Taxing Farmers

1
Taxing Farmers

• Income Averaging,
• Self-employment
• (and some QPAI)

2
Overview

• Income Averaging Some Overlooked Opportunities
• Self-Employment Taxes Selected Base Issues
• Farmland rents?
• Investment or Self-employment income?
• Section 199 Basics Can Farmers Benefit?

3
Income Averaging The Problem

• Variable Income Streams
• Production variation
• Commodity price volatility
• Variable expenditure patterns (e.g. 179)
• Graduated Tax Rates
• Effects exacerbated by phase-out provisions
• Fixed Annual Accounting Periods

4
Income Averaging

• The Partial Solution IRC 1301
• Added in 1997 after a decade-long absence
• 1301 recomputes liability by reducing current
  year tax base by an elected amount and allocating
  it equally among three prior tax years.
  
• You get tax savings if prior tax years have
  marginal rates lower than the current year
  rates.
  

5
Taxpayer A No Variation
6
Taxpayer B Variation (No Avg)
7
Variation 60K Averaging
20K allocated to Y1-Y3, capturing 10 and 15
rates lost in prior years
8
Key Limitations

• Equal amount assigned to each base year
  recapture of lost marginal rates is not complete
  
• For this reason, planners need to be familiar
  with other deferral provisions to smooth out
  single year variations as much as practicable.
  
• Averaging affects tax rates, not tax base for
  purpose of computing eligible tax benefits. Eg
  
• Bad Still subject to section 68 limitation on
  itemized deductions even though averaging
  
• Good Allocation to base years does not trigger
  new limitations on itemized deductions
  

9
Key Limitations Contd

• Taxpayers still lose other phase-out benefits,
  despite averaging.
  
• Self-employment tax base not affected by
  averaging.
  
• AMT Jobs Act provides relief for 2004 ff.
• Kiddie Tax rate determined after election
  effects (benefit for taxpayer)
  
• Averaging election can be made for capital and
  ordinary income amounts.

10
EligibilityFarming business

• cultivation of land or the raising or harvesting
  of any agricultural commodity 1.263A-4(a)(4).
  
• Custom harvesting is not farming
• Plant retailer not farming
• Regulations dont speak to custom feeding of
  animals a common arrangement for livestock
  production

11
Some jurisdictions take food production more
seriously than others.
12
Eligibility Individuals

• C-Corporations No soup for you!
• Others sole proprietor, partner, S-corporation
  shareholder, LLC member (unless taxed as C
  corporation)
  
• Entity activity, not individual activity, is
  critical.
  
• Landlord may be eligible for crop share income,
  despite lack of material participation.
  
• Careful, though, as C-Corp salaries dont count
  (but S Corporation salaries do! See Reg.
  1.1301-1(e)(1))

13
Eligibility Electible Farm Income

• Attributable to farming business
• Follows parameters of farming outlined above.
• Incidental activities can be included (e.g.,
  washing and packaging income) (1.263A-4)
  
• Further processing cannot (e.g., income
  associated with processing wheat into pasta, or
  livestock into packaged meat)
  
• Query Is an allocation method permitted?

14
Electible Farm Income Contd

• Example Is a vineyard with a winery eligible?
  How about grinding hay before delivery to a
  feedlot customer? (common as further processing)
  
• Note that sales of business property regularly
  used for a substantial period are eligible
  (but not farmland).
  
• Such sales are regular occurrences in many farm
  operations (e.g., culling breeding herds)
  
• Retiring farmers may thus benefit from some
  dispositions of property, but still face bunching
  of income on gains on sale of land (LTCG rate
  compensates somewhat for this concern.)

15
Making the Election
Election can be made for any open year,
regardless of whether adjustment is made by the
IRS for that year. This approach allows nearly
perfect hindsight, allowing taxpayers greater
flexibility to benefit from the election.
16
Planning Keep Looking Back!

• Consider elections for prior open years to shift
  income to earlier base years, thus increasing
  their capacity to absorb averaged income.
  
• This could be helpful even if tax savings from
  election in that year are not achieved.
  
• Illustrations can be found in article appended to
  outline.
  

17
Social Security Self Employment

• Some Basics
• OASDI Taxes total 12.4
• Equal shares (6.2) imposed on ER, EE (See I.R.C.
  3101, 3111)
  
• Expanding tax base 94,200 in 2006, up from
  90,000 in 2005
  
• Self-employed get to deduct half of
  self-employment taxes, approximating the
  treatment of employers who may deduct taxes paid
  on employees. (See I.R.C. 164(f))

18
Social Security Self Employment

• Medicare portion of 2.9 applies without regard
  to the 94,200 limit.
  
• Combined tax is thus 15.3 up to 94,200, and
  2.9 thereafter on eligible base.
  
• Big Picture Significant Growth Here (See
  following slides for perspectives)

19

• Federal Government Receipts 1990-2004, 2005-10
  (est.) (Source White House Budget Office, FY 2006
  Budget Historical Tables)

20
Self-Employment TaxesOverview
Indexing base to wage growth CPI (productivity
gains in index)
21
(Source IRS Statistics of Income, Fall 2005).
22
Taxpayer Impacts

• Taxpayers at lower income levels will often pay
  more in employment taxes than in income taxes.
  
• Top Earner 14,412.60 in total employment taxes
  (including employers share) in 2006.
  
• Effect of cap on OASDI base makes this tax
  nominally regressive, but consider these facts
  
• Social security benefits are also capped.
• Benefits are not proportional to contributions
  lower-earning taxpayers get proportionally more
  (a higher replacement rate) than higher-earning
  taxpayers.
• Taxpayers who can do so may find it economically
  advantageous to reduce self-employment taxes and
  invest the savings in alternative investments,
  including qualified retirement savings plans.
  (See below).
• Reform proposals raise concerns about an
  expanding tax base and limited future benefits,
  perhaps leading to even more pressure for
  planning to reduce self-employment taxes.

23
Self-Employment Income Base Excluded Items

• IRC 1402 excludes certain forms of income from
  the self-employment tax base. Clearly excluded
  are
  
• Capital gains 1231 gains
• Interest
• Dividends
• All share common characteristic of derivation
  from capital, vs. labor or services

24
Planning Benefit?

• Can taxpayer planning using capital-related
  exclusions provide net benefits over and above
  the social security benefit?
  
• Comprehensive cost/benefit analysis is
  exceedingly complex, but even a simple analysis
  shows real potential here.

25
Baseline Benefits High Earner

• MAXIMUM EARNER Assumptions
• Born 6/15/1962
• Current (2006) earnings 94,200.00
• Expected future benefits (depending on retirement
  age)
  
• 62 and 1 month in 2024 2,896.00
• 67 in 2029 4,854.00
• 70 in 2032 6,665.00
• http//www.ssa.gov/cgi-bin/benefit6.cgi

26
Baseline Benefits Middle Earner

• MIDDLE EARNER Assumptions
• Date of birth 6/15/1962
• Current (2006) earnings 40,000.00
• Expected future benefits (inflated)
• 62 and 1 month in 2024 1,825.00
• 67 in 2029 3,095.00
• 70 in 2032 4,284.00
• http//www.ssa.gov/cgi-bin/benefit6.cgi

27
Comparison of Benefits

• Age 67 Benefits
• Monthly Annual
• High 4,854 58,248
• Middle 3,095 37,140
• Difference 1,759 21,108
• (Note above are retirement benefits only.
  This does not take into account differential
  value of disability coverage and death benefits
  for survivors.)

28
What Do Benefits Cost?
29
Estimated Investment Growth
30
Comparative Reward

• Estimated Return on Investment (Post-Retirement)
  
  
• Return Annual Monthly
• 4.00 16,370.07 1,364.17
• 6.00 24,555.10 2,046.26
• 8.00 32,740.13 2,728.34
• vs. SS benefit 21,108 1,759
• Note Above investment amounts assume legacy at
  death no legacy from social security amount.

31
Rental Income the Quandry

• Rental income from real estate or property is
  connected to capital. An exclusion applies for
  rent, including crop shares, for those besides
  dealers in real estate.
• BUT the statute excepts rental income if there is
  an arrangement in which the landlord has
  material participation in the production of
  agricultural or horticultural commodities or
  management of such production.

32
IRC 1402(a)(1)

• The Rental Exclusion does 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 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 the 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

33
Fickle Finger of Fate

• Material participation requirement was originally
  added to help farmers by getting them into the
  social security system.
  
• Times have changed.

34
Ginsburg Rule

• Every stick crafted to beat on the head of a
  taxpayer will, sooner or later, metamorphose into
  a large green snake and bite the Commissioner on
  the hind part. Martin Ginsburg, The National
  Office Mission, 27 Tax Notes 99, 100 (1985))

35
Taxpayer Corollary

• A provision designed to single out taxpayers for
  special benefits may metamorphose into a critter
  that someday bites these taxpayers in the hind
  parts.

36
When you sense trouble, sometimes you just need
to keep your head down and keep moving.
37
Rental Income Separating Capital and Labor
Returns

• Can a sole proprietor reduce her self-employment
  tax base by leasing land that she owns to a
  spouse or to another entity?
  
• McNamara v. Commissioner, 236 F.3d 410 (8th Cir.
  2000), reversing Tax Court in three combined
  cases Bot, Hennen, McNamara.
  
• Each case involved payment of FMV cash rent on
  portion of land farmed by taxpayer

38
Case Examples

• McNamara
• Mr. owns corporation.
• Mr. and Mrs. both hired as employees, with total
  wages of 30K
  
• Mr. and Mrs. jointly own farmland rented to
  corporation. No material participation reqd.
  
• Corporation pays rent for farmland, with net
  rental income of 19-23K

39
Case Examples

• Bot
• Mr. owns 160 acres.
• Mrs. owns 240 acres.
• Mr. employs Mrs. in farming operation, and she
  rents her acres to him. No material
  participation required in the agreement.
  
• Mrs. gets 15K/year wages, 18K/year rent.

40
Case Examples

• Hennen
• Similar arrangement to Bot with Mrs. leasing
  her acres to Mr. and employment arrangement with
  Mrs.
  
• Lease silent on participation.

41
Tax CourtArrangement Agreement

• While the concept of an agreement certainly
  includes a contractual agreement, it is a broader
  concept that would also include other forms of
  agreements not necessarily arising from strict
  contractual relationships. Consistent with its
  dictionary definition, in most of the instances
  where it is used in the Internal Revenue Code,
  the word "arrangement" refers to some general
  relationship or overall understanding between or
  among parties in connection with a specific
  activity or situation.

42
Tax Court Policy Supports Broader Tax Base

• In determining whether compensation is
  includible in self-employment income under
  sections 1401-1403 such provisions are to be
  broadly construed so as to favor coverage for
  Social Security purposes.
• The rental exclusion in section 1402(a)(1) is to
  be strictly construed to prevent this exclusion
  from interfering with the congressional purpose
  of effectuating maximum coverage under the Social
  Security umbrella.

43
8th Circuit

• Taxpayers did materially participate.
• However, Court was open to proof re connection
  between participation and lease.
  
• What does it mean to be derived under an
  arrangement?

44
8th Circuit

• 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.
  Id. at 413. The market rate exception, though
  not in the statute, is a practical effect of the
  derived under language. Id.

45
8th Circuit

• Remanded to hear proof on FMV. No one chose to
  retry issue. TC holds for taxpayers no
  deficiency.
  
• IRS Nonacquiescence.

46
IRS Nonacq.

• If, under the overall scheme of farming
  operations it was understood that the farmer
  would materially participate in farm production,
  and the farmer did in fact materially
  participate, then the income received from the
  lessee is subject to self-employment tax. The
  Service continues to believe that this is the
  correct result regardless of whether the material
  participation was explicitly called for under the
  written or oral lease. This interpretation best
  promotes Congress intent that farmers who must
  work for a living have their income replaced
  through coverage under the social security
  system.

47
IRS Position

• Essentially, Farmers are in a worse position than
  other businesses.
  
• E.g., Author of one article on this topic opens
  discussion with fact that his company rents his
  office from him, allowing service income to be
  segregated from capital.
• Policy of expanding base overrides horizontal
  equity between similarly situated taxpayers?
  (Recall the statute does single out this group)

48
Some observations

• Taxpayers here behaved reasonably. They paid for
  labor, and they did not inflate rental values.
  
• Rents were fixed and in cash, not dependent on
  production returns (which as discussed below may
  be problematic).
  
• Note that even interspousal arrangements were
  respected a corporate entity was not required.

49
Post-McNamara Taxpayer Loss

• Solvie, T.C. Memo 2004-55
• Taxpayers formed corporation and leased land and
  hog production facilities to it.
  
• Expanded facilities involved per animal payments
  to owners/employees. (Hog production requires
  labor, which taxpayers provided.)
  
• Fixed rents for other land (29K) and facilities
  (21K) dwarfed by per animal pmts. (44K)

50
Solvie Partial Taxpayer Loss

• Court finds
• Failure of proof that payment was FMV rent for
  building.
  
• Connection between production activity by Solvies
  and payment. (Problem for crop share
  arrangements?)
  
• But note IRS concedes propriety of exclusion of
  other rent not dependent on this production
  activity.
  

51
What About Partnerships?

• Mizell v. Commissioner, T.C. Memo 1995-571
  involved a partnership between father and sons,
  in which father sought to exclude crop share
  rentals for farmland from self-employment income.
  Tax Court analyzed this in terms of arrangement,
  much like Bot/McNamara. (In fact, Mizell is
  cited for this approach).

52
Alternative Partnership Approach

• Section 1402 is clear that self-employment income
  includes a partners distributive share
  (whether or not distributed) of income or loss
  described in section 702(a)(8) from any trade or
  business carried on by a partnership of which he
  is a member.
• Traditional partnership arrangements contemplate
  profit as a product of capital and labor.
  Guaranteed payments for services or capital
  provide a means to segregate these components.
  See I.R.C. 707(c). However, that segregation
  is for limited purposes.

53
Partnership Approach Contd

• 707(c) provides that guaranteed payments are
  considered as made to one who is not a member of
  the partnership, but only for the purposes of
  section 61(a) (relating to gross income) and,
  subject to section 263, for purposes of section
  162(a) (relating to trade or business expenses).
  (Note that 1402 is absent!)
• See also Treas. Reg. 1.707-1(c) For the
  purposes of other provisions of the internal
  revenue laws, guaranteed payments are regarded as
  a partners distributive share of ordinary
  income.

54
What About LLCs?

• Partnership tax structure seems problematic based
  on above analysis. (Even non-farming businesses
  could face challenges.)
  
• Disregarded entity status also presents
  uncertainty could a bachelor accomplish the
  same tax benefits that the Bots and Hennens did?
  
• One commentator (Sowell) suggests segregating
  capital into S corporation in order to ensure
  segregation of capital income. (Substance Form
  challenges?)
• Uncertainty here may gravitate toward use of
  corporate entity. (Choice of entity
  considerations are complex).

55
Cooperatives and Self-Employment Income

• Bot v. Commissioner, 353 F.3d 595 (8th Cir.
  2003), affirming 118 T.C. 138 (2002), involved
  the question of whether self-employment taxes
  applied to value-added payments from a farming
  cooperative paid to members. The Eighth Circuit
  affirmed the Tax Courts finding that these
  payments represented income from carrying on a
  trade or business through agents, and thus were
  not excluded from the self-employment tax base.

56
Bot contd

• Bots (retired farmers?) owned interests in
  cooperative for corn processing.
  
• Retirement was potentially contestable due to
  arrangements with sons that resembled partnership
  activities. IRS did not challenge this,
  however.
• Members could meet obligations to deliver corn to
  cooperative (MCP) from three different sources
  (1) deliver own production (2) purchase from
  others or (3) acquire corn from MCP through an
  option pool arrangement, which involved corn
  purchased by the MCP for the purpose of helping
  members meet their delivery obligations. In each
  case, the Bots used option pool corn, paying MCP
  an acquisition fee of five cents per bushel.

57
Bot- contd

• Bots received payments for value added
  production by cooperative, which they
  characterized as STCG.
  
• IRS said pmts. were self-employment income. Bots
  carried on a trade or business of acquiring and
  selling corn and corn products for profit through
  the cooperative.
• It appears that they delivered substantially more
  grain than they were capable of growing and
  receiving through crop share (700 acres x 150
  bushels x ½ share 52,500 bushels of production.
  Their option pool corn fees of 18,070 at five
  cents per bushel translates into 361,400 bushels
  more than 7 times as much.)
• They chose cooperative, not corporation. Thus,
  they carried on business through agents and
  earnings s/t self-employment tax.

58
Other Cooperative Issues

• Fultz brothers faced similar case also losing
  (p. 14-15). They did not respect the corporate
  form, and instead received pmts individually and
  assigned them to corp.
• Would different result obtain if retired farmer
  delivered crop share rental to cooperative?
  (Magnitude issue presented in Bot vs. means of
  disposing of rental share?)
• See Felber v. Commissioner, T.C. Memo 1992-418,
  affd without published opinion, 998 F.2d 1018
  (8th Cir. 1993) (retired wheat farmer whose
  tenant sold crop share on his behalf not subject
  to self-employment tax)
• What of patronage dividend from passive rental
  activity (e.g., based on fertilizer share)?

59
Section 199 Issues Can Farmers Benefit?

• Basic Provisions.
• Deduction percentage.
• 2005-06 3 percent
• 2007-09 6 percent
• 2010 ff. 9 percent.
• Deduction base. The deduction is a percent of
  the lesser of
  
• Qualified production activities income (QPAI)
  (see below) or
  
• taxable income (or for individuals, adjusted
  gross income subject to certain adjustments).
  See I.R.C. 199(a) (d)(2).

60
199 Basics

• What is QPAI? Domestic production gross receipts
  (DPGR) sum of specified costs. (See
  199(c)(1)).
  
• DPGR gross receipts derived from any lease,
  rental, license, sale, exchange, or other
  disposition of (I) qualifying production property
  which was manufactured, produced, grown, or
  extracted by the taxpayer in whole or in
  significant part within the United States .
  I.R.C. 199(c)(4)(A).

61
199 Basics contd

• Qualifying production property (QPP) includes
  tangible personal property.
  
• The scope of manufactured, produced, grown, or
  extracted (MPGE) encompasses crops or livestock
  grown by farmers within DPGR. See Prop. Reg.
  1.199-3(d)(1)(including cultivating soil,
  raising livestock, and fishing in MPGE).

62
199 Basics contd

• MPGE also includes storage, handling, or other
  processing activities (other than transportation
  activities) within the United States related to
  the sale, exchange, or other disposition of
  agricultural products, provided the products are
  consumed in connection with, or incorporated
  into, the MPGE of QPP whether or not by the
  taxpayer.
• However, the taxpayer must be doing more than
  packaging to qualify.
  
• Grain storage fees are specifically covered in an
  example in the regulations as included within
  DPGR. See Prop. Reg. 1.199-3(d)(5) Example 1.
  

63
199 Basics contd

• Wage limitation deduction allowable is in any
  case limited to the W-2 wages of the employer
  for the taxable year. I.R.C. 199(b).
  (Section 4.02(1)(a) of Notice 2005-14 and
  1.199-2(a)(1) of the proposed regulations
  confirm that this includes common law employees,
  not independent contractors, partners, or
  self-employment income.)

64
199 Basics contd

• Regulations clarify that only one taxpayer may
  obtain the deduction under section 199 for
  production. Reg. 1.199-3(e)(1)
  
• If one taxpayer performs a qualifying
  activity pursuant to a contract with another
  party, then only the taxpayer that has the
  benefits and burdens of ownership of the property
  under Federal income tax principles during the
  period the qualifying activity occurs is treated
  as engaging in the qualifying activity.
• Will custom feeding qualify? Unlikely to meet
  benefits and burdens test.
  
• Sale of feed would qualify, however, raising
  allocation issues.
  

65
199 Basics- contd

• Pass-through entities. Deductions are applied at
  the shareholder, partner, or similar level. See
  id. 199(d)(1)(A). W-2 wages are also allocated
  for this purpose to the partner level, subject to
  additional limitations. See id. 199(d)(1)(B).

66
199 Basics- contd

• Cooperatives. A special rule exists in 199(d)(3)
  to address the issue of agricultural cooperatives
  (as in Bot and Fultz, above). To the extent the
  cooperative is engaged MPGR of an agricultural or
  horticultural product, or marketing of such
  products, and a patronage dividend or per-unit
  written allocation taxable to the patron under
  1385(a)(1) or (3) is received, then patrons are
  allowed to take the deduction under section 199.

67
Some Important Issues for Farmers

• Wage Limitation.
• Contract production may not count.
• Sole proprietors may get nothing if they dont
  pay employees.
  
• Members of farming partnerships or LLCs, who do
  not receive W-2 wages, and who provide the bulk
  of services to the partnership may also not
  benefit from this deduction to the extent W-2
  wages paid to others are not significant.
• Corporate formation may allow advantages,
  especially to the extent that wage payment
  allowed.

68
Farmer Issues - 199

• But note increasing salaries to get greater 199
  deduction may not make sense if higher employment
  taxes result.
  
• Farmers who are not engaged in a trade or
  business (i.e., retired farmers who rent land)
  are not eligible.

69
Farmer Issues- 199

• DPGR Examples
• Livestock or crops in
• Custom work out
• Hedging transactions in
• Special retail food/beverage rules (see outline)
• Note 5 de minimis rule allows you to treat all
  income as DPGR.
  
• Otherwise, allocation is required.