Entity Planning for Farmers and Ranchers: The Additional Taxes Under Obamacare and Farm Program Planning Concerns

October 26, 2015


Overview

The manner in which a farming business is organized and structured can minimize taxes and simultaneously maximize farm program payment limitations.  That can be a particularly important consideration when economic conditions become challenging, which is the current situation that many agricultural operations currently find themselves in.  Balancing liability concerns with tax minimization and, at the same time, finding the optimal structure for farm program payment limitation purposes is a significant focus of farm and ranch business planning.  From a tax perspective, much of the concern involves minimizing two new taxes that Obamacare imposes, and self-employment tax.

Obamacare Taxes – The NIIT and the Additional Medicare Tax

Obamacare introduced many new taxes, but two of them in particular impact entity structuring for farms and ranches.  In addition to the tax of 3.8% on certain passive income (the Net Investment Income Tax - NIIT),[1] Obamacare also increased the Medicare tax rate from 2.9% to 3.8% for certain taxpayers.[2] This additional 0.9% tax is often referred to as the “additional Medicare tax.”  The additional Medicare tax is imposed on taxpayers with wages and/or SE income above the same threshold amount that applies for purposes of the NIIT - $200,000 (single filers); $250,000 (married filing jointly); $125,000 (married filing separately).

From an estate, business, and succession planning perspective, the NIIT and the additional Medicare tax have implications for trusts and may encourage many entities to adopt the pass-through tax treatment provided by partnerships, LLCs, and S corporations.  

Trusts.  Under proposed regulations, the NIIT threshold for trusts is the top tax rate bracket ($12,300 for 2015). The NIIT applies to the lesser of undistributed NII or the excess of the trust’s AGI over the threshold. The regulations allocate investment income between distributed and undistributed income under the usual trust allocation rules. Electing small business trusts (ESBT) must combine their S corporation and non-S corporation income for purposes of computing the tax.[3] For charitable remainder trusts, the proposed regulations treat part of the distributions as investment income.[4]  

Pass-Through Entities – Partnerships and S Corporations.  Although pass-through entities are not subject to the additional Medicare tax, individuals, trusts, and estates that are direct or indirect owners may be subject to taxation on the allocable portion of income and gain derived from these entities. Taxpayers must include the additional Medicare tax in determining their estimated tax payments.[5] 

Partnerships.  Although the NIIT does not apply to income from a trade or business conducted by a partnership (other than passive income), income, gain, or loss on working capital is not considered to be derived from a trade or business and is subject to the NIIT.[6] Gain or loss from a disposition of a partnership interest is included in a partner's NII only to the extent of the net gain or loss the partner would take into account if the partnership sold all its property for fair market value (FMV) immediately before the disposition of the partnership interest.[7] This means that if a taxpayer materially participates in a partnership with trade or business income, the taxpayer will have self-employment income that is potentially subject to the additional Medicare tax of 0.9% and the standard Medicare tax of 2.9%.  That’s a combined 3.8%.  If the taxpayer does not materially participate in the partnership, the taxpayer’s share of partnership income will potentially be subject to the NIIT – 3.8%.  Pick your poison. 

S Corporations.  S corporation income reported to a shareholder is not subject to self-employment tax. In addition, the NIIT does not apply to business income earned by active S corporation shareholders, even if their income is over the threshold amounts. The NIIT does apply, however, to the income of passive shareholders in an S corporation. Thus, as compared to a partnership, because active S corporation shareholders can avoid both self-employment tax and the NIIT, the S corporation would be the preferred entity of the two.  

Limited Liability Companies (LLCs).  In general, income that is subject to self-employment tax is not subject to the NIIT. With respect to an LLC, business income allocated to the general partners of an LLC taxed as a partnership is generally subject to self-employment tax even if it flows to a partner who does not participate in the operations of the LLC.[8] There is no guidance on the self-employment tax treatment of income flowing to LLC (and limited liability partnership (LLP)) owners who do not participate in the operations of the business. However, to the extent a limited liability owner (either an LLC member or an LLP partner) receives a guaranteed payment for services, the law is clear that this payment is subject to self-employment tax.[9] Thus, guaranteed payments for services or capital would always appear to be subject to self-employment tax, even if paid to an individual holding a limited liability interest.  Presumably, LLC members (in an LLC that is taxed as a partnership) have self-employment tax liability on their distributive share unless the member is a treated as a limited partner. 

In the 1990s, the Treasury Department issued proposed regulations to try to clarify the self-employment tax status of LLC members.[10]   The proposed regulations were withdrawn in early 1997 and new proposed regulations were issued.  Under the 1997 proposed regulations, a partnership (or LLC taxed as a partnership) member is subject to self-employment tax under any one of three circumstances.[11]

  1. The individual has personal liability for the debts of, or claims against, the partnership by reason of being a partner or member.
  2. The individual has authority under the statutes of the state in which the partnership is formed to contract on behalf of the partnership (i.e., the individual has management authority).
  3. The individual participated in the entity’s trade or business for more than 500 hours during the entity’s taxable year.

Manager-Managed LLC.  An LLC may be member-managed or manager-managed.  By default, state LLC statutes treat LLCs as member-managed.  The owners of the LLC are responsible for managing the company in a member-managed LLC.  Thus, all of the members are treated as general partners and have self-employment tax liability on their respective distributive shares.  However, a manager-managed LLC is operated by managers who are appointed to run the company. Manager-managed LLCs are designated as such in the LLC formation documents or the LLC operating agreement, and operate in a similar fashion to a corporation that has a board of directors to control the company's affairs.  A manager-managed LLC has at least one member that takes a passive role in terms of operating the company. That feature can provide self-employment tax savings while maintaining limited liability.  In addition, the managers of the LLC can be members, but they don’t have to be.[12]  However, only the designated manager (or managers) in a manager-managed LLC has self-employment tax liability on their distributive share of partnership earnings.   

Making the Choice – Member-Managed or Manager Managed

  • All members are responsible for the daily operation of the business in a member-managed LLC.
  • A manager-managed LLC allows decision-making to be consolidated in one or a few managers.
  • If passive investors are to be involved, a manager-managed structure can be utilized.
  • A manager-managed LLC must be clearly specified as such in the organizational documents – articles of organization or the operating agreement. 
  • The operating agreement for a manager-managed LLC should address the scope of the authority of the manager(s).
  • The greater the number of members in the LLC, the more sense it makes to consolidate decision-making in one or a more hands.
  • In most states, the manager(s) of a manager-managed LLC has greater fiduciary duties to the LLC than the non-manager members do.  This may or may not be an important issue in any given situation, and may require that the LLC operating agreement address the issue.
  • Under most state laws, a member-managed LLC must publicly reveal the names of the LLC members (the owners).  A manager-managed LLC need only reveal to the public the names and addresses of the managers, and need not reveal the names and addresses of the members that are not managers.  Thus, the public notice is provided only of the operators of the business, and not the passive investors.  However, a member-managed LLC can accomplish the same level of privacy if its member is an entity (such as an LLC or a corporation) where the identity of the owner(s) need not be revealed, if state law allows such an ownership structure.

If an LLC member in a manager-managed LLC is treated under the proposed regulations as being subject to self-employment tax on their distributive share, there remain two possible exceptions by which the member can still be treated as a limited partner and avoid self-employment tax.  Both exceptions are tied to the fact that a manager-managed LLC may provide separate classes of membership for managers (who have the authority to bind the LLC under a contract) and non-managers (who have no such authority).  The first exception applies if the members who didn’t meet the tests of the proposed regulations (i.e., are passive investors) own a “substantial continuing interest” in a specific class of interests in the LLC, and these members rights and obligations in that class of interests are the same as the rights and obligations that other members (who do meet the requirements of the proposed regulations) hold in that class.[13]  A “substantial interest” requires an ownership interest in a class of interest exceeding 20 percent.[14]  The second exception applies to those members who don’t satisfy the 500-hour test of the proposed regulations.  In other words, the member participates in the LLC business for more than 500 hours during the entity’s taxable year.  Such a person can still be treated as a limited partner (and escape self-employment tax on their distributive share) if there are other members that meet the requirements of the first exception. 

Example:  Allen, Bob and Charles form XYC Farming Enterprises, LLC, a manager-managed LLC to engage in farming operations.  XYC Farming Enterprises, LLC is classified as a partnership for federal tax purposes and allocates all items of income, deduction and credit as follows:  25 percent to Allen, 50 percent to Bob and 25 percent to Charles.  Allen and Charles each receive one LLC unit for $5.  Bob receives two LLC units for $10.  Allen does not perform services for the LLC.  Bob receives a guaranteed payment for 600 hours of services rendered to the LLC, and Charles receives a guaranteed payment for 1,000 hours of services rendered to the LLC.  Charles is the LLC’s manager and has, under state law, the authority to contract on the LLC’s behalf.[15] 

Result: 

Allen satisfies the proposed regulations (he is not personally liable for LLC debts or claims; does not have the authority to contract for the LLC; and he does not participate for more than 500 hours in the LLC’s business).  Thus, the distributive share of LLC income attributable to his 25 percent LLC interest is not subject to self-employment tax.

Bob does not satisfy the proposed regulations because he participates in the LLC business for more than 500 hours during the tax year.  The first exception (the multiple class exception) does not apply to Bob because the LLC did not issue more than a single class of interest.  However, the material participation exception does apply to Bob because the failed the proposed regulations by participating more than 500 hours in the LLC’s business and Allen is a limited partner who owns more than 20 percent of the LLC and has rights and obligations identical to Bob’s.  Thus, the distributive share attributable to Bob’s 50 percent interest in the LLC is not subject to self-employment tax.  Bob’s guaranteed payment, however, is subject to self-employment tax. 

Charles does not satisfy the proposed regulations (his is the manager).  The first exception does not apply because the LLC only issued a single class of interest.  Likewise, the material participation exception does not apply (because Charles is the manager and failed the proposed regulations on multiple counts).  Thus, the guaranteed payment Charles receives and his distributive share are both subject to self-employment tax. 

As the example points out, to reduce the self-employment tax exposure, the LLC could bifurcate the LLC interest into two classes.

To summarize the proposed regulations and the exceptions:

  • Non-managers who do not meet the 500-hour participation test are not subject to self-employment tax, except to the extent of any guaranteed payments they receive.
     
  • Non-managers who exceed the 500-hour test are not subject to self-employment tax if they own a substantial continuing interest (i.e., at least 20%) in a class of interest and the individual’s rights and obligations of that class are identical to those held by persons who satisfy the general definition of limited partner (i.e., less than 500 hours for a non-manager).
  • Managers are subject to self-employment tax on the distributive share of income from their interest.
  • If there are non-managers who spend less than 500 hours with the LLC and such members own at least 20 percent of the interests in the LLC, those non-managers who participate more than 500 hours are not subject to self-employment tax on the pass-through income but are subject to self-employment tax on the guaranteed payments.[16]
  • It is possible to structure a manager-managed LLC with the taxpayer holding both manager and non-manager interests. In this type of structure, individuals with non-manager interests who spend less than 500 hours with the LLC must own at least 20 percent of the LLC interests.
  • An individual who holds both manager and non-manager interests does not owe self-employment tax on the income attributable to the non-manager interest.[17] The individual is subject to self-employment tax on the pass-through income and guaranteed payments of the manager interest.

Clearly, from a self-employment tax perspective, the use of a manager-managed LLC with two classes of membership provides self-employment tax savings to the non-managing members.  Importantly, both classes of membership provide limited liability protection to the members in their capacity as members. To summarize  

Structuring the Manager-Managed LLC. In an LLC that is structured to minimize self-employment tax and avoid the NIIT, all of the LLC interests can be owned by non-managers (investors) with a third party non-owner named as manager and some or all of the investors working on behalf of the manager. The manager could be an S corporation or a C corporation, with the LLC investors owning part or all of the corporation. The manager must be paid a reasonable management fee and the LLC owners who provide services to the LLC must be paid reasonable compensation. The LLC owners who do not render services to the LLC do not have income that is subject to self-employment tax. The manager could earn, for example, a 1 percent manager interest for the services rendered to the LLC, which generates a guaranteed payment. The guaranteed payment is subject to self-employment tax.

Summary points:

  • LLC non-managers working less than 500 hours annually are subject to self-employment tax only on guaranteed payments.
  • Non-managers who work more than 500 hours annually are subject to self-employment tax only on guaranteed payments if the non-managers who work less than 500 hours annually make up at least 20% of the membership.
  • Although the managers and non-managers own interests commensurate with their investment (i.e., non-manager interests), the managers also receive manager interests as a reward for their services.
  •  Managers recognize self-employment income on the pass-through income associated with the manager interests. All non-manager interests are not subject to self-employment tax, except guaranteed payments.

With respect to the NIIT, there is a special rule that comes into play when spouses are involved.   While a non-manager’s interest in a manager-managed LLC is normally considered passive and is subject to the NIIT,[18] a spouse may take into account the material participation of a spouse who is the manager.[19] Thus, if the manager spouse materially participates, then all non-manager interest(s) owned by both spouses avoid the NIIT.  That gives even more power to the manager-managed LLC with bifurcated interests.

Farm Program Benefits

Under the 2014 Farm Bill, the per-person payment limitation in $125,000.  That’s the general rule.  Peanut growers are allowed an additional $125,000 payment limitation, and the spouse of a farmer is entitled to an additional $125,000 payment limit if the spouse is enrolled at the local Farm Service Agency (FSA) office.  These payment limits are applied at both the entity level and then the individual level (up to four levels of ownership).  Thus, partnerships and joint ventures have no payment limits.  Instead, the payment limit is calculated at the individual level.  However, an entity that limits the liability of its shareholders/members is limited to one payment limitation.  That means that the single payment limit is then split equally between the shareholders/members.   

To be eligible for a payment limit, an adjusted gross income (AGI) limitation must not be exceeded.  That limitation is $900,000.  The AGI limitation is an average of the three prior years, with a one year delay.  In other words, farm program payments received in 2015 would be based off of the average of AGI for 2011, 2012 and 2013. 

The AGI limitation applies to both the entity and the owners of the entity. 

Example:  For example, assume that FarmCo receives $100,000 of farm program payments in 2015.  FarmCo’s AGI is $850,000.  Thus, FarmCo is entitled to a full payment limitation.  But, if one of FarmCo’s owners has AGI that exceeds the $900,000 threshold, a portion of FarmCo’s payment limit will be disallowed in proportion to that shareholder’s percentage ownership.  So, if the shareholder with income exceeding the $900,000 threshold owns 25 percent of FarmCo, FarmCo’s $100,000 of farm program payment benefits will be reduced by $25,000.  

From an FSA entity planning standpoint, the type of entity structure utilized to maximize payment limits will depend on the size/income of the operation. 

  • For smaller producers, entity choice for FSA purposes is largely irrelevant.  Given that the limitation is $125,000 and that payments are made either based on price or revenue (according to various formulas), current economic conditions in agriculture indicate that most Midwestern farms would have to farm somewhere between 3,000 and 4,000 acres before the $125,000 payment limit would be reached.  Thus, for smaller producers, the payment limit is not likely to apply and the manner in which the farming business is structured is not a factor. 
  • For larger operations, the partnership or joint venture form is likely to be ideal for FSA purposes.  If creditor protection or limited liability is desired, the partnership could be made up of single-member LLCs.  For further tax benefits, the partnership could consist of manager-manager LLCs with bifurcated interests. 

Conclusion

The proper structure of the farming business can provide tax benefits and also maximize farm program payments.  Every situation is unique, however, and full consideration should always be given to the family’s goals and objectives.

 

[1] I.R.C. §1411.

[2] I.R.C. §3101.

[3] Prop. Treas. Reg. §1.1411-3(c)(1)(ii). 

[4] Prop. Treas. Reg. §1.1411-3(c)(2). 

[5] I.R.C. §6654.

[6] I.R.C. §1411(c)(3). 

[7] I.R.C. §1411(c)(4). 

[8] Treas. Reg. §1.1402(a)-2(g).

[9] I.R.C. §1402(a)(13); Prop. Treas. Reg. §1.1402(a)-2(g). IRC §1402(a)(13) specifies that the distributive share of a limited partner in a limited partnership is not subject to self-employment tax. 

[10] 59 Fed. Reg. 67,253 (Dec. 29, 1994). 

[11] Prop. Treas. Reg. §1.1402(a)-2(h)(2).  The IRS is bound by any proposed regulation that a taxpayer reasonably relies upon. See Elkins v. Comr., 81 T.C. 669 (1983).  Also, a taxpayer that reasonably relies on a proposed regulation will avoid taxpayer penalties.  See United States v. Boyle, 469 U.S. 241 (1985).  The same is true for a tax practitioner.   

[12] In a manager-managed LLC, unless state law provides otherwise, a manager can be an entity such as an LLC or a corporation. 

[13] Prop. Treas. Reg. §1.1402(a)-2(h)(3). 

[14] Prop. Treas. Reg. §1.1402(a)-2(h)(6).

[15] This example is based on an example contained in the 1997 proposed regulations. 

[16] Prop. Treas. Reg. §1.1402(a)-2(h)(4).

[17] Prop. Treas. Reg. §1.1402(a)-2(h)(3).

[18] I.R.C. §1411(c)(2)(A).

[19] I.R.C. §469(h)(5). 

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CALT does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. CALT's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.

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