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ALTB 04-07 Self Employment Tax
on Rented Farmland
March 2004 
Gary Hoff
Abstract
IRS has challenged taxpayers regarding whether rental payments for
land paid to an owner who materially participates in farming the rented
land is liable for self employment (SE) tax. The Courts have agreed
with IRS in a number of cases. However, the Eight Circuit overruled
the IRS on appeal. Relying on this successful appeal, taxpayers who
did not recognize SE tax liability had an argument to avoid a negligence
penalty. In 2003, IRS issued an official non-acquiescence statement
regarding the appeal, making the possibility of penalties more probable
for both taxpayers and tax professionals.
Renting Land to a Family Entity - The Mizell Problem
The Mizell case involved an Arkansas farmer who rented 731 acres of
farmland to a family partnership operated with his three sons. The
father owned a 25% interest in the partnership and the partnership
agreement specified that each partner had an equal vote in the management
of the partnership operation and in the conduct of the farming business.
Each partner was required to devote full time to the operation, and
the father was active in the partnership in the years in question
and reported the distributive share of partnership income as net earning
from self-employment. The lease was on a 25% crop-share basis with
the partnership paying all of the crop expense.
The father treated the lease as a nonmaterial participation lease
and did not report the rental amounts as SE income. The Tax Court
focused on the language in IRC §1402(a)(1) providing an exception
to the general rule that rentals from real estate are excluded from
net earning from self-employment if there is an "arrangement"
with material participation by the owner in the "production or
the management of the production" of agricultural commodities.
The court noted that the father was materially participating in the
partnership operations and the statutory language referring to "an
arrangement" necessarily included the father's involvement in
the partnership as well as under the lease. Thus, the rental income
under the lease was subject to SE tax. The court reasoned the type
of lease was immaterial where the lessor was materially participating
in the lessee entity.
Subsequent Cases and Rulings
A 1996 technical advice memorandum reached the same conclusion with
a cash rent lease to a corporation. Three Field Service Advice rulings
in 1998 were in agreement.
In three cases decided in 1999, the Tax Court applied Mizell and imposed
SE tax on rents from land rented to a family farming operation. On
appeal, the three Tax Court cases were consolidated and were reversed
in late 2000. The Eighth Circuit held that the lessor-lessee arrangements
should stand on their own, apart from any employment relationship,
and that if the rentals were "consistent with market rates for
agricultural land" the rents were not "derived under an
arrangement" and, therefore, SE tax was not due. The court pointed
out that "the mere existence of an arrangement requiring and
resulting in material participation in agricultural production does
not automatically transform rents received" into SE income. The
court noted that rents 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 remanded the
cases to the Tax Court to provide an opportunity for the IRS to show
a connection between rents and the "arrangement."
On July 10, 2002, the Tax Court rendered its remand opinion holding
that the rental arrangements reflected FMV and that no SE tax should
be imposed.
Note. Based on the Eighth Circuit's opinion in McNamara,
it is imperative that taxpayers who are potentially "subject
to challenge," set the rental rates in keeping with rates in
the area for comparable land. In addition, it is important that evidence
of rental rates be preserved for use in any later audit.
Possible Arguments
For taxpayers occupying a dual status as lessor and lessee, it is
important for the lease to be in writing with standard terms and conditions
calling for a reasonable rental. Also, it is important for the status
as partner, employee, or LLC member to be formally established and
maintained.
Remember, while Mizell involved a partnership, a more general solution
to the problem may be to convey the land to another type of entity
(such as an LLC or LP); however, the regulations on handling SE income
for such pass-through entities are still in limbo.
The key, outside the Eighth Circuit, is to make sure that the taxpayer
is not on "both sides of the equation" as both lessor and
lessee. In the IRS view, supported by the Tax Court opinion in Mizell,
the question is whether the taxpayer's combination of involvement
as lessor and lessee rises to the level of material participation.
In the Eighth Circuit (Arkansas, Iowa, Minnesota, Missouri, Nebraska,
North Dakota, and South Dakota), the key is to make sure the rental
rate is representative of a fair market rental for comparable land.
Another approach may be to transfer the land to a nonparticipating
spouse and have the spouse lease the land to the farming business
under a passive lease. There are several other income tax and estate
tax implications to consider with this approach.
Observation. The IRS continues to litigate Mizell-type
situations. A case involving an upstate New York apple tree and produce
farm is currently pending in the Tax Court and would be appealable
to the Second Circuit. This case was scheduled for trial September
8, 2003. The results of the appeal have yet to be released. Another
case, appealable to the Eighth Circuit, involves the cash leasing
of land by a family partnership to a corporation controlled by the
same individuals.
The IRS argued that the partnership rental income was subject to SE
tax. On January 28, 2003 a stipulated decision was entered. The IRS
entirely dropped the assessment of SE tax. This case was within the
same jurisdiction as McNamara and the taxpayer obtained independent
verification each year that rental amounts were similar to other rents
in the area.
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