The Eighth Circuit Court of Appeals recently addressed whether Federal Conservation Reserve Program (“CRP”) payments made to non-farmers are subject to self-employment taxes. The 8th Circuit in a 2 to 1 decision held that the payments were not subject to self-employment tax and in so doing reversed the United States Tax Court’s earlier decision in the case.

Facts

Mr. Morehouse, a sales manager and publisher, inherited over 1000 of South Dakota farmland. He never farmed any of the land, but instead rented much of the land out to others who farmed various portions of the land. In 1997 Mr. Morehouse enrolled almost 700 acers in CRP. Mr. Morehouse received CRP payments of $37,872 in both 2006 and 2007, which were the years at in the case. On their 2006 and 2007 tax returns, the Morehouses reported themselves as “self-employed” and reported the CRP payments on Schedule E as “rents received”, which were, therefore, not subject to self-employment taxes. The IRS disagreed, mailing the Morehouses a notice of deficiency, which stated the CRP payments should have been reported on a Schedule F, Profit or Loss From Farming, and subject to self-employment taxes.

Litigation ensued. At the Tax Court, Judge Marvel agreed with the IRS, concluding that Mr. Morehouse was “engaged in the business of participating in the CRP . . . with the primary intent of making a profit” and, consequently, the CRP payments should be taxed as self-employment income.

On appeal, the Eight Circuit Court of Appeals sided with the taxpayer and reversed the Tax Court. The Eighth Circuit concluded that “CRP payments to non-farmers constitute rentals from real estate for purposes of § 1402(a)(1) and are excluded from the self-employment tax”. The Eighth Circuit distinguished Wuebker v. Commissioner, 205 F.3d 897, 903 (6th Cir. 2000), a case relied on heavily by the Tax Court, noting that the taxpayers in Wuebker were active farmers.

Some S&I Observations

In considering whether CRP payments constitute rental income, the Court sidestepped the argument that CRP payments were derived from contractual requirements that the landowner engage “tilling, seeding, fertilizing, and weed control”, which are not rental activities (and would seem to be factors indicated that the income should self-employment income). Instead the Court latched on to the contractual provision that gave the USDA rights to access and inspect the property, reasoning that the “CRP payments were ‘consideration paid [by the government] for use [and occupancy] of [Morehouse’s] property’ and thus constituted rentals from real estate”.

The Eighth Circuit’s holding, although favorable to taxpayers, is limited in that it only applies to CRP payment recipients who are not active farmers. Notwithstanding the Eighth Circuit’s conclusion, the IRS on its website (last updated Oct. 16, 2014, six days after Morehouse was decided) still appears to disagree stating, “Although the payments are called ‘annual rental payments’ for purposes of the CRP, these payments are not rental payments for federal tax purposes.”

All of this discussion about whether CRP constitutes “rental income” is moot if the CRP recipient is also receiving Social Security retirement or disability benefits. IRC § 1402(a)(1) specifically excludes from self-employment income CRP payments to individuals who received benefits under section 202 or 223 of the Social Security Act.

So I receive CRP payments, do I owe self-employment tax on those payments?

The following matrix may be helpful:

Scenario Subject to self-employment tax?
Active Farmer not receiving Social Security Yes. See Wuebker.
Non-active Farmer not receiving Social Security If you live in the Eighth Circuit, no. See Morehouse.
Active or non-active Farmer Receiving Social Security No. IRC § 1402(a)(1).

 

Other Implications:

Iowa Capital Gains Deduction

Iowa has a special exclusion of capital gain income for individuals who have held land for ten years and who have “materially participated” in a business with the land for ten years. Although, the Iowa Department of Revenue recently concluded that it would consider a taxpayer to be “materially participating” in CRP ground if self-employment tax were paid. But, as Joe Kristan notes in his blog, it may be worth paying the relatively small amount of self-employment tax in order to avoid Iowa tax on CRP land with lots of built-in-gains.

Divisive tax-free reorganizations

In a similar vein, if low basis CRP land is held in a C-corporation, paying self-employment tax on the CRP payments could be a helpful factor used to argue that the CRP “operation” is active conduct of a trade or business—one of the elements necessary for a tax-free corporate reorganization under section 355(b). Generally cash rental activity does not constitute an active conduct of a trade or business for corporate reorganization purposes. See Rev. Rul. 86-126.

Net Investment Income

Some commentators have indicated that the language used to describe CRP payments in the Morehouse case as resulting from “rental activity”, could be the basis for a position that CRP payments constitute rental from “nondepreciable property” and pursuant to Treas. Reg. § 1.469-2T(f)(3), therefore, may “not [be] from a passive activity”. Accordingly, the argument goes, such CRP may not be subject to the 3.8% tax on net investment income imposed under IRC § 1411, since it is “not from a passive activity”. This argument has some weaknesses, however, in particular, its unclear whether the Treasury Department would extend its temporary section 469 regulations to its application of IRC § 1411. Treasury has already expressed a reluctance to do so in other contexts. See 78 Fed. Reg. 72403 (refusing to adopt a recommendation to apply the “portfolio income” definition set forth in Treas. Reg. §1.469-2T(c)(3) for net investment income purposes within IRC § 1411).



Jonathan C. Landon
Jonathan Landon is an Attorney and Vice President with Shuttleworth & Ingersoll, P.L.C. Jon advises individuals, businesses, and tax-exempt organizations in: Federal and state tax matters; general business transactions; deferred compensation and employee benefits; and estate and succession planning.