The following information was prepared by the Government and Industry Relations Committee (GIRCom) and is intended to assist you as you consider what you are going to do when you are preparing your tax return for the calendar year. We also hope it will help you maximize your protection during an Internal Revenue Service audit. *** This article is not intended to be legal or tax advice. You should consult your lawyer/CPA/financial advisor for advice specific to your own circumstances. Most audits are conducted by correspondence, rather than face-to-face. It is really important to have representation if you do get audited.
Here are the top 10 items that seem to be on the Internal Revenue Service’s radar.
- Business Plan. If you really want to LOSE a significant amount of protection during an audit, do not have a business plan. If you document what you expect to do, and the results you expect, prior to the actual event, i.e., you are expecting a loss for four years, it should help you if the IRS claims that you are not in the alpaca business to make a profit. It is even more important to compare your business plan to the actual events and see if you can improve your situation by acting to prevent a larger loss. It should show your INTENTION to make a profit.
- Donations. Alpaca farmers are very generous and they freely give donations to the associations that they support. The issue is that most trade associations are not “charitable” organizations, and the donation that you made may not tax deductible. Some alpaca farmers donate alpacas to various vet schools, and usually you can establish the value of the alpaca that you donated. If the donation value is over $5,000, you need a formal appraisal, and if under $5,000 you need to document the donation. If I were an Internal Revenue Agent, I would question why you would donate an alpaca worth more than $5,000 when we all have alpacas in our herd that are worth far less than that. Donations made by a business entity, as opposed to an individual, are not deductible as charitable donations, although they may be deductible as something else, such as an advertising expense.
- Depreciation method. There is a prescribed method recognized by the Internal Revenue Service that they expect to see on a farm return and that method is 150% MACRS method or what is commonly referred as the “farm method”. If you do not use this method, and the agent asks the question why you don’t use the prescribed method, are you admitting that you are not a farm? There is another deduction under Internal Revenue Code § 179 that allows you to expense depreciable assets in the year they are placed in service, even late in the year. The deduction is currently limited to $25,000, but Congress usually raises the limit at the end of the year. The deduction can be used for any depreciable asset, including equipment, breeding stock, and single-purpose buildings. It is combined with the depreciation deduction on Schedule F.
- Depreciation life. Not to get too technical, but it’s a great thing to give your advisors Revenue Procedure 87–56 and Revenue Procedure 88-22 which state that “for property NOT described in an asset class life, use a 7 year class life.” Most accountants use a 5-year life for depreciation of an alpaca, but the IRS has not assigned them to an asset class. Considering the lifespan of an alpaca, seven years is probably more reasonable than five years.
- Payroll expense. If you have an employee, make sure you give the employee a W-2 and withhold the appropriate taxes. In addition, most states require you to have workers compensation insurance on the employee, and if you have an employee and the employee gets hurt on your property most of the insurance companies providing your general liability coverage will not pay for the claims. Failing to pay the IRS for payroll taxes can result in dire tax problems. These are called “trust fund taxes” and the responsible person is held responsible for 100% of them.
- Capital Gains. The AOA Government & Industry Relations Committee has prepared and posted on the web site detailed information about considerations for the sale of an alpaca. It appears that if you do get audited, this is one area that most alpaca owners do not understand, and most alpaca owners do not treat the sale of the alpaca as a “capital asset”, subject to capital gains as compared to ordinary income. The brief version is that breeding stock (pregnant females and proven males) are capital gains and should be reported on Form 4797 as compared to your Schedule F. Animals that are purchased or bred to sell are “inventory” and should be reported as ordinary income on Schedule F. Animals that you have bred have no basis and the entire sale price is either income or capital gain. If the animal was part of your breeding program before you sold it, you can report it as capital gain, which currently has a more favorable tax rate than ordinary income.
- Farm vehicles. If you do not have a formal log of business miles driven, you will lose some if not all of your deductions. You may be able to recreate the logs based upon oil change receipts, repair bills etc., but it is usually just as easy to keep a notebook in your car or truck, and record your farm related mileage on a daily or weekly basis depending on the vehicles use. Most office supply companies have inexpensive mileage logs. The IRS takes the position that no vehicle is used 100% for business (unless it’s a tractor or other ranch-specific vehicle.)
- Reporting Wages Paid. Consider using Form 943 to report your wages paid for farm help. This form is used specifically for farms, and depending on the amount of wages, and taxes withheld, you may only have to deal with “payroll reports” once a year. Most accountants use form 941. Your children can be employed as farm labor not subject to FICA tax until they are 18.
- Alpaca products, including alpaca poop and fiber. We talk about the benefits of owning alpacas, especially the wonderful fiber. But, too many alpaca owners do NOTHING with their fiber. If you do nothing with your alpaca fiber, the IRS agent will probably come to the conclusion that you are not trying to make money, thus your whole operation could be in jeopardy. As far as alpaca poop goes, there are more and more farms processing poop for soil amendments, and/or selling it raw, dried, and ground up for fertilizer. This actually helps the alpaca farmer prove they are in business to make a profit.
- Finally, ask your tax advisor if they believe you are a business or a hobby. If your advocate does not support your position that you are in business, the audit outcomes will probably not be in your favor. You have two choices, either take the advice of your advisor and get out the business, or find another advisor!
Ask your tax advisor to play devil’s advocate and pretend to be an IRS agent auditing you.
Whether an activity is considered “for profit” depends on the facts and circumstances of each case. Regulation § 1.183-2(b) of the Internal Revenue Code identifies nine factors to be considered by the IRS in determining whether your alpaca business is a hobby or a business. Frequently, they will ask these questions in a correspondence audit and ask you to reply in writing.
- The manner in which the taxpayer carried on the activity,
- The expertise of the taxpayer or his or her advisers,
- The time and effort expended by the taxpayer in carrying on the activity,
- The expectation that the assets used in the activity may appreciate in value,
- The success of the taxpayer in carrying on other similar or dissimilar activities,
- The taxpayer’s history of income or loss with respect to the activity,
- The amount of occasional profits, if any, which are earned,
- The financial status of the taxpayer, and
- Elements of personal pleasure or recreation.
Note that no single factor controls and other factors may be considered, and the number of factors indicating one way versus the other doesn’t determine the outcome. For example, if five factors say the activity is a hobby, but four say it is for profit, it could still be considered an activity for profit.
The IRS has published an educational fact sheet (FS-2008-23) that provides guidelines to determine if an activity is being operated for profit. The guidelines take the form of the following questions:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
For the activity to be considered for profit, you must have documentation and records to support answers to the above questions and generally must have a written business plan. The IRS can propose a penalty for poor, inadequate, or no records. If you end up in tax court, the burden of proof, instead of being on the IRS, shifts to the taxpayer if his records are inadequate.
However, simply having documentation, records, and a business plan doesn’t automatically mean there is a profit motive. More importantly, there has to be evidence that you actually relied on the records in order to make decisions or changes about the activity. Likewise, there has to be evidence that you actually followed the business plan, and if the original plan was not successful, that you took steps to change the plan to increase profitability. It is really important to review and update your business plan once or twice a year.
If you raise alpacas or are considering getting started with alpacas, you should have a general understanding of the income tax issues relating to the activity. We hope that you will find this information helpful.
IRS Publication 225, Farmers Tax Guide
IRS Publication 946, How to Depreciate Property
IRS Revenue Procedure 87-56 and 88-22
IRS FS-2008-23, June 2008
IRS Regulation § 1.183-2(b)