Wednesday, August 30, 2017
Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end. Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few.
But, what about those equipment rentals? This can be a big issue for many farmers, including those that have recently retired. Must self-employment tax be paid on the income from equipment rents? The answer, as it is with many tax questions, depends on the facts of each situation.
That’s the focus of today’s post – self-employment tax on the rental of farm equipment.
The statute. 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. For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200. It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent. That’s because the self-employment tax is also a deductible expense. In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level.
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 only if the activity constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.
This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate. But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357.
The reporting. Income from a rental activity is normally passive and is reported on Schedule E (Form 1040). From there it flows to page one of Form 1040 and is reported on the line for “Other Income.” Self-employment tax would not apply (but the additional 3.8 percent “passive tax” of I.R.C. §1411 could apply if the taxpayer has income over the applicable threshold). However, as noted at the top of Schedule E, Part 1, taxpayer are directed to report the income and expense from a personal property rental activity on Schedule C (or Schedule C-EZ). Schedule C is for reporting of business income, and the IRS instructions for completing Schedule E (at page E-4) say that Schedule C (or Schedule C-EZ) is to be used to report the income and expense associated with the rental of personal property if the taxpayer is in the business of renting personal property.
Trade or Business
Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property. The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer’s activity is engaged in regularly and continuously with the intent to profit from the activity. Comr. v. Groetzinger, 480 U.S. 23 (1987). But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court. Batok v. Comr., T.C. Memo. 1992-727.
As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21). Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040. A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.
The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business. But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax. Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership. If that is done, the income from the rental activity would flow through to the owner without self-employment tax. However, with an S corporation, reasonable compensation would need to be paid. For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income.
Many farmers lease farm equipment, particularly if they have retired from farming and still own the equipment. In that situation, it is often desirable not to incur self-employment tax on the equipment rental. To achieve that result, the rental activity should not rise to the level of a trade or business, or the equipment should be leased with real estate. Alternatively, the leasing should be done through an S corporation or a partnership.