Taxing Lessons From Court Decisions

Decisions — Which came first?

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What came first, tax law or exclusions from tax law? In a situation involving the taxation of self-employment income, the exclusion from self-employment tax for rentals from real estate and from personal property leased with the real estate came about at the same time as internal revenue code section 1402(a)(1).

Later revisions brought farmers under the umbrella of the social security act, and provided that agricultural land rental payments are not self-employment income unless the payment is part of an agreement that requires the landlord to materially participate in the agricultural production.

In 149 T.C. No. 12 (Martin), the question was whether the taxpayer, a chicken farmer who leased his farm to a poultry producer via an S corporation that he owned, had to pay self-employment tax on the rental income.

The lease excluded the farm residence, access to the residence, and 10 acres, and included the farm’s structures, 176,000 square feet of poultry houses, and equipment. Over the term of the five year lease, the S corporation agreed to pay rent of $1.3 million to the taxpayer. This amount represented fair market rent (according to an appraisal) and was consistent with amounts paid by other growers for the use of similar premises.

Under the agreement, the S corporation had to remit each rent payment irrespective of whether it had fulfilled its requirements as grower to the poultry producer or received sufficient income. The taxpayer was not obligated or compelled to perform farm-related activities as a condition for receiving the rent. The taxpayer materially participated in the farm activity and received a salary from the S corporation at amounts consistent with those of other poultry farms.

The taxpayer filed joint federal income tax returns for 2008 and 2009, reporting rental income from the farm of $259,000 and $271,000, respectively.

The IRS said the rental income was subject to self-employment tax under section 1402(a)(1). According to the IRS, based on the facts and circumstances, the taxpayer had an arrangement between himself and both the S corporation and the poultry producer that required the taxpayer to materially participate in the production of agricultural commodities on the farm.

The taxpayer says the rent payments were not subject to self-employment tax for two reasons. First, the rent payments were consistent with market rates, and there was no nexus between the lease and the employment agreement. Second, the taxpayer’s material participation was not required by either the agreement with the poultry producer or the employment agreement with the S corporation.

In a prior case with similar circumstances, the tax court decided for the IRS. However, that earlier decision was reversed by the court of appeals for the eighth circuit (McNamara).

The appeals court said the mere existence of an arrangement requiring and resulting in material participation in agricultural production would not automatically make rents received self-employment income. Instead, market-rate rent would suggest that the arrangement was a separate transaction.

Note that because the taxpayer in this case lives in Texas, the tax court is not bound to follow the reversal of the previous case by the eighth circuit appeals court.

Here’s the relevant tax law.

From internal revenue code section 1402(a): Provides that the term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle * * * except that in computing such gross income and deductions * * *

(1) there shall be excluded rentals from real estate and from personal property leased with the real estate * * * except that the preceding provisions of this paragraph shall not apply to 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 * * * poultry * * *) 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 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 * * *




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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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Sorry, wrong answer :(
Right answer!

For the taxpayer. The rental income is not self-employment income.

Using the appeals court analysis, the tax court finds that the taxpayer’s agriculture-related rental income is not included in the net self-employment income under section 1402(a)(1).

The taxpayers have shown that the rent payments were at or below market value, and the IRS failed to show — and the record does not contain sufficient evidence showing — a nexus between the rents and the agricultural arrangement requiring petitioners’ material participation.

Editorial note: This was not a unanimous decision. Two judges dissented and the IRS may not acquiesce.

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