Friday, June 7, 2019
Is a farmer that raises an ag commodity (or commodities) under a production contract engaged in the trade or business of farming or a rental activity? Is the farmer engaged in both activities with respect to the same contract? Self-employment tax is imposed on a taxpayer’s trade or business income, but not on rental income. Are there components of both in a contract production setting?
The self-employment tax treatment of contract production income – that’s the topic of today’s post.
There has been a dramatic increase in the contract production of agricultural products of the past 50 years. According to the USDA, as of 2017, 34 percent of U.S. farm output is produced under contract. https://www.ers.usda.gov/webdocs/publications/90985/eib-203.pdf?v=9520.4 That’s up from 12 percent in 1969. Over the past 20 years, the average has been 37 percent. Id. The percentage exceeds 50 percent for peanuts, tobacco (presently 90 percent), sugarbeets, hogs and poultry/eggs. Id. There are billions of dollars associated with ag production contracts annually.
There are two basic types of contracts involving the production of agricultural commodities. For crop farms, marketing contracts predominate. Under a marketing contract, the farmer retains ownership of the commodity while the commodity is being raised. The contract is entered into before harvest and establishes a price for a certain amount of commodity to be sold along with delivery date(s). This could also be termed a “forward” contract, and it may contain a payment or pricing clause that would make it a deferred contract for tax purposes. The other type of contract is a production contract. With this type of contract, the contracting firm owns the ag commodity during the production process, and the farmer is paid a fee for services rendered under the contract. The contract will set forth each party’s responsibilities with respect to the provision of inputs and services. Production contracts predominate in the poultry and hog industries.
The Self-Employment Tax Issue
Definition of self-employment income. I.R.C. §1402(a) of the Code, defines “net earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual…”. Is an ag producer raising a commodity or commodities under a production contract engaged in a “trade or business.” If so, self-employment tax is owed on the contract income. Conversely, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. To date, the IRS hasn’t pushed the employer/employee line of argument. However, the same cannot be said for the self-employment tax issue.
In Gill v. Comr., T.C. Memo. 1995-328, a farmer who contracted with a poultry supplier to raise poultry flocks in barns constructed on the farmer's property, but leased to the supplier, was liable for self-employment tax on payments received under the contract from the supplier because the farmer materially participated in raising the poultry That determination was made based on the services that the farmer was required to provide under the contract. They were extensive. Likewise, in Schmidt v. Comr., T.C. Memo. 1997-41, a dairy farmer who contracted with a vegetable cannery to raise beets on a portion of his farm was also found liable for self-employment tax on the contract payments. The contract required the farmer to supply the labor and equipment to produce the beets.
Exception for “rents.” I.R.C. §1402(a)(1) specifies that “there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares.” That’s an important exception in the ag production contract setting. When an ag production contract also involves the rental of a building (particularly in livestock production settings), if the contract is structured properly the portion of the contract payment attributable to the building should not be subject to self-employment tax. If the contract calls for two separate checks to be issued to the producer (one for building rent and another for services rendered) the tax reporting is simplified – Schedule E for the building rent and Schedule F for the contract services payment. But, if a single check is issued the tax reporting is more difficult. In that situation, the producer will need supporting documentation and evidence of fair rental rates for comparable buildings as well as evidence supporting reasonable labor rates to be able to separate out the building rent portion from the services. Doing so will minimize self-employment tax.
What about W-2 wage income? As noted above, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. That’s not likely to be the case – ag production (and marketing) contracts commonly recite that an employment relationship is not created. Even if there is no specific contract clause stating that the producer is not an employee, the typical contract language and producer requirements would likely not create one. In addition, the definition of self-employment income focuses on income derived from a “trade or business” that a taxpayer engages in on a regular and continuous basis. That is different than the definition of “wages” under I.R.C. §3121 which defines “wages” as “remuneration for employment.” I.R.C. §3121(a). In other words, the presence of an employer/employee relationship is the key. In contract production settings that is not present.
What about “nexus”? Income is self-employment taxable if there is a connection or “nexus” between the income a taxpayer receives, and the taxpayer’s conduct of a trade or business based on all of the facts and circumstances. See, e.g., Newberry v. Comr., 76 T.C 441 (1981); Groetzinger v. Comr., 480 U.S. 23 (1987). In an ag contract production situation, that would be broad enough to subject all of the contract income to self-employment tax. That’s where the real estate rental exception of I.R.C. §1402(a)(1) comes into play. That exception effectively severs the “nexus” with respect to building rents. Without that exception the nexus test has a broad application. See, e.g., Slaughter v. Comr., T.C. Memo. 2019-65.
Many ag products are produced via contract. The rental real estate exception can play an important role in minimizing self-employment tax. Proper structuring of the production arrangement economically and careful drafting of the contract for tax purposes can lead to a more profitable venture for the producer.