Payments From Conservation Reserve Program Were Subject to Self-Employment Tax; Not Excludable as Rentals From Real Estate. (Parker's Federal Tax Bulletin: July 5, 2013)

The payments received by a landowner under the Conservation Reserve Program were includible in his self-employment income because he was engaged in a trade or business and the payments were not excludable from self-employment earnings as rentals from real estate. Morehouse v. Comm'r, 140 T.C. No. 16 (6/18/13).

Rollin Morehouse acquired land in three counties in South Dakota in 1994 through inheritance and by purchasing various interests in the land from his relatives. Most of the land was tillable cropland. Rollin did not personally farm of any of the land. Instead, he rented the tillable portions to individuals who farmed their rented portions. In 1997, Rollin placed the South Dakota properties into the U.S. Department of Agriculture (USDA) Conservation Reserve Program (CRP). Enrollment in the CRP required Rollin to implement a conservation plan and refrain from using the land for agricultural purposes. In return, he was entitled to receive annual payments from the USDA. Rollin hired a contractor to perform some of his responsibilities under the CRP and fulfilled other obligations himself. Between 1997 and 2007, Rollin participated in three CRP haying programs that involved the South Dakota properties, purchased materials to implement the conservation plans, and applied for USDA cost-sharing payments for seeding and weeding activities. In addition to his activities involving the CRP payments, Rollin allowed individuals to hunt on portions of the South Dakota properties. Between 1994 and 2007, Rollin visited the South Dakota properties several times each year.

In 2006 and 2007, Rollin and his wife, Maureen, timely filed their federal income tax returns and identified their occupations as self-employed. On their returns, the couple reported the CRP payments on Schedule E, Supplemental Income and Loss, as farm rental income. The IRS issued a notice of deficiency for 2006 and 2007 because it determined that the CRP payments were erroneously reported as farm rental income and should have been reported as income on Schedule F, Profit and Loss From Farming. The IRS also determined that the CRP payments constituted self-employment income and therefore the couple had unreported self-employment income of $25,604 for 2006 and $28,391 for 2007.

Self-employment income is generally defined as the net earnings from self-employment. Code Sec. 1402 defines net earnings from self-employment as the gross income derived by an individual from any trade or business.

Rollin claimed that the CRP payments were not income from a trade or business and, therefore, were excludable from his self-employment income. He argued that he was not in the trade or business of farming, that his minimal activities with respect to the South Dakota properties did not cause him to become active in the trade or business of farming, and that there was no nexus between the CRP payments and his business activities. In the alternative, Rollin contended that the CRP payments were excluded from his net earnings from self-employment as rentals from real estate under Code Sec. 1402(a)(1).

The IRS argued that the CRP payments were taxable as self-employment income because Rollin received the payments from his trade or business of conducting an environmentally friendly farming operation.

OBSERVATION: Rentals from real estate and from personal property leased with the real estate are generally excluded from net earnings from self-employment, unless the rentals are received in the course of a trade or business as a real estate dealer.

The Tax Court held that Rollin's participation in the CRP was a trade or business, and there was a nexus between the trade or business conducted and the income Rollin received. The court noted that, in Comm'r v. Groetzinger, 480 U.S. 23 (1987), to engage in a trade or business with respect to the deductions allowed under Code Sec. 162, the taxpayer must be involved in the activity with continuity and regularity, and the primary purpose for engaging in the activity must be for income or profit. Rollin expanded his participation in the CRP over the years and participated in the CRP with continuity and regularity in 2006 and 2007. The court noted that he executed the CRP contracts and obligated himself, as the owner of the properties, to significant contractual obligations regarding the use of the properties and compliance with CRP requirements.

The court also rejected Rollin's position that his actual participation was de minimis and did not constitute farming, and the physical work performed by his contractors should not be attributed to him. The court noted that it was immaterial that the physical activities were performed by someone other than Rollin, and that Rollin, or any taxpayer, may conduct a trade or business through an agent.

The court looked at Notice 2006-108, in which the IRS took the position that CRP payments were derived from self-employment. Congress amended Code Sec. 1402(a)(1) in 2008 to provide a limited exception to including CRP payments in self-employment income. The exception applies to certain individuals receiving payments under the Social Security Act. The court interpreted the fact that Congress made a limited amendment to Code Sec. 1402 in 2008 as indicating an intent not to exclude all CRP payments in calculating a taxpayer's net earnings from self-employment. The exclusion from self-employment earnings for rentals from real estate in Code Sec. 1402(a)(1), the court said, did not apply to payments to Rollin from the CRP. The court also looked to Wuebker v. Comm'r, 110 T.C. 431 (1998), which held that CRP payments were not rentals from real estate. The court concluded that Rollin was an active participant in the CRP program and his participation was not merely a passive investment. Rollin received the CRP payments in consideration for fulfilling his obligations under the CRP contracts, and such consideration provided the required nexus between the CRP payments and his trade or business. Therefore, Rollin had to include the CRP payments received in 2006 and 2007 in his self-employment net earnings and such payments were subject to self-employment tax.

For a discussion of agricultural program payments, see Parker Tax ¶161,530.

Staff Editor Parker Tax Publishing

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