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Taxing Farmers

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Self-Employment Taxes: Selected Base Issues. Farmland rents? ... Variable expenditure patterns (e.g. 179) ... Added in 1997 after a decade-long absence ... – PowerPoint PPT presentation

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Title: Taxing Farmers


1
Taxing Farmers
  • Income Averaging,
  • Self-employment
  • (and some QPAI)

2
Overview
  • Income Averaging Some Overlooked Opportunities
  • Self-Employment Taxes Selected Base Issues
  • Farmland rents?
  • Investment or Self-employment income?
  • Section 199 Basics Can Farmers Benefit?

3
Income Averaging The Problem
  • Variable Income Streams
  • Production variation
  • Commodity price volatility
  • Variable expenditure patterns (e.g. 179)
  • Graduated Tax Rates
  • Effects exacerbated by phase-out provisions
  • Fixed Annual Accounting Periods

4
Income Averaging
  • The Partial Solution IRC 1301
  • Added in 1997 after a decade-long absence
  • 1301 recomputes liability by reducing current
    year tax base by an elected amount and allocating
    it equally among three prior tax years.
  • You get tax savings if prior tax years have
    marginal rates lower than the current year
    rates.

5
Taxpayer A No Variation
6
Taxpayer B Variation (No Avg)
7
Variation 60K Averaging
20K allocated to Y1-Y3, capturing 10 and 15
rates lost in prior years
8
Key Limitations
  • Equal amount assigned to each base year
    recapture of lost marginal rates is not complete
  • For this reason, planners need to be familiar
    with other deferral provisions to smooth out
    single year variations as much as practicable.
  • Averaging affects tax rates, not tax base for
    purpose of computing eligible tax benefits. Eg
  • Bad Still subject to section 68 limitation on
    itemized deductions even though averaging
  • Good Allocation to base years does not trigger
    new limitations on itemized deductions

9
Key Limitations Contd
  • Taxpayers still lose other phase-out benefits,
    despite averaging.
  • Self-employment tax base not affected by
    averaging.
  • AMT Jobs Act provides relief for 2004 ff.
  • Kiddie Tax rate determined after election
    effects (benefit for taxpayer)
  • Averaging election can be made for capital and
    ordinary income amounts.

10
EligibilityFarming business
  • cultivation of land or the raising or harvesting
    of any agricultural commodity 1.263A-4(a)(4).
  • Custom harvesting is not farming
  • Plant retailer not farming
  • Regulations dont speak to custom feeding of
    animals a common arrangement for livestock
    production

11
Some jurisdictions take food production more
seriously than others.
12
Eligibility Individuals
  • C-Corporations No soup for you!
  • Others sole proprietor, partner, S-corporation
    shareholder, LLC member (unless taxed as C
    corporation)
  • Entity activity, not individual activity, is
    critical.
  • Landlord may be eligible for crop share income,
    despite lack of material participation.
  • Careful, though, as C-Corp salaries dont count
    (but S Corporation salaries do! See Reg.
    1.1301-1(e)(1))

13
Eligibility Electible Farm Income
  • Attributable to farming business
  • Follows parameters of farming outlined above.
  • Incidental activities can be included (e.g.,
    washing and packaging income) (1.263A-4)
  • Further processing cannot (e.g., income
    associated with processing wheat into pasta, or
    livestock into packaged meat)
  • Query Is an allocation method permitted?

14
Electible Farm Income Contd
  • Example Is a vineyard with a winery eligible?
    How about grinding hay before delivery to a
    feedlot customer? (common as further processing)
  • Note that sales of business property regularly
    used for a substantial period are eligible
    (but not farmland).
  • Such sales are regular occurrences in many farm
    operations (e.g., culling breeding herds)
  • Retiring farmers may thus benefit from some
    dispositions of property, but still face bunching
    of income on gains on sale of land (LTCG rate
    compensates somewhat for this concern.)

15
Making the Election
Election can be made for any open year,
regardless of whether adjustment is made by the
IRS for that year. This approach allows nearly
perfect hindsight, allowing taxpayers greater
flexibility to benefit from the election.
16
Planning Keep Looking Back!
  • Consider elections for prior open years to shift
    income to earlier base years, thus increasing
    their capacity to absorb averaged income.
  • This could be helpful even if tax savings from
    election in that year are not achieved.
  • Illustrations can be found in article appended to
    outline.

17
Social Security Self Employment
  • Some Basics
  • OASDI Taxes total 12.4
  • Equal shares (6.2) imposed on ER, EE (See I.R.C.
    3101, 3111)
  • Expanding tax base 94,200 in 2006, up from
    90,000 in 2005
  • Self-employed get to deduct half of
    self-employment taxes, approximating the
    treatment of employers who may deduct taxes paid
    on employees. (See I.R.C. 164(f))

18
Social Security Self Employment
  • Medicare portion of 2.9 applies without regard
    to the 94,200 limit.
  • Combined tax is thus 15.3 up to 94,200, and
    2.9 thereafter on eligible base.
  • Big Picture Significant Growth Here (See
    following slides for perspectives)

19
  • Federal Government Receipts 1990-2004, 2005-10
    (est.) (Source White House Budget Office, FY 2006
    Budget Historical Tables)

20
Self-Employment TaxesOverview
Indexing base to wage growth CPI (productivity
gains in index)
21
(Source IRS Statistics of Income, Fall 2005).
22
Taxpayer Impacts
  • Taxpayers at lower income levels will often pay
    more in employment taxes than in income taxes.
  • Top Earner 14,412.60 in total employment taxes
    (including employers share) in 2006.
  • Effect of cap on OASDI base makes this tax
    nominally regressive, but consider these facts
  • Social security benefits are also capped.
  • Benefits are not proportional to contributions
    lower-earning taxpayers get proportionally more
    (a higher replacement rate) than higher-earning
    taxpayers.
  • Taxpayers who can do so may find it economically
    advantageous to reduce self-employment taxes and
    invest the savings in alternative investments,
    including qualified retirement savings plans.
    (See below).
  • Reform proposals raise concerns about an
    expanding tax base and limited future benefits,
    perhaps leading to even more pressure for
    planning to reduce self-employment taxes.

23
Self-Employment Income Base Excluded Items
  • IRC 1402 excludes certain forms of income from
    the self-employment tax base. Clearly excluded
    are
  • Capital gains 1231 gains
  • Interest
  • Dividends
  • All share common characteristic of derivation
    from capital, vs. labor or services

24
Planning Benefit?
  • Can taxpayer planning using capital-related
    exclusions provide net benefits over and above
    the social security benefit?
  • Comprehensive cost/benefit analysis is
    exceedingly complex, but even a simple analysis
    shows real potential here.

25
Baseline Benefits High Earner
  • MAXIMUM EARNER Assumptions
  • Born 6/15/1962
  • Current (2006) earnings 94,200.00
  • Expected future benefits (depending on retirement
    age)
  • 62 and 1 month in 2024 2,896.00
  • 67 in 2029 4,854.00
  • 70 in 2032 6,665.00
  • http//www.ssa.gov/cgi-bin/benefit6.cgi

26
Baseline Benefits Middle Earner
  • MIDDLE EARNER Assumptions
  • Date of birth 6/15/1962
  • Current (2006) earnings 40,000.00
  • Expected future benefits (inflated)
  • 62 and 1 month in 2024 1,825.00
  • 67 in 2029 3,095.00
  • 70 in 2032 4,284.00
  • http//www.ssa.gov/cgi-bin/benefit6.cgi

27
Comparison of Benefits
  • Age 67 Benefits
  • Monthly Annual
  • High 4,854 58,248
  • Middle 3,095 37,140
  • Difference 1,759 21,108
  • (Note above are retirement benefits only.
    This does not take into account differential
    value of disability coverage and death benefits
    for survivors.)

28
What Do Benefits Cost?
29
Estimated Investment Growth
30
Comparative Reward
  • Estimated Return on Investment (Post-Retirement)

  • Return Annual Monthly
  • 4.00 16,370.07 1,364.17
  • 6.00 24,555.10 2,046.26
  • 8.00 32,740.13 2,728.34
  • vs. SS benefit 21,108 1,759
  • Note Above investment amounts assume legacy at
    death no legacy from social security amount.

31
Rental Income the Quandry
  • Rental income from real estate or property is
    connected to capital. An exclusion applies for
    rent, including crop shares, for those besides
    dealers in real estate.
  • BUT the statute excepts rental income if there is
    an arrangement in which the landlord has
    material participation in the production of
    agricultural or horticultural commodities or
    management of such production.

32
IRC 1402(a)(1)
  • The Rental Exclusion does not apply to any
    income derived by the owner or tenant of land if
    (A) such income is derived under an arrangement,
    between the owner or tenant and another
    individual, which provides that such other
    individual shall produce agricultural or
    horticultural commodities on such land, and
    that there shall be material participation by the
    owner or tenant (as determined without regard to
    any activities of an agent of such owner or
    tenant) in the production or the management of
    the production of such agricultural or
    horticultural commodities, and (B) there is
    material participation by the owner or tenant (as
    determined without regard to any activities of an
    agent of such owner or tenant) with respect to
    any such agricultural or horticultural commodity

33
Fickle Finger of Fate
  • Material participation requirement was originally
    added to help farmers by getting them into the
    social security system.
  • Times have changed.

34
Ginsburg Rule
  • Every stick crafted to beat on the head of a
    taxpayer will, sooner or later, metamorphose into
    a large green snake and bite the Commissioner on
    the hind part. Martin Ginsburg, The National
    Office Mission, 27 Tax Notes 99, 100 (1985))

35
Taxpayer Corollary
  • A provision designed to single out taxpayers for
    special benefits may metamorphose into a critter
    that someday bites these taxpayers in the hind
    parts.

36
When you sense trouble, sometimes you just need
to keep your head down and keep moving.
37
Rental Income Separating Capital and Labor
Returns
  • Can a sole proprietor reduce her self-employment
    tax base by leasing land that she owns to a
    spouse or to another entity?
  • McNamara v. Commissioner, 236 F.3d 410 (8th Cir.
    2000), reversing Tax Court in three combined
    cases Bot, Hennen, McNamara.
  • Each case involved payment of FMV cash rent on
    portion of land farmed by taxpayer

38
Case Examples
  • McNamara
  • Mr. owns corporation.
  • Mr. and Mrs. both hired as employees, with total
    wages of 30K
  • Mr. and Mrs. jointly own farmland rented to
    corporation. No material participation reqd.
  • Corporation pays rent for farmland, with net
    rental income of 19-23K

39
Case Examples
  • Bot
  • Mr. owns 160 acres.
  • Mrs. owns 240 acres.
  • Mr. employs Mrs. in farming operation, and she
    rents her acres to him. No material
    participation required in the agreement.
  • Mrs. gets 15K/year wages, 18K/year rent.

40
Case Examples
  • Hennen
  • Similar arrangement to Bot with Mrs. leasing
    her acres to Mr. and employment arrangement with
    Mrs.
  • Lease silent on participation.

41
Tax CourtArrangement Agreement
  • While the concept of an agreement certainly
    includes a contractual agreement, it is a broader
    concept that would also include other forms of
    agreements not necessarily arising from strict
    contractual relationships. Consistent with its
    dictionary definition, in most of the instances
    where it is used in the Internal Revenue Code,
    the word "arrangement" refers to some general
    relationship or overall understanding between or
    among parties in connection with a specific
    activity or situation.

42
Tax Court Policy Supports Broader Tax Base
  • In determining whether compensation is
    includible in self-employment income under
    sections 1401-1403 such provisions are to be
    broadly construed so as to favor coverage for
    Social Security purposes.
  • The rental exclusion in section 1402(a)(1) is to
    be strictly construed to prevent this exclusion
    from interfering with the congressional purpose
    of effectuating maximum coverage under the Social
    Security umbrella.

43
8th Circuit
  • Taxpayers did materially participate.
  • However, Court was open to proof re connection
    between participation and lease.
  • What does it mean to be derived under an
    arrangement?

44
8th Circuit
  • Rents that are consistent with market rates very
    strongly suggest that the rental arrangement
    stands on its own as an independent transaction
    and cannot be said to be part of an arrangement
    for participation in agricultural production.
    Id. at 413. The market rate exception, though
    not in the statute, is a practical effect of the
    derived under language. Id.

45
8th Circuit
  • Remanded to hear proof on FMV. No one chose to
    retry issue. TC holds for taxpayers no
    deficiency.
  • IRS Nonacquiescence.

46
IRS Nonacq.
  • If, under the overall scheme of farming
    operations it was understood that the farmer
    would materially participate in farm production,
    and the farmer did in fact materially
    participate, then the income received from the
    lessee is subject to self-employment tax. The
    Service continues to believe that this is the
    correct result regardless of whether the material
    participation was explicitly called for under the
    written or oral lease. This interpretation best
    promotes Congress intent that farmers who must
    work for a living have their income replaced
    through coverage under the social security
    system.

47
IRS Position
  • Essentially, Farmers are in a worse position than
    other businesses.
  • E.g., Author of one article on this topic opens
    discussion with fact that his company rents his
    office from him, allowing service income to be
    segregated from capital.
  • Policy of expanding base overrides horizontal
    equity between similarly situated taxpayers?
    (Recall the statute does single out this group)

48
Some observations
  • Taxpayers here behaved reasonably. They paid for
    labor, and they did not inflate rental values.
  • Rents were fixed and in cash, not dependent on
    production returns (which as discussed below may
    be problematic).
  • Note that even interspousal arrangements were
    respected a corporate entity was not required.

49
Post-McNamara Taxpayer Loss
  • Solvie, T.C. Memo 2004-55
  • Taxpayers formed corporation and leased land and
    hog production facilities to it.
  • Expanded facilities involved per animal payments
    to owners/employees. (Hog production requires
    labor, which taxpayers provided.)
  • Fixed rents for other land (29K) and facilities
    (21K) dwarfed by per animal pmts. (44K)

50
Solvie Partial Taxpayer Loss
  • Court finds
  • Failure of proof that payment was FMV rent for
    building.
  • Connection between production activity by Solvies
    and payment. (Problem for crop share
    arrangements?)
  • But note IRS concedes propriety of exclusion of
    other rent not dependent on this production
    activity.

51
What About Partnerships?
  • Mizell v. Commissioner, T.C. Memo 1995-571
    involved a partnership between father and sons,
    in which father sought to exclude crop share
    rentals for farmland from self-employment income.
    Tax Court analyzed this in terms of arrangement,
    much like Bot/McNamara. (In fact, Mizell is
    cited for this approach).

52
Alternative Partnership Approach
  • Section 1402 is clear that self-employment income
    includes a partners distributive share
    (whether or not distributed) of income or loss
    described in section 702(a)(8) from any trade or
    business carried on by a partnership of which he
    is a member.
  • Traditional partnership arrangements contemplate
    profit as a product of capital and labor.
    Guaranteed payments for services or capital
    provide a means to segregate these components.
    See I.R.C. 707(c). However, that segregation
    is for limited purposes.

53
Partnership Approach Contd
  • 707(c) provides that guaranteed payments are
    considered as made to one who is not a member of
    the partnership, but only for the purposes of
    section 61(a) (relating to gross income) and,
    subject to section 263, for purposes of section
    162(a) (relating to trade or business expenses).
    (Note that 1402 is absent!)
  • See also Treas. Reg. 1.707-1(c) For the
    purposes of other provisions of the internal
    revenue laws, guaranteed payments are regarded as
    a partners distributive share of ordinary
    income.

54
What About LLCs?
  • Partnership tax structure seems problematic based
    on above analysis. (Even non-farming businesses
    could face challenges.)
  • Disregarded entity status also presents
    uncertainty could a bachelor accomplish the
    same tax benefits that the Bots and Hennens did?
  • One commentator (Sowell) suggests segregating
    capital into S corporation in order to ensure
    segregation of capital income. (Substance Form
    challenges?)
  • Uncertainty here may gravitate toward use of
    corporate entity. (Choice of entity
    considerations are complex).

55
Cooperatives and Self-Employment Income
  • Bot v. Commissioner, 353 F.3d 595 (8th Cir.
    2003), affirming 118 T.C. 138 (2002), involved
    the question of whether self-employment taxes
    applied to value-added payments from a farming
    cooperative paid to members. The Eighth Circuit
    affirmed the Tax Courts finding that these
    payments represented income from carrying on a
    trade or business through agents, and thus were
    not excluded from the self-employment tax base.

56
Bot contd
  • Bots (retired farmers?) owned interests in
    cooperative for corn processing.
  • Retirement was potentially contestable due to
    arrangements with sons that resembled partnership
    activities. IRS did not challenge this,
    however.
  • Members could meet obligations to deliver corn to
    cooperative (MCP) from three different sources
    (1) deliver own production (2) purchase from
    others or (3) acquire corn from MCP through an
    option pool arrangement, which involved corn
    purchased by the MCP for the purpose of helping
    members meet their delivery obligations. In each
    case, the Bots used option pool corn, paying MCP
    an acquisition fee of five cents per bushel.

57
Bot- contd
  • Bots received payments for value added
    production by cooperative, which they
    characterized as STCG.
  • IRS said pmts. were self-employment income. Bots
    carried on a trade or business of acquiring and
    selling corn and corn products for profit through
    the cooperative.
  • It appears that they delivered substantially more
    grain than they were capable of growing and
    receiving through crop share (700 acres x 150
    bushels x ½ share 52,500 bushels of production.
    Their option pool corn fees of 18,070 at five
    cents per bushel translates into 361,400 bushels
    more than 7 times as much.)
  • They chose cooperative, not corporation. Thus,
    they carried on business through agents and
    earnings s/t self-employment tax.

58
Other Cooperative Issues
  • Fultz brothers faced similar case also losing
    (p. 14-15). They did not respect the corporate
    form, and instead received pmts individually and
    assigned them to corp.
  • Would different result obtain if retired farmer
    delivered crop share rental to cooperative?
    (Magnitude issue presented in Bot vs. means of
    disposing of rental share?)
  • See Felber v. Commissioner, T.C. Memo 1992-418,
    affd without published opinion, 998 F.2d 1018
    (8th Cir. 1993) (retired wheat farmer whose
    tenant sold crop share on his behalf not subject
    to self-employment tax)
  • What of patronage dividend from passive rental
    activity (e.g., based on fertilizer share)?

59
Section 199 Issues Can Farmers Benefit?
  • Basic Provisions.
  • Deduction percentage.
  • 2005-06 3 percent
  • 2007-09 6 percent
  • 2010 ff. 9 percent.
  • Deduction base. The deduction is a percent of
    the lesser of
  • Qualified production activities income (QPAI)
    (see below) or
  • taxable income (or for individuals, adjusted
    gross income subject to certain adjustments).
    See I.R.C. 199(a) (d)(2).

60
199 Basics
  • What is QPAI? Domestic production gross receipts
    (DPGR) sum of specified costs. (See
    199(c)(1)).
  • DPGR gross receipts derived from any lease,
    rental, license, sale, exchange, or other
    disposition of (I) qualifying production property
    which was manufactured, produced, grown, or
    extracted by the taxpayer in whole or in
    significant part within the United States .
    I.R.C. 199(c)(4)(A).

61
199 Basics contd
  • Qualifying production property (QPP) includes
    tangible personal property.
  • The scope of manufactured, produced, grown, or
    extracted (MPGE) encompasses crops or livestock
    grown by farmers within DPGR. See Prop. Reg.
    1.199-3(d)(1)(including cultivating soil,
    raising livestock, and fishing in MPGE).

62
199 Basics contd
  • MPGE also includes storage, handling, or other
    processing activities (other than transportation
    activities) within the United States related to
    the sale, exchange, or other disposition of
    agricultural products, provided the products are
    consumed in connection with, or incorporated
    into, the MPGE of QPP whether or not by the
    taxpayer.
  • However, the taxpayer must be doing more than
    packaging to qualify.
  • Grain storage fees are specifically covered in an
    example in the regulations as included within
    DPGR. See Prop. Reg. 1.199-3(d)(5) Example 1.

63
199 Basics contd
  • Wage limitation deduction allowable is in any
    case limited to the W-2 wages of the employer
    for the taxable year. I.R.C. 199(b).
    (Section 4.02(1)(a) of Notice 2005-14 and
    1.199-2(a)(1) of the proposed regulations
    confirm that this includes common law employees,
    not independent contractors, partners, or
    self-employment income.)

64
199 Basics contd
  • Regulations clarify that only one taxpayer may
    obtain the deduction under section 199 for
    production. Reg. 1.199-3(e)(1)
  • If one taxpayer performs a qualifying
    activity pursuant to a contract with another
    party, then only the taxpayer that has the
    benefits and burdens of ownership of the property
    under Federal income tax principles during the
    period the qualifying activity occurs is treated
    as engaging in the qualifying activity.
  • Will custom feeding qualify? Unlikely to meet
    benefits and burdens test.
  • Sale of feed would qualify, however, raising
    allocation issues.

65
199 Basics- contd
  • Pass-through entities. Deductions are applied at
    the shareholder, partner, or similar level. See
    id. 199(d)(1)(A). W-2 wages are also allocated
    for this purpose to the partner level, subject to
    additional limitations. See id. 199(d)(1)(B).

66
199 Basics- contd
  • Cooperatives. A special rule exists in 199(d)(3)
    to address the issue of agricultural cooperatives
    (as in Bot and Fultz, above). To the extent the
    cooperative is engaged MPGR of an agricultural or
    horticultural product, or marketing of such
    products, and a patronage dividend or per-unit
    written allocation taxable to the patron under
    1385(a)(1) or (3) is received, then patrons are
    allowed to take the deduction under section 199.

67
Some Important Issues for Farmers
  • Wage Limitation.
  • Contract production may not count.
  • Sole proprietors may get nothing if they dont
    pay employees.
  • Members of farming partnerships or LLCs, who do
    not receive W-2 wages, and who provide the bulk
    of services to the partnership may also not
    benefit from this deduction to the extent W-2
    wages paid to others are not significant.
  • Corporate formation may allow advantages,
    especially to the extent that wage payment
    allowed.

68
Farmer Issues - 199
  • But note increasing salaries to get greater 199
    deduction may not make sense if higher employment
    taxes result.
  • Farmers who are not engaged in a trade or
    business (i.e., retired farmers who rent land)
    are not eligible.

69
Farmer Issues- 199
  • DPGR Examples
  • Livestock or crops in
  • Custom work out
  • Hedging transactions in
  • Special retail food/beverage rules (see outline)
  • Note 5 de minimis rule allows you to treat all
    income as DPGR.
  • Otherwise, allocation is required.
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