Relief From Self-Employment Tax on Farm Rental Income

by Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

The Eighth Circuit Court of Appeals recently decided a case that should be considered when advising clients involved in agricultural leasing operations. Generally, the case may allow land owners to structure leasing situations so that fair market value rents received may avoid self-employment tax, even if the land owner participates in the farming activities pursuant to an unrelated contract.

Background

In order to fund Social Security benefits for the self-employed, the Internal Revenue Code taxes self-employment income. Generally, taxable self-employment income excludes sources that do not depend on an individual’s labor, including rentals from real estate. The distinction between real estate rentals and labor is often blurred in agricultural settings, where land owners may enter into a variety of agreements that require some services or participation by them in the farming activities. Rent derived under an "arrangement" between a land owner and third party, under which the third party produces agricultural commodities and the owner materially participates in the activity, is generally includible in farm rental income and constitutes earnings from self-employment. In these circumstances, § 1402(a)(1) specifically imposes self-employment tax on:

"any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity."

This provision potentially subjects a variety of agriculture related income to self-employment tax, and it has resulted in litigation over the past few years, primarily relating to the meaning of the phrase "derived under an arrangement."

Eighth Circuit Analysis

In McNamara v. Commissioner, 2001-1 USTC ¶50,188 (December 29, 2000), the Eighth Circuit limited the application of the phrase "derived under an arrangement" in § 1402(a)(1), reversing the Tax Court. In this case, land owners leased ground to their farming operations pursuant to lease agreements, and were also employed by the farming operations pursuant to separate employment agreements. The IRS and Tax Court looked beyond the terms of the leases in question and determined that "the overall scheme" of the farming operations amounted to an arrangement for purposes of § 1402(a)(1), subjecting the rental income to self-employment tax.

The Eighth Circuit disagreed with these conclusions. The court accepted the taxpayers’ argument that the lessor-lessee relationship should stand on its own apart from the employer-employee relationship. Contrary to IRS arguments and prior Tax Court holdings, the Eighth Circuit was not willing to look at all of the agreements between the lessor and the lessee to find the "arrangement" calling for material participation. The Eighth Circuit summarized its analysis as follows:

"What is missing from both the Commissioner’s and the Tax Court’s analyses is any mention of a nexus between the rents received by Taxpayers and the "arrangement" that requires the landlords’ material participation. We believe this omission overlooks §1402(a)(1)’s requirement that rents be "derived under" such an arrangement. That is to say, the mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement.

Rents that are consistent with market rates very strongly suggest that the rental arrangement stands on its own as an independent transaction and cannot be said to be part of an "arrangement" for participation in agricultural production. Although the Commissioner is correct that, unlike other provisions in the Code §1402(a)(1) contains no explicit safe-harbor provision for fair market value transactions, we conclude that this is the practical effect of the "derived under" language."

This decision is contrary to the IRS position and prior Tax Court opinions, and the IRS may appeal the Eighth Circuit opinion. It is also important to note that the Eighth Circuit decision should only be relied upon by taxpayers in this circuit (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota).

Conclusion

The Eighth Circuit opinion allows an agricultural land owner to avoid self-employment tax on fair market rentals if the rental arrangement does not require the landowner to materially participate in the farming operation, despite unrelated agreements that may require participation in the farming operations on the land. From a planning and drafting perspective, taxpayers in these circumstances will certainly want to separate farm rental income from income relating to services in the farming operations, if their goal is to avoid self-employment tax. However, it is important to note that many farming operations generate losses for their owners. In these circumstances, the opposite planning motivations may apply: the taxpayers may want to demonstrate a nexus between their material participation and the income and expenses relating to the farm property. Thus, the planning possibilities provided by the Eighth Circuit opinion should be carefully considered in light of a given taxpayer’s overall circumstances.