Farmers get their fair share of cases heard by the U.S. Tax Court, but the decision in the Martin case announced Sept. 27 is particularly significant. It could have a direct bearing on most producers.
Charles and Laura Martin farm 300 acres in Texas. In late 1999, they spent $1.2 million to construct eight poultry houses to raise chickens and entered into a broiler production arrangement (BPA) with Sanderson Farms. The 15-year contract contained extensive production requirements. Sanderson Farms would deliver chicks to the Martins, and 49 days later, the company would return to pick them up.
Lease Complexities. In 2004, the Martins organized CL Farms as an S-corporation, which hired the couple to manage the corporation’s business and established salaries. Laura provided bookkeeping and Charles provided management and labor.
In January 2005, Sanderson Farms approved the assignment of the BPA from the Martins to CL Farms. The Martins entered into a five-year lease agreement with CL Farms, which would rent from the Martins their farm, structures, equipment and poultry houses. CL Farms would pay $1.3 million to the Martins for an average annual payment of $260,000. The amount represented fair market value.
IRS Steps In. For 2008, CL Farms paid the Martins $259,000 and for 2009, the amount increased to $271,000. They reported it on their personal return. The IRS determined these amounts should have been reported as self-employment income and assessed additional tax of $13,409 and $15,408, respectively. The federal code taxes self-employment income, but there is an exclusion for rental income from real estate. The IRS contended the exclusion did not apply because the arrangement among the Martins, CL Farms and Sanderson Farms required the Martins to materially participate in the production of agricultural commodities.
The Martins contended self-employment tax did not apply for two reasons. First, rent payments were consistent with market rates. They maintained there was no nexus between the lease and either the BPA or the employment agreements. Second, they argued neither CL Farms’ BPA nor their oral agreements with CL Farms required their material participation.
Both the IRS and Martins relied primarily on the McNamara case, decided in 1999 by the Tax Court and reversed in 2000 by the Eighth Circuit Court of Appeals. In that case, the Tax Court held that rental income from a wholly owned corporation was received pursuant to an arrangement between the parties to produce agricultural commodities. Thus, the income was subject to self-employment tax.
The Eighth Circuit reversed the Tax Court, saying no nexus existed between the rental agreement and any arrangement requiring the taxpayers’ material participation. It held a rental agreement may stand on its own in certain circumstances.
The Eighth Circuit remanded the case back to the Tax Court, which found the rental payments were made at market rates and thus ruled in favor of the McNamaras. These cases, commonly called McNamara No. 1 and No. 2, are relevant because the IRS contended McNamara No. 1 should apply to the Martins. The Tax Court ultimately ruled in favor of the Martins by indicating McNamara No. 2 is correct.
What It Means. Ever since McNamara and related cases, there has been some confusion about whether self-employment tax applies to self-rental income received by farmers as landlords from their wholly owned farming entities. In light of the Martin case, it is apparent that properly structured farm leases should exempt this income from self-employment tax.
The key requirements are that rental income remain at or less than market value and that the lease call for no material participation by the landlord. If this applies to your situation, the Martin case provides the correct guidance.