The Tax Court held that rent payments to husband and wife chicken farmers by their wholly owned S corporation for use of their farm in the corporation's poultry farming operations qualified for the exclusion for rental payments from self-employment income.
Background
Since July 1999, Charles and Laura Martin have owned a farm consisting of more than 300 acres of land, various agricultural and horticultural structures, and their personal residence. Laura Martin performed the farm's bookkeeping; Charles Martin performed a portion of the physical labor and other management services as necessary.
In late 1999, the Martins began constructing the first of eight poultry houses in which they would raise young chickens designated as broilers. The poultry houses were built in accordance with detailed specifications provided by Sanderson Farms Inc. (Sanderson Farms)—a Fortune 1000 company and the third-largest poultry producer in the United States.
In 2000, the Martins entered into a broiler production agreement (BPA) with Sanderson Farms. This 15-year agreement contained extensive instructions and requirements for the Martins as growers of broilers for Sanderson Farms. In essence, five or six times a year, Sanderson Farms would deliver the couple a flock of broilers—along with the necessary proprietary blend of feed for the birds—and 49 days later, it would return to pick them up. Over the course of those 49-day cycles, the Martins were responsible for the care of each flock of broilers using good poultry husbandry practices, but they were required to feed the birds only the feed provided by Sanderson and had little or no discretion under the contract as to how they raised the broilers.
In 2003, the Martins obtained an agricultural appraisal of their farm, which appraised the cost of the farm's property and analyzed the cost of its operations. On Nov. 19, 2004, the Martins organized CL Farms Inc. (CL Farms) as an S corporation. Using the appraisal as a guide for the cost of labor and management services and incorporating information gathered from other broiler growers, the Martins entered into oral employee agreements with CL Farms and set their salaries at amounts consistent with those of other growers. Laura would provide bookkeeping services to the corporation, and Charles, along with any hired laborers or employees, would provide the requisite labor and management services.
The Martins assigned their BPA to CL Farms. CL Farms also rented the Martins' farm under a five-year lease agreement for a fair market rent. The agreement required CL Farms to remit each rent payment whether or not it had fulfilled its requirements as grower to Sanderson Farms or received sufficient income. The lease did not require the Martins to perform any farm-related duties.
In 2008 and 2009, CL Farms met the terms of the lease, and the Martins reported the rent payments the corporation made to them as rental income that was not subject to self-employment tax. The Martins did not believe they were—and were not actually—obligated or compelled to perform farm-related activities as a condition of CL Farms' obligation under the lease to pay the Martins rent.
For 2008 and 2009, CL Farms also fulfilled its duties as grower to Sanderson Farms; the Martins were similarly not obligated to perform farm-related activities in CL Farms' production of agricultural commodities under the BPA. Although the Martins materially participated in the broiler production activity, CL Farms consistently hired numerous laborers to clean and reset the houses between flocks and also hired professional and legal counsel in conjunction with the farm's management.
The IRS audited the Martins returns for 2008 and 2009. The IRS determined that the rental payments from CL Farms to the Martins were subject to self-employment tax because they were net earnings from self-employment under Sec. 1402(a)(1). The Martins challenged the IRS's determination in Tax Court.
The Tax Court's decision
Sitting en banc, the Tax Court held that the rent payments from CL Farms to the Martins were not subject to self-employment tax. The court adopted the reasoning and analysis of the Eighth Circuit's decision in McNamara, 236 F.3d 410 (8th Cir. 2000), rev'g T.C. Memo. 1999-333, in determining that the rental agreement was a separate and distinct agreement from the Martins' employment obligations and, thus, the rental income was not compensation to the Martins that was includible in self-employment income.
The Code: Sec. 1401 imposes a tax upon self-employment income; Sec. 1402 provides instructions for calculating the amount. As relevant to this case, Sec. 1402(a) provides:
The term "net earnings from self-employment" means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle . . . except that in computing such gross income and deductions . . .
(1) there shall be excluded rentals from real estate and from personal property leased with the real estate . . . except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if
(A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including . . . poultry . . .) on such land and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or management of the production of such agricultural or horticultural commodities, and
(B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity . . .
McNamara: In McNamara, a case with virtually identical facts to the Martins', the Eighth Circuit addressed whether the exclusion from self-employment income under Sec. 1402(a)(1) applied to rental payments for a farm. It determined that the exclusion did apply because the taxpayer did not produce agricultural commodities as specified in Sec. 1402(a)(1)(B). The court focused on the "derived under" requirement in Sec. 1402(a)(1)(B), finding that "the practical effect of the 'derived under' language" was to require a nexus between the rents received by a taxpayer and the "arrangement" requiring the landlord's material participation. The court noted:
[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. . . . [McNamara, 236 F.3d at 413]
Therefore, in the Eighth Circuit, if rent is paid at a market rate pursuant to a rental agreement like the Martins', the rent will not be self-employment income under the exception in Sec. 1402(a)(1).
The parties' positions in Tax Court: The IRS contended that the rent payments the Martins received were subject to self-employment tax because, taking into account all the facts and circumstances, there existed an arrangement between the Martins and both CL Farms and Sanderson Farms that required the Martins to materially participate in the production of agricultural commodities on their farm. This was the same position the IRS took, and the Tax Court accepted in McNamara, before its decision was overturned by the Eighth Circuit.
The Martins, on the other hand, contended 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 BPA or the employment agreement. Second, neither the CL Farms' BPA nor the Martins' oral employment agreements with CL Farms required their material participation. This argument was based on the Eighth Circuit's decision inMcNamara.
The Tax Court follows the Eighth Circuit: The Tax Court found that it was Congress's intent with respect to Social Security tax (and, by extension, the self-employment tax) to reach income of an individual that tends to be diminished or wiped away because of old age or disability, and not to reach income of an individual (such as rental income) that is the fruit of someone else's labor and continues in spite of old age or disability. According to the court, the test developed by the Eighth Circuit was consistent with this intent because it "resolves the issues arising in separating true rental income from wage income in circumstances where farmers receive separate payments" and "supplements existing factors for consideration and serves to implement congressional intent, placing farmers in the same position as their urban contemporaries."
After considering the evidence, the court found that the rent payments the Martins received represented fair market rent and were consistent with amounts paid by other Sanderson Farms growers for the use of similar premises. Thus, the burden shifted to the IRS to show that there was a nexus between the rents paid to the Martins and the agricultural arrangement requiring the couple's material participation. The IRS had put forward no evidence to prove this nexus (having simply argued that the court should interpret "arrangement" broadly to include any and all contracts related to CL Farms) and, consequently, the court found that the rental agreement was separate and distinct from the Martins' employment obligations, so the rental income was not self-employment income.
Reflections
While the fair market rental test created by the Eighth Circuit and adopted by the Tax Court has the virtue of being a seemingly fair and simple solution to the problem of applying the self-employment tax to taxpayers in situations like the Martins', as a dissent signed onto by four judges correctly points out, it has the vice of having absolutely no basis in the Code as written. As the dissent notes, if Congress had wanted to create a safe harbor in cases where the rental payment for property was at a fair market rate, it could have easily done so, and there are reasons why it may have specifically declined to do so. Therefore, it would seem to be improper for the courts to rewrite the law based on theories about how doing so fits into the grand scheme of Social Security and self-employment taxes.
Martin, 149 T.C. No. 12 (2017)
