IRS Sticking to Its (Unofficial) Position That CRP Payments Are Subject to SE Tax

Overview

In 2014, the U.S. Court of Appeals for the Eighth Circuit reversed the Tax Court and held that Conservation Reserve Program (CRP) payments paid to non-farmers are rents from real estate that are excluded from self-employment tax under I.R.C. §1402(a)(1).[1] In so holding, the court gave no deference to an IRS Notice of Proposed Revenue Ruling[2] which, had it been formally adopted, would have reversed the longstanding position of the IRS that land conservation payments paid to non-farmers are not subject to self-employment tax.[3]  After the judicial rejection of the unofficial IRS position, the IRS did not issue the Revenue Ruling that would have obsoleted the older contrary rulings.  Instead, the IRS issued a non-acquiescence to the court’s decision, sticking to its new (unofficial) position on the self-employment taxability of CRP payments and announced that audits would continue unabated – even in the Eighth Circuit.[4]

Background                                                                                                            

The Conservation Reserve Program (CRP), originally enacted in 1985, is an agricultural program administered by the U.S. Department of Agriculture (USDA).  Under the program, the program participant agrees to remove the land from active farming, implement a conservation plan, and seed the tract to permanent grass or other vegetative cover to prevent erosion and improve soil and water resources.  The USDA, in exchange, generally shares the initial cost of the conservation measures and makes an annual rental payment (reported on a Form 1099) to the owner of the land.

History of SE Tax Treatment of Government Payments

In 1965, the IRS ruled that grain storage fees paid under a price support loan program of the Commodity Credit Corporation (CCC) were SE income if they were paid to an active farm operator, but excludable from SE income if they were paid to a taxpayer who did not materially participate in the farming operation.[5]  That ruling followed-up on and is consistent with another ruling that IRS had released in 1960 in which the IRS took the position that payments received for acres idled under the Soil Bank program were SE income "if he operates his farm personally … or … if his farm is operated by others and he participates materially in the production of commodities."[6]

When the CRP was created with the 1985 Farm Bill (the CRP has been termed the “son of Soil Bank”), the IRS maintained that its rulings from the 1960s applied and that CRP rents were not SE taxable in the hands of a non-farmer.  CRP rents, according to the IRS would only be SE taxable if the recipient was a farmer.  For example, in Ray v. Comr.,[7] an active farmer who received income from CRP was required to pay SE tax on the CRP rents, because the farmer was found to already be in the business of farming and the CRP had a direct relationship (nexus) to the farming business. While the farmer was required to care for and conserve the acreage, he was required not to farm or graze the land.

In 1998, the Tax Court held that CRP payments in the hands of an active farmer were not subject to SE tax.  Under the facts of the case, an active farmer received about $18,000 of CRP program payments in 1992 and 1993. The payments were reported on Schedule E as land rents. At the same time, the taxpayer was reporting other farming activity on Schedule F subject to SE tax. The IRS assessed SE tax on the CRP income. However, the Tax Court concluded that the CRP payments were rental income, and accordingly exempt from SE tax under I.R.C. §1402(a)(1).[8]  The Tax Court noted that both the federal legislation authorizing the CRP program and the CRP contractual terms described the payments as rental income. Further, the court noted that the farmer’s service requirements with respect to the land (implementing a conservation plan and establishing ground cover) were incidental, particularly after the first year. Thus, the court concluded that the CRP payments represented rental for the use of land rather than payment for services, and excluded the payments from SE income as rentals from real estate. Having determined that CRP income qualifies as rental from real estate under I.R.C. §1402(a)(1), the Tax Court pointed out that, based on Treas. Reg. §1.1402(a)-4(d), the CRP income is exempt from SE tax even if the payments are associated with a taxpayer’s active farming operation.[9]

The IRS appealed the Tax Court’s decision, and the Sixth Circuit reversed in a split decision.[10]    In reaching its decision, the Sixth Circuit noted that the taxpayer was actively engaged in farming prior to and during the term of the CRP contract, and that the CRP payments were “in connection with” and had a “direct nexus to” the taxpayer’s ongoing farming business.  The Sixth Circuit concluded that the key to the SE tax analysis was the substance, rather than the form, of the transaction. Even though the USDA program labeled the CRP payments as rent, the court reasoned that this fact alone was not determinative of the tax issue, given the connection of the CRP income to the active farm business.  However, the Sixth Circuit did not clearly analyze where the line is between activity that constitutes a trade or business for purposes of self-employment tax and activity that does not rise to that level. 

The Sixth Circuit also differed with the Tax Court on the basic issue of whether CRP income was rent. Noting that rent is defined as payment “for the use or occupancy of property,” the Sixth Circuit observed that the U.S. Department of Agriculture (the payor of the CRP revenue) was not using or occupying the farmland. The Wuebkers, the court noted, continued to have control over and access to their property, despite the CRP restrictions on the agricultural use of the land.

In 2003, the IRS signaled that it was changing its position on the self-employment taxability of CRP payments.  In Chief Counsel Memo. 200325002,[11] the IRS took the position that a taxpayer’s signature on a CRP contract was sufficient to constitute a trade or business which would then make the CRP payments subject to self-employment tax. 

In late 2006, the IRS announced a proposed Revenue Ruling in which it would officially take the position of the 2003 Chief Counsel Memo, revoke the prior Revenue Rulings to the contrary, thereby making official the government’s position that CRP payments are always subject to SE tax, whether received by an active farmer or an inactive landlord/investor.[12]  Thus, the IRS was announcing that it planned to change its official, long-held position that such payments were not subject to self-employment tax. 

The proposed Revenue Ruling (which was never made final) contained two situations to illustrate its potential holdings:

• In the first situation, an individual actively engaged in the business of farming enrolled a portion of his land in the CRP program. The proposed ruling held that the individual would be subject to SE tax on the CRP income.

• In the second situation, individual B, a land owner, ceases all activities related to the business of farming in the year before he enters into a CRP contract. In that subsequent year, B rents out a portion of his land to another farmer and enters into a 10 year CRP contract with respect to the remaining portion of his land. A third party performs the seeding and weed control required under the CRP contract. The proposed ruling held that the individual must treat his CRP rental income as subject to SE tax. This second situation relied on the Sixth Circuit’s Wuebker decision, and focused on the activities required under the CRP contract (tilling, seeding, fertilizing and weed control).

As a result of a provision included in the 2008 Farm Bill effective for CRP payments made after tax years after 2007, individuals receiving benefits under Section 202 (i.e., retirement) or Section 223 (i.e., disability) of the Social Security Act are exempt from the payment of self-employment tax on CRP income.[13]  For other taxpayers, no change was made in the SE tax treatment of CRP payments.[14]

Reporting of CRP Payments – Pre-Morehouse

Based on the court rulings, IRS Revenue Rulings and Private Letter Rulings, the IRS had significant support for its position that an active farmer is subject to SE tax on CRP income. As a result, many practitioners took the conservative approach of reporting CRP income as Schedule F income subject to SE tax on the tax returns of active farmers. The Ray case and Sixth Circuit’s Wuebker opinion represent strong authority for treating CRP income in the hands of an active farmer as business-related income subject to SE tax.

However, some practitioners, particularly those representing clients not within the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee) took a more aggressive approach, on a case-by-case basis, by advising active farmers of the controversy and continuing to report CRP income as non-SE income based on the Tax Court’s Wuebker opinion.[17]

For taxpayers who are not actively involved in farming (and not receiving Social Security benefits) the IRS position that CRP rents in the hands of these taxpayers are SE taxable is much weaker.   As noted above, the IRS had always held that Soil Bank and CRP payments are not subject to SE tax in the hands of a non-farmer, and the courts had confirmed that view.

CRP and Non-Farmers – The Morehouse Litigation

In 2013, the U.S. Tax Court released its opinion in Morehouse v. Comr.[18]  In Morehouse, the taxpayer was a non-farmer that lived in Texas and worked for the University of Texas. In 1994, he inherited farmland in South Dakota and bought other farmland from his family members. He never personally farmed the land, but rented it out. In 1997, he put the bulk of the property in the CRP while continuing to rent-out the non-CRP land. He hired a local farmer to maintain the CRP land consistent with the CRP contract (e.g., plant a cover crop and maintain weed control).  In 2003, the petitioner moved to Minnesota, but still never personally engaged in farming activities. Consequently, the petitioner reported his CRP income on Schedule E where it was not subject to SE tax.

The IRS took the position that the CRP rents were subject to SE tax, based on its administrative change of position that it first asserted in 2003.  The Tax Court, in a full Tax Court opinion, agreed.[19]  The Tax Court found the existence of a trade or business based on either the petitioner’s personal involvement with the CRP contract[20] or through the local farmer that he hired to maintain the land. The court cited the Sixth Circuit’s decision in Wuebker[21] as controlling even though the taxpayer in that case was an active farmer and Morehouse had never been engaged in farming. Thus, Wuebker was factually distinguishable. However, the court stated that the petitioner was in the business of maintaining “an environmentally friendly farming operation.”

The Tax Court’s opinion was appealed to the U.S. Court of Appeals for the Eighth Circuit. The majority opinion, issued by Judge Beam, noted that the CRP is the current federal program in a long line of conservation programs and is similar to the old Soil Bank program – even noting that the CRP program has been referred to as the “Son of Soil Bank.” Based on that close tie, the court noted that the IRS, in Rev. Rul. 60-32,[22] said that Soil Bank payments paid to non-farmers were not subject to SE tax, but they were subject to SE tax if they were paid to materially participating farmers. The IRS again restated that position in Rev. Rul. 65-149.[23]  The court found those rulings to be persuasive and binding on the IRS given the similarities between the CRP and the Soil Bank program.  Thus, the court held that “CRP payments made to non-farmers constitute rentals from real estate for purposes of I.R.C. §1402(a)(1) and are excluded from the self-employment tax.”

The court distinguished the Sixth Circuit’s opinion in Wuebker[25] on the basis that the taxpayer in Morehouse was not a farmer and that the taxpayer in Wuebker was an active farmer. On that point, the court noted that the Sixth Circuit “neither recognized nor rejected the IRS’s position in Rev. Rul. 60-32 that similar payments [i.e., Soil Bank payments] to non-farmers were not self-employment income.”

The court also viewed the CRP payments that the taxpayer received as being for the use and occupancy of his land, noting that the CRP contract reserves the government’s right of entry on the land. The court also found it important that the IRS had represented that if the taxpayer had not fulfilled the contractual requirements, “the USDA could arrange for any needed work to complete ‘on his behalf.’ ” Similarly, the court noted that, via a CRP contract, the government is using the taxpayer’s land for the government’s own purpose of removing sensitive cropland from production and other environmental purposes for the benefit of the public. Accordingly, the court held that “the 2006 and 2007 CRP payments were “consideration paid [by the government] for use [and occupancy] of [Morehouse’s property]” and thus constituted rentals from real estate fully within the meaning of I.R.C. §1402(a)(1).

Because the court determined that CRP payments paid to non-farmers are rentals from real estate that are not subject to self-employment tax under the statutory exclusion of I.R.C. §1402(a)(1), the court did not analyze the trade or business issue.  However, during oral argument, both justices Beam and Loken noted that if the CRP payments were not “rents” the CRP payments must be derived from the taxpayer’s trade or business.  The court clearly did not agree with the IRS argument that all arrangements entered into for profit, regardless of the level of the taxpayer’s involvement, are automatically deemed to constitute a trade or business.  There is absolutely no support for that position.

The bottom line is that the Eighth Circuit reversed the Tax Court and distinguished the Sixth Circuit’s Wuebker opinion by holding that CRP payments in the hands of a non-farmer are not subject to self-employment tax. The court also held that CRP payments at issue (paid before 2008) qualify as “rentals from real estate” because they were payments for the government’s use and occupancy of the taxpayer’s land.

Self-Employment Taxation of CRP Payments Post-Morehouse – Guidance For Practitioners

Inside the Eighth Circuit (AR, IA, MN, MO, NE, ND and SD).  The Eighth Circuit’s reversal of the Tax Court means that non-farmers do not have to pay self-employment tax on CRP payments. That’s the case at least within the Eighth Circuit. Active farmers still have self-employment tax to pay on CRP payments unless the 2008 Farm Bill provision applies to them. But, non-farmers and non-materially participating farm landlords are given relief within the Eighth Circuit. For CRP rents paid after 2007, the question is whether the recipient is a materially participating farmer.  The Eighth Circuit’s opinion is helpful in arguing that a non-farmer is not materially participating with respect to the CRP. The majority stated, “The record indicates that Morehouse never personally farmed the CRP Properties and that he tilled and fertilized the land so that he could establish grass covering of which he could make no economic use. We suspect, respectfully, that the Commissioner’s characterization of Morehouse’s activities as even remotely resembling a “farming operation” would be met with a fair modicum of skepticism by anyone who has carried on (or closely observed) such an enterprise.” That’s very helpful language that could even support an argument that an active farmer that has CRP ground that is, for example, located in a location distant from the actual farming operation, need not pay self-employment tax on CRP rents.

Inside the Sixth Circuit (KY, MI, OH and TN).  For practitioners representing taxpayers in the Sixth Circuit, CRP payments are considered farm income rather than rents from real estate if there is a “nexus” with the taxpayer’s farming operation.  Thus, a taxpayer receiving CRP payments but who is not a farmer could reasonably take the position on the return that CRP payments are not subject to self-employment tax due to a lack of nexus with a farming operation.  For instance, an Ohio farmer with hunting property in Colorado which includes CRP acres would not be subject to self-employment tax on the CRP payments received. 

Outside the Sixth and Eighth Circuits.  For taxpayers in neither the Sixth or Eighth Circuits, CRP payments could be treated as real estate rents that are excludible from self-employment tax under I.R.C. §1402(a)(1).  This position is based on the full Tax Court opinion in Wuebker that CRP payments are “rents.” 

Recipients of Social Security.  Taxpayers receiving social security retirement or disability payments as well as CRP payments can exclude CRP payments from self-employment income regardless of where they are located.

IRS Non-Acquiescence in Morehouse

On September 23, 2015, the IRS announced its disagreement with the Eighth Circuit’s Morehouse decision in A.O.D. 2015-02.[26]  The IRS asserted that the Eighth Circuit “misinterprets” Rev. Rul. 60-32 and Rev. Rul. 65-149.  Of course, Rev. Rul. 60-32 is a major obstacle to the current position of the IRS on the self-employment taxability of CRP payments in the hands of a non-farmer.  The IRS, in the A.O.D., claimed that Rev. Rul. 60-32 only applies in the context of landlords who do not materially participate in a farming operation on their land.  Since Morehouse was not a landlord, IRS claimed that Rev. Rul. 60-32 didn’t apply to shield the CRP payments from self-employment tax.  Under the IRS rationale, Morehouse was an “operator” of his CRP land which doesn’t require material participation to trigger self-employment tax.  The IRS claimed to base its position on the exception to the rental real estate exception of I.R.C. §1402(a)(1) that is contained in I.R.C. §1402(a)(1)(a).  That provision subjects income to self-employment tax that is derived under an arrangement between a farm owner or tenant and another individual which provides that the other individual will produce agricultural or horticultural commodities on the land and provides that there shall be material participation by the owner or tenant in the production or the management of the production of the commodities, and that there actually is material  participation by the owner or tenant in the production of the commodities on the land.  The IRS made no mention of the fact that the statute (I.R.C. §1402(a)), the U.S. Supreme Court (Comr. v. Groetzinger, 480 U.S. 23 (1987)) and the Eighth Circuit (at least during oral arguments in Morehouse), require income to be derived from the taxpayer’s trade or business for the income to be subject to self-employment tax.

The IRS position is absurd.  Rev. Rul. 60-32 states that payments and benefits attributable to the acreage reserve program (a.k.a. the Soil Bank – the precursor to the CRP) are includible in determining the recipient’s net earnings from self-employment if the taxpayer operates his farm personally or through agents or employees but if “. . . he does not so operate or materially participate, payments received are not to be included in determining net earnings from self-employment.” (Emphasis added).  Notice that it says “personally” and “he does not so operate.”  Thus, Rev. Rul. 60-32 is not limited in its application to landlords, it includes “operators” and it is directly applicable to the facts of Morehouse (and countless other non-farmers with CRP income), and remains a major obstacle to the changed position of the IRS first announced in 2003.

The IRS, in the A.O.D. also claimed that Rev. Rul. 65-149 merely elaborated the point made in Rev. Rul. 60-32 that the only situation addressed was that non-materially participating landlords would not have self-employment tax on their Soil Bank payments, but that non-landlord investors or non-farmer estate beneficiaries would.  Again, that is a mischaracterization of Rev. Rul. 65-149.  In that Revenue Ruling, the IRS stated that annual payments under farm programs comparable to the CRP are not subject to self-employment tax if the taxpayer was not materially participating in farming operations (either personally or via a lease) on land not in the government land diversion program.  “Personally” refers to being the “operator.” 

Note:  The key to understanding the IRS position is that, with respect to CRP, a recipient of CRP payments is either a farm landlord or a farmer.  There is no room, in the IRS view, for a non-farmer who is not a landlord.  A non-farmer is an “operator” for which the material participation requirement doesn’t apply.  Thus, the CRP income is subject to self-employment tax without any requirement that the income be derived from the taxpayer’s conduct of a trade or business. 

The Eighth Circuit did not, as the IRS claims in the A.O.D., assert that either Rev. Rul. 60-32 or Rev. Rul. 65-149 support the conclusion that the CRP payments in Morehouse constituted rents from real estate.  Instead, the Eighth Circuit opinion was two-pronged:  (1)  the CRP, as the modern-day version of the Soil Bank, resulted in payments that should be treated the same for self-employment tax purposes as Soil Bank Payments were under the revenue ruling that IRS had not obsoleted – not subject to self-employment tax in the hands of a non-farmer; and (2) the CRP payments in the hands of a non-farmer are real estate rentals that are statutorily excluded from self-employment tax under I.R.C. §1402(a)(1). 

The IRS also claimed in the A.O.D. that the 2008 Farm Bill amendment to I.R.C. §1402(a)(1), by implication, meant that CRP payments paid before 2008 were not covered by the rental real estate exception of I.R.C. §1402(a)(1), and that for those payments made after 2007 are subject to self-employment tax unless the recipient is also receiving social security retirement or disability payments.  However, as pointed out above, the dissent’s point in Morehouse that the court’s rent analysis was inapplicable to post-2007 payments seems to indicate that the dissenting judge believes that the statutory change to I.R.C. §1402(a)(1) means that CRP payments paid post-2007 are “rents” that are statutorily exempt from self-employment tax.  That conclusion is precisely the opposite of the IRS statement in the A.O.D.

What To Do Now

Given the IRS non-acquiescence to Morehouse, what is a practitioner to do?  In the A.O.D., the IRS said it will continue to audit returns where CRP income is not reported as subject to self-employment tax, and will maintain its position that all CRP income is subject to self-employment tax unless the 2008 Farm Bill provision applies.  That includes the Eighth Circuit, where the only relief (according to the IRS) applies to non-farmers receiving CRP payments before 2008.  Given that the IRS position is wholly without support, and substantial authority exists for excluding CRP rental income from self-employment tax in the hands of a non-farmer, or even in the hands of a farmer where the CRP land has no nexus with the farming operation, the guidance mentioned earlier still applies.  The IRS still has no substantial authority for its position that CRP payments are subject to self-employment tax absent the application of the 2008 Farm Bill provision.    

Conclusion

In recent months, much news has been made about court decisions being “the law of the land” that must be followed.  Apparently, the Federal Government doesn’t believe that mantra applies when it[CWH2]  disagrees with a court’s opinion, as evidenced by the A.O.D.  The A.O.D. is a recycling of the failed arguments contained in the government’s brief in Morehouse and the government’s statements made at oral argument in the Eighth Circuit – which the court flatly rejected.  The A.O.D. represents the most recent pronouncement of the IRS that it disagrees with the trade or business requirement of I.R.C. §1402(a) and that all income-producing ventures should be subject to self-employment tax:  a position that renders the statute superfluous.  The proper course for the IRS to take is to follow the required procedures to issue a new revenue ruling that obsoletes its prior contrary rulings.  Trying to distinguish prior rulings that are directly on point is a pointless exercise that will unnecessarily subject many taxpayers to needless audits and litigation.