Monday, April 5, 2021
A lot of farmland is leased. Farmers (and landlords) are often good at understanding the components of economic risk associated with a farm lease and utilize the best type of lease accordingly. But what about tax issues? There are numerous income tax issues associated with leasing farmland. Sometimes the tax issues of leasing also impact estate and business planning issues for the farm landlord. These can be very important issues that shouldn’t be overlooked when deciding the type of lease to utilize.
Tax and planning considerations when leasing farmland – it’s the topic of today’s post.
Types of Leases
Different types of agricultural land leasing arrangements exist. The differences are generally best understood from a risk/return standpoint.
- Cash leases involve the periodic payment of a rental amount that is either a fixed number of dollars per acre, or a fixed amount for the entire farm. Typically, such amounts are payable in installments or in a lump sum.
- A flexible cash lease specifies that the amount of cash rent fluctuates with production conditions and/or crop or livestock prices.
- A hybrid cash/guaranteed bushel lease contains elements similar to those found in crop-share leases. For example, a hybrid cash lease usually specifies that the rental amount is to be determined by multiplying a set number of bushels by a price determined according to terms of the lease, but at a later date. The tenant will market the entire crop. The landlord benefits from price increases, while requiring no management or selling decisions or capital outlay. However, the rental amount is adversely affected by a decline in price. The tenant, conversely, will not bear the entire risk of low commodity prices, as would be the case if a straight-cash lease were used, but does bear all of the production risk and must pay all of the production costs. The tenant delivers a set amount of a certain type of grain to a buyer by a specified date. The landlord determines when to sell the grain, and is given an opportunity to take advantage of price rises and to make his or her own marketing decisions. However, the landlord must make marketing decisions, and also is subject to price decreases and the risk of crop failure. For the tenant, the required capital outlay will likely be less, and the tenant should have greater flexibility as to cropping patterns. While the rental amount may be less than under a straight-cash lease, the tenant will continue to bear the risk of crop failure.
- A minimum cash or crop share lease, involves a guaranteed cash minimum. However, the landlord has the opportunity to share in crop production from a good year (high price or high yield) without incurring out-of-pocket costs. For a tenant, the minimum cash payment likely will be less than under a straight-cash lease because the landlord will receive a share of production in good years. The tenant, however, still retains much of the production risk. In addition, the tenant typically does not know until harvest whether the tenant will receive all or only part of the crop. This may make forward cash contracting more difficult.
- Under a crop-share leasing arrangement, the rent is paid on the basis of a specified proportion of the crops. The landlord may or may not agree to pay part of certain expenses. There are several variations to the traditional crop-share arrangement. For example, with a crop share/cash lease, rent is paid with a certain proportion of the crops, but a fixed sum is charged for selected acreage such as pasture or buildings, or both. Under a livestock-share leasing arrangement, specified shares of livestock, livestock products and crops are paid as rent, with the landlord normally sharing in the expenses. For irrigation crop-share leases, rent is a certain proportion of the crops produced, but the landlord shares part of the irrigation expenses. Under labor-share leases, family members are typically involved and the family member owning the assets has most of the managerial responsibility and bears most of the expenses and receives most of the crops. The other family members receive a share of yield proportionate to their respective labor and management inputs.
Type of lease matters. Self-employment tax is imposed on net earnings derived from self-employment. I.R.C. §1402. That phrase is defined as gross income derived by an individual from a trade or business that the taxpayer conducts. Id. However, rents from real estate and from personal property leased with 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 operation are not classified as self-employment income subject to Social Security tax (and, thus, do not count toward eligibility for Social Security benefits in retirement). I.R.C. §1402(a)(1)(A). Only if the rental income is produced under a crop or livestock-share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income. Id.
Avoiding self-employment tax. Income received under a cash rental arrangement is not subject to self-employment tax, nor does such income count toward eligibility for Social Security benefits in retirement. An exception to this rule exists if the lessor leases land to an entity in which the lessor is materially participating. I.R.C. §1402(a)(1)(A). IRS has won several cases in which they have successfully attributed the lessor’s material participation in the entity to the leasing arrangement with the result that passive cash rent income is transformed into material participation income subject to self-employment tax. But, if the rental income represents a fair market rate of rate, the rental income is not subject to self-employment tax. Martin v. Comr., 149 T.C. 293 (2017). So, the key to avoiding self-employment tax on “self-rentals” is to make sure that the lease is a “passive” lease (i.e., a cash lease) and that the rental rate is set at a fair market rate of rent (or very closely to it).
Material participation leases. The key concept for farm landlords attempting to qualify rental income as self-employment subject to Social Security tax is material participation. Rental income is self-employment income if it results from a material participation lease. If the lease is a material participation lease, the income is subject to self-employment tax. If it is not such a lease, the income is not subject to the tax. 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 does make a material participation arrangement easier to establish. In addition, agricultural program payments that are received under a crop-share or livestock-share lease are considered to be self-employment income for Social Security purposes if the landlord materially participates under the lease.
Observation: Managing earned income in retirement years is important and can influence the type of lease that is utilized. Once full retirement age is reached, a taxpayer can receive an unlimited amount of income without the loss of Social Security benefits. Full retirement age is either 66, 67, or 66 and a certain number of months, depending on your year of birth. For persons age 62 to 65, the earnings limit in 2021 is $18,240. For excess amounts, benefits are reduced $1 for every $2 over the limit. For a person reaching full retirement age in 2021, the limit increases to $50,520. Above that level, $1 in Social Security benefits are lost for every $3 of earnings. A key point in all of this is that, for retired farm landlords under full retirement age, they may not be able to receive full Social Security benefits if they are materially participating under a lease.
Income Tax Considerations
USDA cost-sharing payments. Under certain federal farm programs, especially those programs designed to provide environmental benefits, the USDA shares in part of the expense associated with complying with the program. If certain requirements are satisfied, the farmer that receives cost-share payments can exclude them from income. I.R.C. §126. Crop-share and livestock-share landlords are eligible to exclude cost-share payments from income.
Soil and water conservation expenses. Taxpayers engaged in farming can (upon satisfying several requirements) deduct soil and water conservation expenses in the year incurred under a one-time election, rather than capitalizing the expenditures. I.R.C §175. One of those requirements is that the taxpayer be engaged in the business of farming. A farm operator or landowner receiving rental income under a crop-share or livestock-share lease satisfies the test. But, a landlord collecting rental income on a cash rent basis is not eligible to deduct soil and water conservation expenses on the associated real estate. The landlord must materially participate in the farming operation.
Fertilizer and lime. A taxpayer can deduct fertilizer and lime costs by making an election on the tax return, if the taxpayer is in the trade or business of farming. I.R.C. §180. For farm landlords, the lease must be a crop-share or livestock-share lease. A landlord under a cash rent lease cannot deduct the cost of fertilizer and lime. A farm landlord must be materially participating under the lease.
Interest. Most farm interest is fully deductible as business interest. Crop-share and livestock-share leases with substantial involvement in decisionmaking by the landlord are deemed to be “businesses” for this purpose.
Farm income averaging. Income averaging is available for farmers and fishermen, and allows current farm income to be averaged over three prior base years. I.R.C. §1301. The provision is available by election (by filing Schedule J) and provides the benefit of applying lower income tax rates from the prior base years. A “farming business” for purposes of income averaging is defined as the trade or business of farming involving the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity and includes operating a nursery or sod farm or the raising or harvesting of trees bearing fruit, nuts, or other crop or ornamental trees (but not evergreen trees more than six years old when severed from the roots). Also included in the definition is the raising, shearing, feeding, caring for, training and managing animals. Crop-share landlords are deemed to be engaged in the business of farming if the lease is in writing and is entered into with the tenant before the tenant begins significant activities on the land.
Special Use Valuation.
As I wrote in a recent post, a special use valuation election can be made in an estate to value the farmland used in farming at its agricultural value rather than fair market value. That eliminates factors that put upward price pressure on the land and helps the land stay in farming by the family be reducing or eliminating the federal estate tax on the decedent’s estate. However, many tests have to be satisfied to make the election, one of which requires the decedent (if the decedent was a landlord) to have had material participation under a lease for five of the last eight years before the earlier of retirement, disability or death if a special use valuation election is going to be made for the agricultural real estate included in the decedent-to-be’s estate. I.R.C. §2032A(b)(1)(A).
The solution, if a family member is present, may be to have a non-retired landlord not materially participate, but rent the land that is to be elected in the landlord’s estate upon death to a materially participating family member or to hire a family member as a farm manager. Cash leasing of elected land to family members is permitted before the landlord dies, but generally not after death. The solution, if a family member is not present, is to have the landlord retire at full retirement age or older, materially participate during five of the eight years immediately preceding retirement, and then during retirement rent out the farm via a non-material participation crop-share or livestock-share lease.
Leases and Farm Program Benefits
Leases can also have an impact on a producer’s eligibility for farm program payments. In general, to qualify for farm program payments, an individual must be “actively engaged in farming.” Each “person” who is actively engaged in farming is eligible for one payment limit of federal farm program payments. A tenant qualifies as actively engaged in farming through the contribution of capital, equipment, active personal labor or active personal management. Likewise, a landlord qualifies as actively engaged in farming by the contribution of the owned land if the rent or income for the operation’s use of the land is based on the land’s production or the operation’s results (not cash rent based on a guaranteed share of the crop). In addition, the landlord’s contribution must be “significant,” must be “at risk,” and must be commensurate with the landlord’s share of the profits and losses from the farming operation.
A landlord who cash leases land is considered a landlord under the payment limitation rules and may not be considered actively engaged in farming. In this situation, only the tenant is considered eligible. Under the payment limitation rules, there are technical requirements that restrict the cash-rent tenant’s eligibility to receive payments to situations in which the tenant makes a “significant contribution” of (1) active personal labor and capital, land or equipment; or (2) active personal management and equipment.
Utilizing the “correct” farm lease for your farming operation involves more than just the economics of the relationship. Taxes and planning considerations also play an important role. Properly consideration should be made. Do your “due diligence.”