From time to time, especially in the start-up phase, Christmas tree farms show a tax loss rather than a profit. Fortunately, this loss is normally deductible against a grower’s other income, resulting in tax savings. However, if the IRS deems a Christmas tree farm a “hobby” rather than a “business,” a Christmas tree grower may owe additional taxes.
This article will explain the difference between a hobby and a business, as well as strategies to avoid application of the hobby loss rules.
Why You Don’t Want Your Christmas Tree Farm to be a Hobby
According to federal tax law, a business is an activity that is (1) entered into primarily for profit and is (2) regularly and continuously carried on. Conversely, a hobby is an activity that is not engaged in for profit.
The benefit of a business classification is that any loss is fully deductible against other income, including wages or other business profits. However, a hobby classification results in no tax deduction for a loss. Any income from a hobby is taxable, while few, if any, tax deductions are permitted.
Business v. Hobby Example
Nick Nordmann is a single Christmas tree grower whose farm had a tax loss in 2021 of $20,000, resulting from sales of $40,000 and expenses of $60,000.
Nick also works a job where he earned $80,000 in wages. He has no other income or expenses.
If Nick’s Christmas tree farm is classified as a business, he may fully deduct his $20,000 tax loss from his $80,000 wages when computing his adjusted gross income. Therefore, his 2021 adjusted gross income is $60,000. His $20,000 Christmas tree farm loss saved him $4,400 in taxes because he is in the 22% tax bracket ($20,000 * 22%).
If Nick’s Christmas tree farm is classified as a hobby, his Christmas tree sales are taxable, but his expenses are not deductible. This means Nick now has $120,000 in adjusted gross income ($80,000 wages + $40,000 Christmas tree sales). His expenses of $60,000 are not deductible, meaning his Christmas tree farm now costs him an additional $9,473 in income taxes due to its hobby classification ($6,375 * 22% + $33,625 *24%).
Although the above calculations are simplified and do not consider self-employment tax, itemized deductions, or possible capital gain taxation, a grower clearly would rather have their Christmas tree farm classified as a business, rather than a hobby.
Hobby Loss Factors
When a grower is audited by the IRS, the agent will look at nine factors to determine if the Christmas tree farm is a hobby, rather than a business. Having as many factors as possible in favor of a business classification is best. However, there is not a set number of factors required for a business classification. Every situation is evaluated on a case-by-case basis.
The following nine factors are adapted from Treasury Regulation § 1.183-2. A “yes” to the questions below indicate a Christmas tree farm is a business rather than a hobby:
1) Do you run your Christmas tree farm like a business?
At a minimum, you should have accurate and organized books and records, a separate business bank account and credit cards, a legal entity, and other business formalities.
2) Do you have expertise in growing Christmas trees, or have you consulted experts?
This can include attending Christmas tree meetings, consulting with other growers, and consulting with tax and legal experts who are familiar with the Christmas tree industry.
3) Does the time and effort you put into growing Christmas trees indicate you intend to make a profit?
If you spend significant time and effort growing Christmas trees, this is indicative of a profit motive. Spending only a few hours a week growing trees is more indicative of a hobby.
4) Do you expect to make a profit in the future from the eventual sale of the farmland?
5) Have you made a profit from farming or other similar activities in the past?
6) Have you made a profit in some years from Christmas tree growing?
If you made a profit in 3 out of the last 5 years, the IRS will presume your Christmas tree farm is a business rather than a hobby.
7) If there are losses, are they in the start-up phase of the Christmas tree farm? Are losses due to circumstances beyond your control? Are the losses small compared to expected future profits?
Having a business plan that shows a path to profitability is extremely important for a Christmas tree farm in the start-up phase. A new grower should also consider generating income from other sources during the start-up phase, such as selling pre-cut trees purchased from another grower, selling other farm products (pumpkins, etc.), or hosting a fall or spring festival.
8) Do you depend on income from Christmas tree growing?
9) Do you enjoy Christmas tree growing?
Here, a “yes” answer actually weighs against you. However, this factor is not given as much weight as the others because many people enter into a business because they like at least some aspects the work.
How to Avoid Application of the Hobby Loss Rules
If you think the IRS may consider your Christmas tree farm a hobby, there are several things you can do to avoid application of the hobby loss rules.
One solution is to incorporate your business and become a C Corporation, the same business form as most publicly-traded companies. The corporation pays tax separately from the owners. However, incorporation is generally not recommended because it often results in higher taxes (as compared to a partnership, LLC, or S-Corporation) and is time-consuming due to more corporate formalities.
The following three recommendations to avoid application of the hobby loss rules can be applied to any Christmas tree farm. While following these recommendations does not guarantee the IRS will classify your farm as a business, they are important activities that indicate a profit motive:
1) Maintain Proper Documentation
Proper documentation supports factor #1, running your Christmas tree farm like a business. You should maintain accurate and organized books and records. Quickbooks is a popular bookkeeping software. However, there are free options available, such as Wave Accounting, which I recommend to many growers.
You should also keep all receipts, invoices, and other documentation to support your books. It’s easy to save all this documentation using a cloud storage provider, such as Dropbox, Google Drive, or Evernote.
Another important document is a business plan with financial projections. The IRS will want to see you are following a plan to be profitable sometime in the future.
Finally, you should also keep a mileage log if you deduct business miles on your car or truck. This is one of the most frequently audited issues and the IRS requires a mileage log to substantiate a mileage deduction.
2) Seek Advice from Experts
Most Christmas tree growers are not tax or legal experts. Therefore, Christmas tree growers should seek out knowledgeable professional accountants and attorneys for business advice.
Further, attending Christmas tree association meetings, reading Christmas tree articles, and networking with other growers are great ways to increase your knowledge about Christmas tree growing.
Doing the above activities show the IRS that you are trying to become profitable by increasing your knowledge and implementing expert advice.
3) Keep a Time Log
A time log supports factor #3. If you can show the IRS that you spend significant time growing trees and trying to create a profitable farm, that indicates a profit motive rather than just a hobby.
At a minimum, a time log should show the date, time spent on Christmas tree growing, and the activities performed.
Conclusion
Avoiding the hobby loss rules as a Christmas tree grower is critical to saving taxes, especially if your farm shows a loss for multiple years. Every grower’s situation is different. Therefore, I recommend consulting with a tax professional before implementing any of the above tips. Ultimately, planning for and creating a profitable Christmas tree farm is the best way to avoid a hobby classification.
