McNamara v. Commissioner
The IRS has held that partners or shareholders that own land outside of the partnership
or corporation they own and operate are subject to self-employment tax on the
rents they receive from that same partnership or corporation. The issue is that
they are continuing to farm the land the same as if they were farming it as a
sole proprietor. The Tax Court has agreed with the IRS. The Eighth Circuit has
reversed and remanded the Tax Court decision and has given the IRS an opportunity
to show a connection between the rents and the production arrangement. This material
discusses the facts of the cases.
360 ACTIVITIES NOT FOR PROFIT
McNamara v. Commissioner
|The Eighth Circuit reverses and remands on farmland rentals subject to
self-employment tax in McNamara, Hennen, and Bot.
Facts. Each of the three couples, McNamara, Bot, and Hennen, had owned
farmland for many years. Each of the couples rented the farmland to the farm activity
for at or below market rates, and each had employment contracts requiring material
participation by the landlord. For the years at issue the couples reported real
estate rental income and wages paid on their joint returns. The IRS determined
deficiencies for self-employment tax on the rental payments. The Tax Court agreed
with the IRS.
Issue. Whether rental payments received by taxpayers from the farm activity
are includable in taxpayers' net earnings from self-employment under I.R.C. §1402(a)(1)
and thus subject to self-employment taxes.
Analysis. The court noted that generally taxable self-employment income
excludes sources that do not depend on an individual's labor, including rentals
from real estate. Under I.R.C. §1402(a)(1), however, rents are included if,
"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 . . . in the production or the management of the production
of such agricultural or horticultural commodities, and . . . there is material
participation by the owner or tenant . . . with respect to any such agricultural
or horticultural commodity."
The court disagreed with taxpayers' contention that §1402(a)(1) applies
only to rental payments derived from sharecropping or share-farming, stating that
no such restriction appears in the Code. The court also rejected taxpayers' contention
that the instructions accompanying Form 4835 (Farm Rental Income and Expenses)
contradict and therefore override §1402(a)(1).
Further, the court acknowledged that the Tax Court did not clearly err in concluding
that the wives were required by the employment arrangements to materially participate.
However, the court found compelling the taxpayers' argument that the lessor-lessee
relationships should stand on their own apart from the employer-employee relationships.
The court acknowledged that rents consistent with market rates very strongly suggests
that the rental arrangement stands on its own as an independent transaction and
not part of an "arrangement" for participation in agricultural production.
The court found missing from both the IRS's and the Tax Court's analyses any mention
of a nexus between the rents received by taxpayers and the "arrangement"
that requires the landlords' material participation. The court remarked, "
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 an arrangement that such rents can be said to derive
from the arrangement."
Holding. The Eighth Circuit reversed and remanded the Tax Court's decisions
to give the IRS an opportunity to show a connection between those rents and the
[McNamara v. Commissioner, 236 F.3d 410 (8th Cir. 2000), reversing and remanding
78 T.C.M. (CCH) 530 (1999); Hennen v. Commissioner, 78 T.C.M. (CCH) 445 (1999);
and Bot v. Commissioner, 78 T.C.M.
(CCH) 220 (1999)]
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