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Farm Rental Income from Wholly Owned S Corp Was Not Subject to Self-Employment Tax

(Parker Tax Publishing October 2017)

The Tax Court held that the owners of a farm who rented a portion of it to a wholly owned S corporation that contracted with an unrelated company to raise chickens did not have to include the rent as self-employment (SE) income because the rent payments were at or below fair market value and the IRS failed to show a nexus between the rents and the owners' obligation to participate in the business. While there were several dissenting opinions, the Tax Court ruled that, because of the reversal of a prior Tax Court decision on similar facts, it was reconsidering its prior holdings. Martin v. Comm'r, 149 T.C. No. 12 (2017).

Facts

Charles and Laura Martin, a married couple, owned a 300 acre farm in Texas consisting of various agricultural and horticultural structures as well as their personal residence. Mrs. Martin performed the farm's bookkeeping while Mr. Martin performed a portion of the physical labor and other management services as necessary.

In 1999, the Martins began constructing the first of eight poultry houses in which they would raise young chickens called broilers. The houses were built according to detailed specifications provided by Sanderson Farms, Inc. (Sanderson), the third largest poultry producer in the U.S. Each poultry house had over 22,000 square feet of usable space. The Martins also installed over $1.2 million in specialized equipment including heating, air conditioning, and other improvements.

In 2000, the Martins entered into a 15 year Broiler Production Agreement (BPA) with Sanderson. The agreement contained extensive instructions and requirements for the Martins as the growers of broiler chickens. Several times per year, Sanderson would deliver a flock of broilers to the Martins, along with the daily necessary proprietary blend of feed for the birds, and would return 49 days later to pick them up. In carrying out Sanderson's detailed instructions, the Martins were allowed to hire additional laborers or employees, but their discretion ended there. Sanderson retained ownership of the broilers and all feed consumed or unconsumed by the flock. Sanderson required the broilers to be cared for according to their standards and its employees checked on the broilers daily throughout the 49 day cycle. The program restricted the broilers' diet and required any deviation to be specifically approved by Sanderson.

In 2004, the Martins formed CL Farms, Inc. as an S corporation. The Martins entered into oral employment agreements with CL Farms and set their salaries at amounts consistent with those of other broiler growers. The Martins also relied on a 2003 appraisal that analyzed the costs of running the broiler operation as an investment (rather than as active participants), and they priced CL Farms' activities to exceed the appraisal's projected labor and management costs. Mrs. Martin would provide bookkeeping services to the corporation and Mr. Martin, along with any hired laborers or employees, would provide the needed labor and management services. Sanderson approved an assignment of the Martins' BPA to CL Farms in 2005. CL Farms' BPA anticipated relying on employees to meet the requirements of the Sanderson broiler growing program. CL Farms, rather than the Martins, would be responsible as the grower; nothing in the BPA required the Martins to personally perform the grower duties.

The Martins entered into a five year lease with CL Farms by which CL Farms would rent the farm from the Martins (excluding their residence and 10 acres). The lease included structures, 176,000 square feet of poultry houses, and equipment. CL Farms agreed to pay rent of $1.3 million to the Martins over the term of the lease. CL Farms had to make each rent payment regardless of whether it had fulfilled its requirements as the grower to Sanderson or received sufficient income. The rent amount represented fair market rent and was consistent with amounts paid by other Sanderson growers for the use of similar premises.

At no point during 2008 and 2009, the years at issue, were the Martins obligated or compelled to perform farm related activities as a condition to CL Farms' obligation to pay rent to the Martins under the lease. The Martins were similarly not obligated to perform farm related activities in CL Farms' production of agricultural commodities. Although the Martins materially participated in broiler production activity, CL Farms consistently hired numerous laborers to clean and reset the houses between flocks. CL Farms also hired professional and legal counsel in connection with the farm's management. For 2008 and 2009, CL Farms paid approximately $78,000 and $86,000, respectively, for labor, employee benefits, and professional services.

The Martins reported the rent payments from CL Farms as rental income that was excludable from self-employment (SE) income. The Martins reported rental income of $259,000 for 2008 and $271,000 for 2009. The IRS determined that these amounts were subject to SE tax because they constituted net SE earnings under Code Sec. 1402. Deficiencies of around $13,000 and $15,000 were determined for 2008 and 2009, respectively. The Martins petitioned the Tax Court for a redetermination of the deficiencies.

Under Code Sec. 1402, rental income is generally excluded from a taxpayer's SE income. However, under Code Sec. 1402(a)(1)(A), the rent earned by the owner of land is subject to SE tax if the income is derived under an arrangement pursuant to which the owner is required to materially participate in the agricultural production and the owner actually materially participates.

Eighth Circuit's McNamara Decision

In McNamara v. Comm'r, 236 F.3d 410 (8th Cir. 2000), the Eighth Circuit reversed the Tax Court's holding that rental income was subject to SE tax on facts that were materially indistinguishable from the Martins' case. The Eighth Circuit held that, based on the term "derived" in the statute, there had to be a nexus between the rental agreement and the arrangement requiring the owners' material participation. The Eighth Circuit held that, regardless of material participation, rental payments at or below market rate strongly suggest that the rental agreement stands on its own as an independent transaction and is not part of an arrangement for participation in agricultural production.

The IRS, noting its nonacquiescence in AOD 2003-03 in the Eighth Circuit's McNamara decision, did not address the nexus issue with respect to the Martins' case. It said that, under the facts and circumstances, there existed an arrangement between the Martins and both CL Farms and Sanderson that required the Martins to materially participate in the production of poultry on their farm. According to the IRS, the rental income was subject to SE tax because such an arrangement existed and the Martins actually materially participated in the production of the broilers. The Martins took the position that, under McNamara, their rent payments were not subject to SE tax because the payments were at the market rate and there was no nexus between the lease and either the BPA or their employment agreements.

Tax Court's Decision

The Tax Court, following the Eighth Circuit's decision in McNamara, held that the Martins' rental income for 2008 and 2009 was not subject to SE tax because the rents they received represented fair market rent and were consistent with amounts paid by other Sanderson growers for the use of similar premises. The Tax Court interpreted McNamara as creating a presumption that, regardless of material participation, a rental agreement stands on its own where rental payments are at or below market rate, and that, in such a case, the burden shifts to the IRS to produce evidence of a nexus between the rental agreement and the arrangement requiring material participation by the owner. The Tax Court said that, because it had found that the rents were at market value, and the IRS did not address the nexus issue, it had no alternative but to conclude that the rental agreement was separate and distinct from the Martins' employment obligations and, therefore, the rental income was not includable in their net SE income.

The Tax Court asserted that the fair market rents were enough to establish that the rental agreement stood on its own, but it cited two additional facts to support its conclusion. First, the Tax Court noted that the Martins had invested over $1.2 million in the improvements required by Sanderson, and under the rental agreement, CL farms used around 10 acres and the single use structures for purposes of the BPA. Practically speaking, the agreement functioned as a return on investment rather than income recharacterization, according to the Tax Court. Second, the Martins had obtained an appraisal detailing the costs of operating the farm purely as an investment and priced CL Farms' activities to exceed the appraisal's projected costs. The Tax Court reasoned that these amounts were not merely remainder payments to the Martins after the rent checks were cashed, but rather were appropriate amounts for CL Farms to spend for the services required to operate its broiler houses as well as its grazing and other agricultural activities. The structure of these expenses demonstrated to the Tax Court the lengths to which the Martins went to operate CL Farms as a legitimate business, and not as a way to avoid SE tax.

Observation: There were two dissenting opinions. In one, two judges said that the presence of market rate rents should have been only one factor tending to show that there was no arrangement providing compensation for labor, and not a special factor giving rise to a presumption that shifted the burden of production. In the other, four judges would have held that the Eighth Circuit's focus on market value rents in McNamara was not supported by the plain language of Code Sec. 1402, and would have treated that decision as binding only in the Eighth Circuit.

For a discussion of calculating a farmer's net earnings from self-employment, see Parker Tax ¶168,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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