Friday, September 29, 2017

Self-Employment Tax on Farm Rental Income – Is the Mizell Veneer Cracking?


Self-employment tax applies to income that is derived from a “trade or business.”  That’s a fact-based determination.  In addition, by statute, “rentals from real estate and from personal property leased with the real estate” are excluded from the definition of net earnings from self-employment. I.R.C. §1402(a)(1).  Likewise, income from crop share and/or livestock share rental arrangements for landlords who are not materially participating in the farming or ranching operation will not be classified as self-employment income.  Only if the rents are produced under a crop or livestock share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income.  Income received under a cash rental arrangement is not subject to self-employment tax.

But, what is “material participation”?  A lease is a material participation lease if (1) it provides for material participation in the production or in the management of the production of agricultural or horticultural products, and (2) there is material participation by the landlord.  Both requirements must be satisfied. While a written lease is not required, a written lease certainly makes a material participation arrangement easier to establish (or not established, if that is desired).

But, what about leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity?  Does the real estate exemption from the definition of net earnings from self-employment apply in that situation?  Does the type of lease or the rate of rent charged under the lease matter?  In 1995, the Tax Court rendered an important decision on the first question that, apparently, also answered the second question.  Mizell v. Comr., T.C. Memo. 1995-571.  Later, the U.S. Court of Appeals for the Eighth Circuit carved out an exception from the 1995 Tax Court decision for fair market leases.  McNamara, et al. v. Comr., 263 F.3d 410 (8th Cir. 2000), rev’g., T.C. Memo 1999-333.  Now, the Tax Court, in a full Tax Court opinion, has applied the Eighth Circuit’s analysis and holding to a case with similar facts coming from Texas – a jurisdiction outside the Eighth Circuit.  Martin v. Comr., 149 T.C. No. 12 (2017). 

The Mizell Case

In Mizell, the petitioner was a farmer who, in 1986, structured his farming operation to become a 25 percent co-equal partner in an active farming partnership with his three sons. In addition, in 1988, leased about 730 acres of farmland to the farm partnership.  The lease called for the petitioner to receive a one-quarter share of the crop, and the partnership was responsible for all expenses.  The petitioner reported his 25 percent share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rents from real estate that was exempt from self-employment tax.

The IRS disagreed with that tax treatment of the land rent, assessing self-employment tax on the crop share lease income for the years 1988, 1989 and 1990.  The parties agreed that he materially participated in the agricultural production of his farming operation.  The IRS took the position that the crop share rental and the farming partnership constituted an “arrangement” that needed to be considered in light of the entire farming enterprise in measuring self-employed earned income.  Thus, the IRS position was that the landlord role could not be separated from the employee or partner role.  That meant that any employee or partner-level participation by the landowner triggered self-employment tax on the rental income. On the other hand, the petitioner, argued that the crop share lease did not involve material participation and that the crop share rental income should be exempt from self-employment tax.  In other words, the IRS looked to the overall farming arrangement to find a sufficient level of material participation on the petitioner’s part, but the petitioner confined the analysis to the terms of the lease which wasn’t a material participation lease.

While, rents from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income, there is an exception, however, if three criteria are met:

  • The rental income is derived under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land;
  • The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities; and
  • There is actual material participation by the owner.. R.C. §1402(a)(1)(A); Treas. Reg. §1.1402(a)-4(b)(1).

The Tax Court, agreeing with the IRS, focused on the word "arrangement" in both the statute and the regulations, noting that this implied a broader view than simply the single contract or lease for the use of the land between the petitioner and the farming partnership.  By measuring material participation with consideration to both the crop share lease and the petitioner’s obligations as a partner in the partnership, the court found that the rental income must be included in the petitioner’s net earnings for self-employment purposes.

Following its win in Mizell, the IRS privately ruled in 1996 that a married couple who cash-rented land to their agricultural corporation were subject to self-employment tax on the cash rental income, because both the husband and wife were employees of the corporation. T.A.M. 9637004 (May 6, 1996).

Implications of Mizell.  The Mizell decision was a landmine that posed a clear threat to the common set-up in agriculture where an individual leases farmland to an operating entity in which the individual is also a material participant.  Importantly, the type of lease was apparently immaterial to the court.  On that point, the wording of Treas. Reg. § 1.1402(a)-4(b)(2) appears to be broad enough to include income in any form, crop share or cash, if received in an arrangement that contemplates the material participation of the landowner.

Exception to the Mizell “Arrangement” Theory 

The Tax Court, in 1998, decided three more Mizell-type cases.   In Bot v. Comr., T.C. Memo. 1999-256, the court determined that rental income (at the rate of $90 per acre) received by a wife for 240 acres of land, paid to her by her husband’s farm proprietorship, was subject to self-employment tax. The wife also received an annual salary from the proprietorship of approximately $15,000, and the court said that the rental amount and the salary amounted to a single arrangement.   In Hennen v. Comr., T.C. Memo1999-306, the court again held that self-employment tax applied to rental income that a wife received on land leased to her husband’s farming business.  Like Mrs. Bot, Mrs. Hennen worked for the farming business and was paid a salary ($3,500/year).  McNamara v. Comr., T.C. Memo. 1999-333, also involved a husband and wife who owned land that they leased to their farming C corporation under a written, cash rent lease. The rent payment averaged about $50,000 per year.  The husband was employed full time by the corporation, and the wife was employed doing part-time bookkeeping and farm errand duties.  She was paid a nominal amount – about $2,500 annually.  The court again determined that the rental arrangement and the wife’s employment were to be combined, which meant that the rental income was subject to self-employment tax.

All three cases were consolidated on appeal to the U.S. Court of Appeals for the Eighth Circuit.  The Eighth Circuit, reversing the Tax Court, determined that the lessor/lessee relationship was to be analyzed separate and distinct from the employer-employee relationship. The Eighth Circuit interpreted I.R.C. §1402(a)(1) as requiring material participation by the landlord in the rental arrangement itself in order to subject the arrangement to self-employment tax. The court stated that, “The 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.”

The Eighth Circuit remanded the case to the Tax Court for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. The IRS could not establish a connection.  The rents were cash rents that were at or slightly below fair market value.  However, the IRS later issued a non-acquiescence to the Eighth Circuit’s decision.  A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003).   That meant that the IRS would continue to litigate the issue outside of the Eighth Circuit.

More Litigation

As the non-acquiescence indicated, the IRS continued to litigate the matter and two more cases found their way to the Tax Court.  In Johnson v. Comr., T.C. Memo. 2004-56, the petitioners verbally cash leased 617 acres of land to their farm corporation.  They also had a verbal employment agreement with the corporation and received a nominal salary.   The farming operation was located within the Eighth Circuit, which meant that the if the land rental and the employment agreement were two separate arrangements the land rental income would not be subject to self-employment tax.  Ultimately, the Tax Court determined that the rental amount under the lease was representative of a fair market rate of rent, and the rental payments were not tied to any services the petitioners provided to the farming corporation.  The compensation paid to the petitioners was also not understated.

However, in Solvie v. Comr., T.C. Memo. 2004-55, the Tax Court reached a different conclusion on a set of facts similar to those involved in Johnson.   In Solvie, the petitioners leased real estate to their controlled corporation and also received compensation as corporate employees.  Later, an additional hog barn was constructed which increased the total rent paid to the petitioners which the IRS claimed was subject to self-employment tax.  The Tax Court agreed because the additional rent was much greater than the rental amounts the received from the corporation for the other hog buildings even though the new building had a smaller capacity.  In addition, the court noted that the petitioners’ wages did not increase even they overall hog production increased, and the additional rent was computed on a per-head basis which meant that no building rent would be paid if there was no hog production. 

The Downfall of Mizell?

In Martin v. Comr., 149 T.C. No. 12 (2017), the Tax Court (in an opinion authored by Judge Paris) delivered its most recent opinion concerning the self-employment tax treatment of leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity.  Under the facts of the case, the petitioners, a married couple, operated a farm in Texas – a state not located within the Eighth Circuit’s jurisdiction.  In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator.  The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services.  They also pegged their salaries at levels consistent with other growers.  The wife provided bookkeeping services and the husband provided labor and management.  In 2005, they assigned the balance of their contract to the S corporation.  Thus, the corporation became the “grower” under the contract.  In 2005, the petitioners entered into a lease agreement with the S corporation.  Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period.  The court noted that the rent amount was consistent with other growers under contract with the integrator.  The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.

The Tax Court noted that the IRS agreed that the facts of the case were on all fours with McNamara.  In addition, the court determined that the Eighth Circuit’s rationale in McNamara was persuasive and that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation.  In other words, there must be a tie between the real property lease agreement and the employment agreement.  The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners’ investment in their facilities.  Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business.  Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara and relying on the court to broadly interpret “arrangement” to include all contracts related to the S corporation.  Accordingly, the court held that the petitioner’s rental income was not subject to self-employment tax.

A dissenting judge complained that the IRS should not have the burden of producing evidence of establishing a nexus between the land lease and the employment agreement once the petitioner establishes that the land lease is a fair market lease.  Another dissenter would have continued to apply the Mizell arrangement theory outside of the Eighth Circuit.


The cases point out that leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement.  Services and labor participation should remain solely within the domain of the employment agreement.  In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases.  If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services.  If lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services. 


The Martin decision, a full Tax Court opinion, is a breath of fresh air for agricultural operations that are structured with leases of farmland to an operating entity in which the lessor is also a material participant.  Proper structuring of the land lease and a separate employment agreement can provide protection from an IRS claim that self-employment tax applies to the land rental income.  Now there is substantial authority for that proposition outside the Eighth Circuit.

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