Eighth Circuit Reverses Tax Court on Treatment of CRP Payments to Nonfarmer.
(Parker Tax Publishing November 2, 2014)

Conflicting IRS guidance and opposing court decisions during the past several years have caused confusion among practitioners and taxpayers alike over whether certain agricultural payments from the U.S. government constitute self-employment income or are characterized as rentals from real estate. The distinction is important because it determines whether the income is subject to self-employment tax. The issue boils down to whether a taxpayer who is not a farmer is considered to be in a trade or business when the taxpayer receives such government payments.

Last year, in Morehouse v. Comm'r, 140 T.C. No. 16 (2013), the Tax Court held that payments a nonfarmer landowner received under the Conservation Reserve Program (CRP) were includible in his self-employment income because he was engaged in a trade or business and there was a nexus between that trade or business and the CRP payments. Thus, the payments could not be excluded from self-employment earnings as rentals from real estate. In a 2-1 decision, the Eighth Circuit, in Morehouse v. Comm'r, 2014 PTC 534 (8th Cir. 10/10/14), reversed the Tax Court and held that the CRP payments were not self-employment income because the landlord was not engaged in the trade or business of farming. The court concluded instead that the payments constituted rentals from real estate.

Practice Tip: If the CRP payments are treated as being received in a trade or business, they are outside the scope of the 3.8 percent net investment income tax. However, if the taxpayer's position is that the payments are not subject to self-employment tax because they are considered rental income, then the net investment income tax will most likely apply to the payments, assuming the taxpayer meets the threshold for being subject to the net investment income tax.

Background

Rollin Morehouse inherited land in three counties in South Dakota in 1994 and then purchased various interests in land from his relatives. Most of the land was tillable cropland. Rollin did not personally farm of any of the land but instead rented the tillable portions to individuals who farmed their rented portions. In 1997, Rollin placed much of the tillable cropland into the U.S. Department of Agriculture (USDA) CRP program. This required Rollin to implement a conservation plan and refrain from using the land for agricultural purposes. In return, the Commodity Credit Corporation (CCC) executed the CRP contracts that entitled Rollin to receive annual payments from the USDA.

Under the CRP agreement, Rollin was required to establish and maintain specific types of grass and legume or perennial vegetative cover on portions of the CRP properties and periodically engage in weed and pest control. Rollin was also required to fulfill certain annual paperwork obligations and he visited the CRP properties approximately three times each year to ensure the properties complied with the CRP contracts. In return for Rollin's compliance with the CRP contracts, the CCC agreed to pay part of his costs for implementing the conservation plans, along with an "annual rental payment."

Rollin hired a contractor to perform some of his responsibilities under the CRP contract and fulfilled other obligations himself. Between 1997 and 2007, Rollin participated in three CRP haying programs involving the 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 properties. Between 1994 and 2007, Rollin visited the South Dakota properties several times each year.

Rollin received CRP payments of $37,872 in both 2006 and 2007. He and his wife filed joint tax returns for both years and identified their occupations as "self-employed." On Schedules E of their tax returns, the Morehouses listed the CRP payments for both years as "rents received" and excluded the payments from self-employment income.

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

The IRS assessed a deficiency, saying the Morehouses owed self-employment tax because the CRP payments were self-employment income. According to the IRS, the payments were appropriately characterized as payments from a trade or business of conducting an environmentally friendly farming operation.

Income Subject to Self-Employment Taxes

Code Sec. 1402 imposes a tax on net earnings from self-employment derived by an individual. Net earnings from self-employment refer to the gross income derived by an individual from any trade or business carried on by that individual. In Bot v. Comm'r, 353 F.3d 595 (8th Cir. 2003), the Eight Circuit said that the "derived from" requirement necessitates a nexus between the income and the trade or business actually carried on by the taxpayer. Code Sec. 1402(a)(1) excludes from the definition of "net earnings from self-employment" several types of income, including rentals from real estate and CRP payments made to individuals receiving benefits under Section 202 or 223 of the Social Security Act.

Prior Guidance on CRP Payments and Self-Employment Tax

The CRP is the current version of a long line of federal soil conservation programs, and is so substantially similar to its predecessor, the Soil Bank Act, that it has been referred to as the "Son of Soil Bank." In Rev. Rul. 60-32, the IRS concluded that soil bank payments made to persons who did not operate or materially participate in a farming operation were not included in determining net earnings from self-employment. Soil bank payments to farmers, however, were to be treated as self-employment income derived from their farming business. Although Rev. Rul. 60-32 did not explain why the IRS differentiated between farmers and nonfarmers, the IRS subsequently issued Rev. Rul. 65-149 in which it indicated that it viewed soil bank payments to nonfarmers as rental income.

In Wuebker v Comm'r, 110 T.C. 431 (1998), the taxpayers were active farmers who claimed their CRP payments constituted rentals from real estate. The Tax Court agreed with the taxpayers' position that CRP payments constituted rentals from real estate that were excludable from self-employment income. However, the Sixth Circuit (205 F.3d 897 (6th Cir. 2000)), reversed the Tax Court, holding that CRP payments to farmers do not fall within the "ordinary or natural" meaning of the phrase "rentals from real estate," and that therefore CRP payments to farmers are not excludable from self-employment tax as rentals from real estate. Subsequently, in Notice 2006-108, the IRS issued a proposed ruling in which it said that CRP rental payments (including incentive payments) to an individual not otherwise actively engaged in the trade or business of farming who enrolls land in CRP and fulfills the CRP contractual obligations by arranging for a third party to perform the required activities, were includible in net income from self-employment and were not excludible as rentals from real estate.

Tax Court's Opinion

In Morehouse, the Tax Court agreed with the IRS and concluded that the CRP payments received by the Morehouses were subject to self-employment tax. In reaching this decision, the Tax Court concluded that Rollin was engaged in a trade or business by virtue of participating in the CRP with the primary intent of making a profit. The Tax Court also rejected the Morehouses' assertion that CRP payments were rentals from real estate under Code Sec. 1402(a)(1) and should thus be excluded from net earnings from self-employment. According to the Tax Court, the CRP payments were proceeds from Rollin's own use of his land and thus did not constitute rent. The Morehouses appealed to the Eighth Circuit.

Eight Circuit's Analysis

The Eighth Circuit reversed the Tax Court and held that CRP payments made to nonfarmers constitute rentals from real estate for purposes of Code Sec. 1402(a)(1) and are not subject to the self-employment tax. The court noted this was the same conclusion reached by the IRS in Rev. Rul. 65-149 with respect to soil bank payments. The court was also persuaded, given the significant overlap between the CRP and the soil bank program, by the judgment expressed by the IRS in Rev. Rul. 60-32 excluding such payments to nonfarmers from self-employment income. According to the court, the CRP payments represent consideration paid by the government for the use and occupancy of the Morehouse's property.

The Eighth Circuit distinguished the Wuebker court's determination that the CRP payments at issue constituted self-employment income because in that situation the taxpayers' maintenance obligations under their CRP contracts were intrinsically similar to activities performed in their active farming operation (i.e., tilling, seeding, fertilizing, and weed control), and thus those obligations were not rental income. The Eighth Circuit noted that the Wuebker court neither recognized nor rejected the IRS's position in Rev. Rul. 60-32 that similar payments to nonfarmers were not self-employment income.

The Eighth Circuit also noted that the IRS never adopted the proposed ruling in Notice 2006-108 and observed that the proposed ruling does not represent the IRS's longstanding treatment of land conservation payments made to nonfarmers as rental income as outlined in Rev. Rul. 60-32. Thus, the court afforded it no deference and held that the 2006 and 2007 CRP payments were rental income excluded from the self-employment tax.

OBSERVATION: In a dissenting opinion, Judge Gruender said he would follow the Sixth Circuit's persuasive interpretation of "rentals from real estate" as it relates to CRP payments. He said it was clear that the IRS effectively abandoned its earlier positions on the subject when it issued Notice 2006-108, in which it concluded that CRP payments to a nonfarmer, like Morehouse, were not rentals from real estate. The judge noted that the IRS issued this proposed revenue ruling in response to, among other things, the Sixth Circuit's opinion in Wuebker, which held that CRP payments to farmers did not constitute rentals from real estate. In adopting Wuebker's rationale and applying it to both farmers and nonfarmers, the judge said, the IRS recognized that Notice 2006-18 would render Rev. Rul. 60-32 obsolete. He did note, however, that the IRS's conflicting views and its failure to adopt Notice 2006-108 as a formal revenue ruling was a problem for the court. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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