It may seem like a trivial matter, but to the IRS commingling of funds is a factor that suggests your ranch or farm is a hobby rather than a business. What exactly is “commingling?” The usual situation is depositing checks made payable to your business into your personal bank account, or using your business account for personal expenditures. If this is done only occasionally, for reasons of expedience, some sort of documentation should be made. In fact, at times it is necessary to transfer funds between your business and personal accounts, but in doing so it is crucial to provide backup documentation.
Many Tax Court cases have faulted the taxpayer for commingling of funds, particularly if there is a long history of losses in the livestock or farming activity, and these losses are used as tax deductions against the taxpayer’s main source of income.
Sloppy accounting and recordkeeping is one of the first things the IRS will notice if you are audited. This makes a bad impression and suggests you are not operating in a business like manner.
Commingling of funds is also a red flag if you are operating under the auspices of an LLC or corporate entity. If you treat your business’s money the same as your own, you put the entity at risk for exposure to your personal creditors’ claims. This is under the legal notion of “piercing the corporate veil.”
The commingling problem was a factor that resulted in a ruling against the taxpayers in an important case involving livestock farming, Kahla v. Commissioner [T.C. Memo 2000-127]. Mr. and Mrs. Harold Kahla of Tomball, Texas were denied farm deductions of $2,658,774 for their cattle and deer ranches, even though Mr. Kahla was knowledgeable about livestock farming and was highly successful in other businesses.
The Tax Court said that they didn’t conduct their farm in a businesslike manner, had no formal business plan, budget or accounting records, and what records they did have were incomplete.
The court noted that the taxpayers also commingled funds, and that there were significant recreational components of their farm activities.
The court also found that the taxpayers did not seriously investigate the possibility of changing or abandoning any of their current methods of operation. Their failure to take affirmative measures to mitigate losses was inconsistent with operating with a profit motive.
Keep in mind that under the IRS hobby loss rule, if you are engaged in ranching or farming, the IRS will likely considered your activity to be a “hobby” unless you can show two profit years in a five-year period. You are still entitled to take tax deductions even if you do not have two profit years in a five year period, but you will need to prove, through objective evidence, that it is your intention to be engaged in a business, not a hobby.
It’s crucial for ranchers and farmers to obtain a tax opinion letter from a lawyer that justifies your expenditures if you have several years of losses. Armed with a tax opinion letter, you will have evidence that can enable you to win if you are audited by the IRS.
If you are audited it is important to be careful what you say to the IRS auditor. It is important to have, in advance, documentary evidence that helps support your contention that you are operating a business. In addition to avoiding commingling of funds, contracts and employment agreements should be in writing, to the extent possible.
For example, Gloria Takahashi, who was a science teacher, owned a 40-acre grape farm in Fresno, Cali. The farm originally was owned by her grandfather and had remained in the family. She entered into an oral agreement with her father in which he agreed to operate and manage the farm. She was to receive farm income to the extent of farm expenses, while her father would receive any remaining income. In the event the farm operations resulted in a net loss, all losses would be allocated to Mrs. Takahashi. The farm incurred net losses over an extended number of years, and Mrs. Takahashi used these losses to offset her salary as a teacher and that of her husband’s.
Mrs. Takahashi made two mistakes: First, the agreement with her father was oral, not written. Second, in a letter to the IRS, Mrs. Takahashi said: “My intent is not to make money but to have a tax shelter and mostly help my folks, whose income is solely from this small farm.” The Tax Court said that “this letter, standing alone, is an admission by petitioner that she engaged in the operation of the farm primarily to provide her parents with a steady income and to obtain tax deductions rather than to make an economic profit.” [Takahashi v. Commissioner, 87 T.C. 126 (1986).]
John Alan Cohan is a lawyer who has served the livestock, farming and horse industries since l98l.