Friday, June 23, 2017
Tax Treatment of Cooperative Value-Added Payments
Many farmers sell their products through a marketing cooperative of which they are likely to be a member. As a member, they have stock ownership in the cooperative, and typically must buy the right to market certain units of production from their farming business. Along with that right also comes (in most instances) a requirement that the farmer deliver those units of production on an annual basis.
In these situations, the cooperative will annually pay its members a “value-added” which represents the excess amount the cooperative received for a commodity from members over what it paid for the commodity. That raises tax issues associated with how the farmer should report the payment? Is it subject to self-employment tax? What if the grain delivered to the cooperative came from a landlord’s share of the crop under a lease?
The tax issues associated with value-added payments from a cooperative. That’s today’s topic.
The Self-Employment Tax Issue
In recent years, the self- employment tax issue has arisen with respect to payments received by individuals from closed cooperatives, such as local ethanol-production plants. In the typical scenario, an individual subscribes to ownership units that require the individual either to deliver bushels of grain grown on the individual’s farm or to purchase an equivalent amount for delivery to the cooperative. At the end of the production year, the individual receives a “value-added payment” for a share of the cooperative’s profit.
Clearly, the value-added payment is ordinary income to the recipient, but the question remains as to whether the payment is also subject to self-employment tax. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax if the operation constitutes a trade or business “carried on by such individual.” Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business. In general, to be subject to self-employment tax, an activity must be engaged in on a substantial basis with continuity and regularity.
In 1996, the IRS ruled that the value-added payments represented a part of the recipient’s farming business and were, therefore, subject to self-employment tax. Tech. Adv. Memo. 9652007 (Aug. 30, 1996). Under the facts of the ruling, the taxpayer was a grain grower that was obligated to deliver stated quantities of grain to the cooperative for processing three times annually. The farmer could satisfy the obligation by delivering grain grown on the farm, by delivering “pooled” grain maintained by the cooperative, or by delivering grain purchased from other growers. For the most part, the taxpayer satisfied his obligation by delivering grain grown by others. Grain that was grown on the farm was primarily used as livestock feed. Indeed, the taxpayer stated that “except for one year, all of the raised grain was fed to the taxpayer’s livestock and he had not raised sufficient amounts of grain to provide a full year’s supply of grain for the livestock. Consequently, the farmer purchased grain from other local farmers to feed the livestock. While the farmer indicated that he joined the cooperative as an investor with the intent of purchasing the grain that he would need to deliver to the cooperative rather than producing it on his own farm, the IRS determined that the value-added payments to the farmer were subject to self-employment tax because he remained an active farmer.
In Hansen v. Commissioner, T.C. Sum. Op. 1998-91, the taxpayer had retired from active farming in 1990. In 1993 (the year at issue), the taxpayer received $12,052 in value-added payments. The taxpayer reported the payments as farm rental income, not subject to self-employment taxes, on Form 4835 attached to the taxpayer’s 1993 return. The IRS determined that the value-added payments constituted Schedule F farm income and thereby subjected the payments to self-employment tax. While the taxpayer maintained that the value-added payments were not subject to self-employment tax because the taxpayer did not personally participate in the trade or business of growing corn or processing corn during 1993, the IRS argued that the cooperative’s corn processing activity was attributable to the taxpayer for the purpose of determining whether the taxpayer was engaged in a trade or business.
The Tax Court disagreed with the IRS’s position, noting instead that the taxpayer’s relationship with the cooperative ceased to be a principal-agent relationship as of the date the taxpayer retired from the trade or business of growing corn. In addition, the Tax Court concluded that the cooperative’s activity was not attributable to the taxpayer as a member of a partnership because a cooperative is an incorporated organization which is not considered a partnership. In April, 1999, the Chief Counsel of IRS announced a change in litigating position concerning value-added payments and self-employment tax, conceding to the Tax Court’s decision in Hansen. IRS Notice (36)000-3, Apr. 21, 1999.
In Bot v. Comm’r., 118 T.C. 138 (2002), aff’d, 353 F.3d 595 (8th Cir. 2003), a retired farmer and his wife (who were members of a value-added cooperative which also required the delivery of corn) were operating under a crop-share lease with their sons as tenants. The court held that the value-added payments the farmer and his wife received from the cooperative were subject to self-employment tax. The court noted that Hansen could not be cited as precedent and held that the taxpayers were engaged in the trade or business of producing, marketing and selling corn and corn products in relationship with the cooperative. The court determined that, inasmuch as the value-added payments were directly related to the volume of corn delivered to the cooperative, the value-added payments had a direct nexus to their trade or business and must be included in self-employment income. The court reached its conclusion in light of the involvement by the taxpayers in the operation and the involvement of their sons. However, since 1974, imputation of activities by an agent to a principal as a property owner under a lease (and involving the production of agricultural or horticultural commodities) has been barred for purposes of self-employment tax liability. In the case, the only apparent business relationship of the taxpayers and their sons was through the crop-share lease. On that basis, the court’s opinion is inconsistent with the statute. But, even without imputing the sons’ activities, the taxpayers might have been sufficiently involved in the business for self-employment tax to apply. See also Fultz v. Comm’r, T.C. Memo. 2005-45 and Fultz v. Comm’r, T.C. Memo. 2005-46 in which the Tax Court followed its earlier opinion in Bot.
Thus, for individuals who are members of cooperatives that require the members to buy equity shares and to deliver an amount of grain based on the number of equity shares purchased, any payment received by the member for the value added to the grain during processing is subject to self-employment tax if the member is an active farmer. The value-added payment received as a patronage distribution would be reported on lines 3a and 3b of Schedule F (Form 1040). It is ordinary income subject to self-employment tax. The same reporting result is reached if the farmer is a landlord under a material participation crop-share lease who satisfies the delivery obligation out of grain produced under the lease.
For members of such cooperatives that serve as landlords pursuant to a cash lease where the cash rent is reported on Schedule E, or a non-material participation crop share or livestock lease with minimal involvement by the landlord (where the rent is reported on Form 4835), the value-added payments should not be subject to self-employment tax. If a member is retired at the time the member subscribes to ownership units in the cooperative and satisfies the member’s obligation to the cooperative solely with pooled grain, the value-added payments represent investment income and are not subject to self-employment tax. However, Bot makes it clear that retired members of value-added cooperatives need to watch their involvement under the arrangement with the cooperative if self-employment tax is to be avoided. To avoid a CP-2000 Notice from the IRS in this situation, the distribution could be reported on Schedule F so that the IRS computer gets a match, and then an offsetting deduction could be taken.
The self-employment tax issue reaches many areas for agricultural producers. Cooperative value-added payments creates a self-employment tax issue for farmers, but the basic principles still apply.