Taxing Farmers
Income Averaging,
Self-employment
(and some QPAI)
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?
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
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.
Taxpayer A: No Variation
Tax Rates:
Total Income
Total Tax
Year 1:
Year 2:
Year 3:
Year 4:
Total
Average
Income
Income
Income
Income
Income
Rate
30%
$10,000
$10,000
$10,000
$10,000
$40,000
15%
$10,000
$10,000
$10,000
$10,000
$40,000
0%
$10,000
$10,000
$10,000
$10,000
$40,000
$30,000
$30,000
$30,000
$30,000
$120,000
$4,500
$4,500
$4,500
$4,500
$18,000
15.00%
Taxpayer B: Variation (No Avg)
Year 1:
Year 2:
Year 3:
Year 4:
Total
Tax Rates: Income
Income
Income
Income
Income
30%
$0
$0
$0
$100,000
$100,000
15%
$0
$0
$0
$10,000
$10,000
0%
$0
$0
$0
$10,000
$10,000
Total Income
$0
$0
$0
$120,000
$120,000
Total Tax
$0
$0
$0
$31,500
$31,500
Average
Rate
26.25%
Variation + $60K Averaging
Tax Rates
Year 1:
Year 2:
Year 3:
Year 4:
Total
Income
Income
Income
Income
Income
30%
$0
$0
$0
$40,000
$40,000
15%
$10,000
$10,000
$10,000
$10,000
$40,000
0%
$10,000
$10,000
$10,000
$10,000
$40,000
Total
$20,000
$20,000
$20,000
$60,000
$120,000
Tax
$1,500
$1,500
$1,500
$13,500
$18,000
Tax Rate
15.00%
$20K allocated to Y1-Y3, capturing 10% and 15% rates “lost” in prior years
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
Key Limitations: Cont’d
• 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.
Eligibility:
Farming 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 don’t speak to custom feeding
of animals – a common arrangement for
livestock production
Some jurisdictions take food production more seriously than others.
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 don’t count (but S
Corporation salaries do! See Reg. 1.1301-1(e)(1))
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?
Electible Farm Income: Cont’d
• 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.)
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.
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.
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 selfemployment taxes, approximating the
treatment of employers who may deduct taxes
paid on employees. (See I.R.C. §164(f))
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)
Federal Government Receipts
3,000,000
Dollars in Millions
2,500,000
Other
2,000,000
Excise Taxes
1,500,000
Social Insurance Taxes
Corporate Income Taxes
1,000,000
Individual Income Taxes
500,000
19
90
19
93
19
96
19
99
20
02
20
05
20
08
0
Fiscal Year
•Federal Government Receipts 1990-2004, 2005-10 (est.) (Source
White House Budget Office, FY 2006 Budget Historical Tables)
Self-Employment Taxes:
Overview
$100,000
$90,000
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
2006
2001
1996
1991
1986
1981
1976
1968-71
Earnings Base
1937-50
Base
Social Security Earnings Base
Year
Indexing base to wage growth > CPI (productivity gains in index)
2003 Individual Income Taxes
50.00%
40.00%
% of Returns
30.00%
% of AGI
20.00%
% of Tax
10.00%
0.00%
0-25
25-50 50-100 100-200 200-500 5001000
AGI ($000s)
(Source: IRS Statistics of Income, Fall 2005).
Over
1000
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
employer’s 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.
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
Planning Benefit?
• Can taxpayer planning using capitalrelated 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.
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
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
Comparison of Benefits
Age 67 Benefits:
• High
• Middle
• Difference
Monthly
$4,854
$3,095
$1,759
Annual
$58,248
$37,140
$21,108
(Note: above are retirement benefits only. This
does not take into account differential value of
disability coverage and death benefits for
survivors.)
What Do Benefits “Cost”?
Annual Tax Cost:
High
Middle
Tax Difference
Rate
12.40%
12.40%
Base
$94,200
$40,000
Annual Tax
$11,681
$4,960
$6,721
Estimated Investment Growth:
Estimated Future Value of Tax Savings With
Lower SS Base Due to Planning:
Annual Interest Rate
8%
Number of Payments
23
Amount of Payment
Future Value
-$6,721
$409,252
Comparative Reward:
Estimated Return on Investment (Post-Retirement)
•
•
•
Return
4.00%
6.00%
8.00%
Annual
$16,370.07
$24,555.10
$32,740.13
Monthly
$1,364.17
$2,046.26
$2,728.34
vs.
SS benefit
$21,108
$1,759
Note: Above investment amounts assume legacy at death; no legacy
from social security amount.
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.
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
“Fickle Finger of Fate”
• Material participation requirement was
originally added to help farmers by getting
them into the social security system.
• Times have changed.
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))
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.
When you sense trouble, sometimes you just need to keep your
head down and keep moving.
Rental Income: Separating Capital
and Labor Returns
•
Can a sole proprietor reduce her selfemployment 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
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 req’d.
– Corporation pays rent for farmland, with net
rental income of $19-23K
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.
Case Examples
• Hennen
– Similar arrangement to Bot – with Mrs. leasing
her acres to Mr. and employment
arrangement with Mrs.
– Lease silent on participation.
Tax Court:
Arrangement > 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.”
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.”
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”?
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.
8th Circuit
• Remanded to hear proof on FMV. No one
chose to retry issue. TC holds for
taxpayers – no deficiency.
• IRS: Nonacquiescence.
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.”
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)
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.
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)
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.
What About Partnerships?
• Mizell v. Commissioner, T.C. Memo 1995571 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).
Alternative Partnership Approach:
• Section 1402 is clear that self-employment
income includes “[a partner’s] 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.
Partnership Approach: Cont’d
• 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 partner’s distributive share of ordinary
income.”
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).
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 Court’s 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.
Bot – cont’d
•
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.
Bot- cont’d
• 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 selfemployment tax.
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, aff’d
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)?
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).
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).
199 Basics cont’d
• 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).
199 Basics – cont’d
• 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.
199 Basics – cont’d
•
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.)
199 Basics – cont’d
• 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.
199 Basics- cont’d
•
Pass-through entities. Deductions are
applied at the “shareholder, partner, or
similar level.” See id. § 199(d)(1)(A). W2 wages are also allocated for this
purpose to the partner level, subject to
additional limitations. See id. §
199(d)(1)(B).
199 Basics- cont’d
• 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.
Some Important Issues for Farmers
•
•
•
•
•
Wage Limitation.
Contract production may not count.
Sole proprietors may get nothing if they don’t 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.
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.
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.