On September 27, the U.S. Tax Court ruled that a Texas farm couple was not liable to pay self-employment tax on rents they received from the S corporation through which they conducted a poultry growing operation. The decision in Martin v. Commissioner, 149 T.C. 12 (Sept. 27, 2017), adopted the analysis of McNamara v. Commissioner, 236 F.3d 410 (8th Cir. 2000), and comes 14 years after the IRS announced its non-acquiescence[i] with that key 8th Circuit case.
The taxpayers, who were husband and wife, acted as contract poultry growers for Sanderson Farms, Inc. Although they originally signed their broiler production agreement with Sanderson Farms as individuals, they later formed an S corporation and assigned their responsibilities under the agreement to that entity. The S corporation, CL Farms, Inc., employed the wife to provide bookkeeping services and the husband to provide labor and management services. Nothing in the agreement required the taxpayers to personally perform the duties of grower, and the company hired additional employees.
The taxpayers then entered into a five-year agreement under which CL Farms would rent from the taxpayers their farm, including 176,000 square feet of poultry houses and equipment, in exchange for $1.3 million. This was fair market rent and was consistent with amounts paid by other Sanderson Farm growers for the use of similar premises. The rent was due whether or not CL Farms fulfilled its grower requirements or received sufficient income to pay the rent.
For both 2008 and 2009, the taxpayers reported their rental income from CL Farms as rents, not subject to self-employment tax. The IRS determined that these amounts of $259,000 and $271,000, respectively, were subject to self-employment tax because they constituted net earnings from self-employment under IRC § 1402(a)(1).
In a 12-4 decision, the U.S. Tax Court sided with the taxpayers. The court well summarized current law at the heart of the Martin dispute:
IRC § 1402(a)(1) generally excludes rental real estate income from the computation of a taxpayer’s net earnings from self-employment. This exclusion, however, also provides that rent derived by the owner of land is not excluded from the computation of net earnings from self-employment 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. (emphasis added)
On one hand, the IRS contended that the rent payments the taxpayers received from CL Farms were subject to self-employment tax because there was an arrangement between the taxpayers and both CL Farms and Sanderson Farms that required the taxpayers to materially participate in the production of agricultural commodities on their farm.
On the other hand, the taxpayers argued that 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 either the taxpayers’ employment agreement with CL Farms or CL Farms’ agreement with Sanderson Farms. Second, the taxpayers alleged that their material participation was not required by either CL Farms’ agreement with Sanderson farms or their employment agreements with CL Farms.
The tax court began by stating that under “virtually identical circumstances,” it had, in 1999[ii], ruled that rental income from a wholly owned corporation was received pursuant to an arrangement between the parties to produce agricultural commodities on the farm within the meaning of section 1402(a)(1)(A). In McNamara, the taxpayers, a husband and wife, had leased property, at fair market value, to their farm corporation for which they also worked. The Eighth Circuit later reversed the tax court’s McNamara decision[iii] on the grounds that there was no nexus between the rental agreement and any arrangement requiring the taxpayers’ material participation. The Eighth Circuit found that despite the existence of a separate employment agreement requiring the taxpayers’ material participation--and despite their actual material participation--a rental agreement may stand on its own in certain circumstances. In so finding, the Eighth Circuit stated, “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.” On remand, the tax court ruled that the Commissioner had not shown “a nexus between the rents received by [the McNamaras] and the ‘arrangement’ that requires the landlords’ material participation.” As such, the McNamara taxpayers prevailed.
In Martin, the IRS did not disagree that the facts were similar to those in McNamara. Rather, the agency asked the tax court to follow its own McNamara decision, rather than that of the Eighth Circuit. The taxpayers argued that the Eighth Circuit had properly decided the McNamara case and that the tax court should adopt its reasoning.
The court sided with the taxpayers and ruled that its 1999 McNamara decision did not give sufficient consideration to the requirement of IRC § 1402(a)(1) that the rent in question be “derived under” an arrangement requiring the landlord’s material participation. In other words, there was in the 1999 decision insufficient consideration given to the “nexus between the rents received by [the] taxpayers and the ‘arrangement’ that requires the landlords’ material participation.”
While reviewing the Eight Circuit’s McNamara opinion, the tax court noted that “self-employment tax provisions are construed broadly in favor of treating income as earnings from self-employment.” Even so, the court agreed that the plain language of the “derived under” language in § 1402(a)(1) required a nexus between the rents received by a taxpayer and the “arrangement” requiring the landlord’s material participation. The Eighth Circuit had explained:
[T]he 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 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.
The court then adopted and summarized the Eight Circuit’s “test” as follows: Regardless of a taxpayer’s material participation, if the rental income is shown to be less than or equal to market value for rent, the income is presumed to be unrelated to any employment agreement. At that point, the burden of production shifts to the IRS to show a nexus between the rent and the taxpayer’s obligation to materially participate. Such a showing would render the lease and employment agreements part and parcel of a larger “arrangement.”
The court noted that this test does not contradict congressional intent, but places farmers in the same position as their urban contemporaries with respect to rental income that is insufficiently related to their trade or business. Congress’ intent, the court explained, was to afford income protection to taxpayers who might not otherwise be able to provide for themselves in old age. In circumstances where the two agreements are truly separate and distinct, the taxpayer is not in jeopardy of losing his rental income if he is unable to materially participate. Rather, he must only hire someone else to perform those tasks that he was otherwise performing.
The court then applied the Eighth Circuit’s McNamara test to the facts of the current case.
Because the parties stipulated that the taxpayers materially participated in the production of agricultural commodities during the years in issue, the court only needed to decide whether there existed an arrangement sufficient to subject the taxpayers’ rental income to self-employment tax.
The court found that the rent payments represented fair market rent and were consistent with amounts paid by other Sanderson Farms growers for the use of similar premises. This, the court found, was sufficient to establish that the agreement stood on its own.[iv] Consequently, the burden of production shifted to the IRS to show a nexus between the rents and the agricultural arrangement requiring the taxpayers’ material participation.
The court ruled that the IRS failed to show--and the record did not contain sufficient evidence to show--a nexus between the rents and the agricultural arrangement requiring the taxpayers’ material participation.[v] The court thus concluded that the rental agreement was separate and distinct from the taxpayers’ employment obligations and, therefore, the rental income was not includible in their net self-employment income.
Four justices joined two dissenting opinions. One argued that the court had improperly allowed the reasonableness of rent to shift the burden to the IRS to prove a nexus. This result, the dissenters alleged, was not warranted by McNamara. The other dissenting opinion argued that the plain reading of the SE tax statute was inconsistent with the Eighth Circuit's McNamara decision. As such, the dissenters would not have applied that reasoning to the instant case.
For now, agricultural taxpayers outside of the Eighth Circuit also have a court opinion upon which they can rely to exclude self-rental income from the reach of self-employment tax in certain circumstances. Namely, an agricultural taxpayer who leases property to an entity in which he materially participates should be able to exclude that rental income from self-employment tax liability if (1) rent is at or below fair market value and (2) there is no nexus between the rents paid and the arrangement requiring the taxpayer’s material participation.
We’ll watch to see if the IRS appeals the case to the Fifth Circuit.
[i] AOD CC-2003-003 (Oct. 20, 2003).
[ii]McNamara v. Commissioner, T.C. Memo. 1999-333.
[iii]In addition to Hennen v. Commissioner, T.C. Memo. 1999-306, and Bot v. Commissioner, T.C. Memo. 1999-256.
[iv] The court also noted that the taxpayers’ agreement functioned as a return on investment rather than a method of income recharacterization.
[v] The court noted that the IRS did not make an argument based upon earlier tax court decisions finding a nexus between rental income and a taxpayer’s production arrangement. These cases had found a nexus where such rent was based, for example, upon number of pigs raised or volume of corn delivered. Instead, the court pointed out that the IRS put “all of his proverbial eggs” in the basket of its nonacquiescence to the McNamara case and arguing for a broad interpretation of the CL Farms agreement with Sanderson Farms.
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