of these resources can be found at the MSU Extension Farm Management website: https://www.canr.msu.edu/farm_management. Contact your Farm Business Management Extension Educator if you need help finding the right resources for your particular situation.
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