Monday, November 6, 2017
H.R. 1, the House tax bill, was publicly released last week. Of course, it’s getting a lot of attention for the rate changes for individuals and corporations and flow-through entities. However, there is an aspect that is getting relatively little focus – how the self-employment tax rules would change and impact leasing and entity structuring.
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. However, an examination of the text of the recently released tax bill, H.R. 1, reveals that self-employment tax planning strategy for farmers will change substantially if the bill becomes law. If enacted, many farmers would see an increase in their overall tax bill while others would get a tax break. In addition, existing business structures put in place to minimize the overall tax burden would likely need to be modified to achieve that same result.
Today’s post examines the common strategies employed to minimize self-employment tax, and the impact of H.R. 1 on existing business structures and rental arrangements.
The Basics – Current Law
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 (see I.R.C. §1402(a)(1)) 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)(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.
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 is engaged in the activity 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.
Planning strategy. 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.
Passive loss rules. In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469. But, there are a couple of major exceptions to this general rule. Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Treas. Reg. §1.469-2T(f)(3). The effect of this exception is to convert rental income (and any gain on disposition of the activity) from passive to portfolio income. But, that is only the result if there is net income from the activity. If the activity loses money, the loss is still passive.
Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6).
LLC members. Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations, an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. The husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment with respect to his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of both spouses from passive to active income that will not be subject to the 3.8 percent surtax. Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
What about an S corporation? The manager-managed LLC provides a better result than that produced by the member-managed LLC for LLCs that are not service partnerships. For those that are service providers, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to FICA and Medicare taxes, but the balance drawn from the entity can be received free of self-employment tax. The disadvantage of operating a business or holding property in the S corporation is inflexibility. Appreciated property cannot be removed from the S corporation without triggering gain. Upon the death of an S corporation shareholder, the tax bases of the underlying assets are not adjusted to fair market value. The partnership is the more tax-friendly and flexible structure.
Impact of H.R. 1 on Business Structures
In general. The new proposals (contained in H.R. 1) add complexity in many situations involving partnerships and leasing arrangements. Section 1004 of H.R. 1 eliminates the rental real estate exception from self-employment tax of existing I.R.C. §1402(a)(1) and proposes a new maximum tax of 25 percent to income received from a flow-through entity (such as a partnership, LLC or S corporation). The 25 percent rate applies to all net passive income, plus all “qualified business income.” Under Sec. 1004 of H.R. 1, “qualified business income” is the greater of 30 percent of active business income or a deemed return from the sum of the investment in depreciable property plus real property used in the business. Depreciable property is determined without regard to bonus depreciation and Section 179. Also in Sec. 1004, the deemed return is set at seven percent plus the short-term Applicable Federal Rate (AFR) as of the end of the year. The short-term AFR is slightly over 1 percent at the present time.
How does the formula for the application of the 25 percent tax flow-through rate work? Consider the following:
Robert has capital invested in his farming S corporation of $4 million (based on depreciated values not including Section 179 and bonus depreciation). His allowed deemed return is 7 percent plus the short-term AFR rate as of the end of the year (assume, for purposes of the example, one percent). Thus, if Robert’s farming activity generates $320,000 or less, the farm income will be subject to the 25 percent rate, but not self-employment tax. If Robert’s S corporation generates more than $320,000, the excess amount will also be subject to self-employment tax.
In essence, H.R. 1 replaces the self-employment tax on business income with a computation that deems 70 percent of the business income to be attributable to labor and subject to self-employment tax, in accordance with the formula above. This applies to businesses of all types – sole proprietorships, partnerships and S corporations. That has some very important implications.
S corporations. S corporations have never been subject to self-employment tax. They will be under H.R. 1 in what appears to be an attempt to conform the business tax rate with the self-employment tax. For instance, if 70 percent of the income of the S corporation is subject to the labor rate, then 70 percent of the overall income of the S corporation (considering the amount of shareholders wages) should also be subject to self-employment tax.
Partnerships. The distributive share of a general partner in a general partnership has always been subject to self-employment tax. The distributive share of a limited partner has not. That changes under H.R. 1 via the repeal of I.R.C. §1402(a)(13) contained in Sec. 1004. Thus, a portion of a limited partner’s distributive share of partnership income will become subject to self-employment tax.
Sole proprietorships. The self-employment tax changes of H.R. 1 will also impact sole proprietorships. But, in this instance, the impact of the self-employment tax changes of H.R. 1 could work in the opposite direction. While sole proprietorship farming operations will also be subject to the 70 percent provision, it would actually result in a decrease in self-employment. tax. Under present law, 100 percent of the income of an active farmer that is reported on Schedule F is subject to self-employment. tax. Under H.R. 1, only 70 percent of Schedule F income would be subject to self-employment tax, but 70 percent of passive rental income would also be subject to S.E. tax. The bottom line – the ultimate tax outcome depends upon the mix that any particular farmer has of Schedule F (farm) income relative to Schedule E (passive rental income).
Multiple entities. Farmers who have arranged their farming business such that the land is in a separate entity (such as a limited liability company or other flow-through entity) and is leased to their operating farming business, would see an increase in self-employment tax. In addition, if the taxable income of these farmers has been taxed at a 25 percent rate or less, they won’t have the income tax benefits from the maximum 25 percent rate applied to flow-through entities. They will see a tax increase, because more of the income will be subject to S.E. tax.
This impact of this change in self-employment tax in the context of multiple entity farming arrangements is important to understand. The recent taxpayer victory in Martin v. Comr., 149 T.C. No. 12 (2017) which expanded the exception of McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000) for fair market leases to leases beyond the jurisdiction of the U.S. Court of Appeals for the Eighth Circuit, could be short-lived. Under the language of H.R. 1, the IRS will most assuredly argue that such rental income is part of an active trade or business such that 70 percent of it would be subject to self-employment tax.
What About Conservation Reserve Program (CRP) Income?
The IRS has long argued that CRP income is not rental income that could be excluded from self-employment tax under I.R.C. §1402(a). With that Code section removed, CRP income becomes business income under H.R. 1. As business income, the land owner is certainly passive in the CRP activity, which makes it business income subject to the maximum tax rate of 25 percent and not subject to self-employment tax. Even If CRP income were materially participating business income, however, only 70 percent of it would be subject to the self-employment tax at the labor rate of 25 percent. In any event, this change to the self-employment tax rules would likely stop IRS audits of CRP income.
Conclusion. So, what’s the bottom-line? The typical farmer that owns land and farms it either as a sole proprietor or as a general partner in a general partnership will see an overall tax decrease. That will be particularly true for these farmers in the high tax brackets. That’s because only 70 percent of the farm income will be subject to self-employment tax. However, a farmer that owns the land and rents it to a separate farming entity will incur more S.E. tax than under present law. If that farmer would be in a tax bracket higher than 25 percent, the benefit of the maximum business rate may fully offset the additional S.E. tax. That’s probably an oversimplification of the impact of H.R. 1. Obviously, each situation is unique and will require its own analysis. And, remember, H.R. 1 is only a proposal. It may never actually become law.