Leased farmland and the active business requirement for a tax-free reorganization

By Steve Drucker, CPA, Williams & Company PC, Spencer, Iowa

Editor: Michael D. Koppel, CPA/PFS/CITP

A large number of family-owned farm businesses throughout the United States are involved in the leasing of farmland. Many of these farm businesses are seeing the younger generation start to get involved and having their own ideas about how the leasing operations should function. Family members might disagree about how to proceed, and some might want to go their separate ways. If this happens, a tax-free separation could be the answer to split up the business interest. However, it might be complicated to complete a tax-free reorganization for a corporation when the leasing of farmland is part of the corporation's operations.

A divisive reorganization under Sec. 368(a)(1)(D) is the way to complete a tax-free reorganization of a corporation involving a split-off of a business. A split-off involves creating a subsidiary corporation under the parent corporation and transferring assets of the parent to the subsidiary. The parent corporation would then distribute the stock of the subsidiary to the shareholder in exchange for the shareholder's entire interest in the parent corporation. That shareholder would then own 100% of his or her own corporation with some of the former assets of the parent corporation now in the split-off corporation.

That shareholder could run that business as he or she sees fit. As long as the requirements of Sec. 368(a)(1)(D) and Sec. 355 are satisfied, no tax liability would be incurred by any shareholder or corporation involved in the reorganization transaction. Shareholders must be prepared to show they have met the requirements in Sec. 368(a)(1)(D) and Sec. 355.

One such requirement of a tax-free divisive reorganization is the active trade or business requirement of Sec. 355. Sec. 355(b)(1)(A) requires that after the distribution of subsidiary stock, both the parent and subsidiary corporation must be engaged in the active conduct of a trade or business. The trade or business must have also been actively conducted throughout a five-year period immediately before the distribution under Sec. 355(b)(2)(B). The question for a business leasing farmland is whether this activity meets both of these requirements under Sec. 355. If the IRS determines that the land transferred to the subsidiary has not been used or will not be used in the active conduct of a trade or business, the reorganization may be treated as a fully taxable corporate separation.

Regs. Sec. 1.355-3(b)(2)(iv)(B) states that the active conduct of a trade or business does not include the ownership and operation (including leasing) of real or personal property used in a trade or business unless the owner performs significant services in operating and managing the property. If land leased to a tenant farmer or shareholder is the primary asset being transferred to the subsidiary, the tax-free split-off may be unable to meet the active trade or business requirement. Cash rent of the land would almost certainly fail this requirement since the owner would not be performing significant operating and management services for the property.

A corporation itself must perform active and substantial management and operational functions under Regs. Sec. 1.355-3(b)(2)(iii). Therefore, the degree of involvement of the officers and employees of the corporation in managing and operating the leased property will determine whether the active trade or business requirement is met. This determination can be subjective, but the IRS has issued two revenue rulings that address this issue and provide guidance to corporations looking to split off leased farmland in a tax-free reorganization.

Rev. Rul. 73-234

In Rev. Rul. 73-234, a corporation engaged in business as an insurance agency owned all the stock of a corporation engaged in the business of farming. The insurance corporation distributed all the stock of the farm corporation to its sole shareholder in a transaction intended to be treated as qualifying for a tax-free corporate split-off. The corporation requested a ruling from the IRS regarding whether the farming operation conducted by the subsidiary corporation constituted an active trade or business under Sec. 355(b).

The planting, raising, and harvesting of crops and the breeding and raising of livestock in the farm operation were done by tenant farmers, acting as independent contractors. The tenant farmers were compensated by a share of the proceeds from the sale of all crops and livestock resulting from the farm operation. The corporation employed a general handyman to maintain the farm property and equipment. The corporation also employed the sole shareholder to participate in the farm operation.

The sole shareholder was an experienced farmer who entered into agreements with the tenant farmers and allotted to them their responsibility for their portion of the farm operation. He devoted significant time and effort to the farm business. This included studying federal price support and acreage reserve programs; planning all rotation, planting, and harvesting of crops; and purchasing and planning the breeding of livestock. He hired seasonal workers and purchased farming equipment, was responsible for handling sales of all crops and livestock, and was responsible for accounting to the tenant farmers for their share of the proceeds from the total sales.

The IRS in Rev. Rul. 73-234 stated that Sec. 355, by requiring that a trade or business be actively conducted, connotes substantial management and operational activities directly carried on by the corporation itself, and not the activities of others outside the corporation, including independent contractors. The IRS went on to state, however, that the fact that a portion of a corporation's business activities is performed by independent contractors will not preclude the corporation from being engaged in the active conduct of a trade or business if the corporation itself directly performs active and substantial management and operational functions.

Rev. Rul. 73-234 concluded that the activities conducted by the farm corporation through its employees constituted substantial management and operational functions apart from those activities performed by tenant farmers and that the corporation satisfied the active business requirement under Sec. 355.

Rev. Rul. 86-126

In contrast to Rev. Rul. 73-234, Rev. Rul. 86-126 held that the corporation did not engage in substantial operational and managerial activities for farmland leased to tenant farmers and consequently could not satisfy the active business requirement under Sec. 355.

In Rev. Rul. 86-126, the corporation held large tracts of farmland owned evenly by two shareholders. The corporation had sought to transfer one-half of the farmland to a subsidiary and split off the subsidiary to one of the shareholders in a tax-free split-off reorganization.

Both shareholders were independent farmers who farmed their own land and served as officers of the corporation. The corporate farmland was leased to tenant farmers under an arrangement where all income and expenses of the farm were shared equally. The tenant farmers under the agreement were responsible for obtaining financing necessary for their share of the farming expenses. The planting, raising, and harvesting of crops was completed solely by the tenant farmers. The tenant farmers were required to supply the equipment used in farming the corporation's land and maintained the equipment and irrigation system. The shareholders consulted with the tenant farmers regarding herbicides, insecticides, and fertilizer that the tenant farmers purchased. The tenant farmers, after consulting with the shareholders, contracted to sell the crops and provided an accounting of the proceeds to the corporation.

The shareholders, in their capacities as officers of the corporation, periodically inspected the crops and improvements on the leased land. The shareholders notified the tenant farmer of any problems noticed, and the tenant farmer corrected them. The shareholders decided what portion of the corporation's land to lease, considering soil conservation needs, market conditions, and federal price support and acreage reserve programs. The shareholders reviewed each tenant's accounting of operations and sales.

The IRS determined that the active business requirement was not met in Rev. Rul. 86-126, distinguishing the activities of the taxpayer from those in Rev. Rul. 73-234. In Rev. Rul. 86-126, the shareholders did not engage in the activities described in Rev. Rul. 73-234, or engaged in them only on a limited basis. At best, the corporation could be considered to engage in some managerial and operational activity but not enough to qualitatively distinguish its operations from mere investments.

The IRS found that the following factors set forth in Rev. Rul. 73-234 were lacking in Rev. Rul. 86-126:

  • Hiring seasonal workers;
  • Supplying and maintaining equipment;
  • Arranging financing;
  • Planning crop rotation, planting, and harvesting;
  • Purchasing livestock and planning livestock breeding;
  • Selling crops and livestock; and
  • Accounting to the tenant farmers.

The IRS held that the lack of these factors distinguished the two rulings, and found that the corporation in Rev. Rul. 86-126 did not meet the active business requirement under Sec. 355.

Taxpayers contemplating a corporate reorganization of their leased farmland can look at the factors listed in Rev. Rul. 86-126 to help them satisfy the active business requirement under Sec. 355. These factors will help them assess their involvement in the business activity.

One factor in Rev. Rul. 86-126 is the financing of the farming operations. A corporation engaged in an agreement with a tenant farmer should structure the arrangement so that the corporation provides the financing.

Hiring seasonal workers was another factor. Corporations should attempt to hire seasonal workers or at least be involved in the process of selecting them.

Another factor has the corporation, rather than the tenant farmers, selling the crops and accounting for the proceeds. The actual selling of the crops should be done by the corporation, but consulting with the tenant farmer regarding if and when to sell the crop is acceptable.

Supplying and maintaining the equipment used in the farm operation is an additional factor the IRS considered. Corporations should own or lease the equipment used in the farm operations.

Preserving tax-free status

Taxpayers should attempt to meet as many as possible of the factors set forth in Rev. Rul. 86-126 to ensure that they meet the active trade or business requirement under Sec. 355 before undertaking a corporate split-off. Meeting the active trade or business requirement is critical to ensuring a corporation engaged in the business of leasing farmland will qualify for a tax-free divisive reorganization under Sec. 368(a)(1)(D).


Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

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