Taxing Farmers Income Averaging, Self-employment (and some QPAI) 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? 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 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. Taxpayer A: No Variation Year 1: Year 2: Year 3: Year 4: Total Average Tax Rates: Income Income Income Income Income Rate 30% $10,000 $10,000 $10,000 $10,000 $40,000 15% $10,000 $10,000 $10,000 $10,000 $40,000 0% $10,000 $10,000 $10,000 $10,000 $40,000 Total Income $30,000 $30,000 $30,000 $30,000 $120,000 Total Tax $4,500 $4,500 $4,500 $4,500 $18,000 15.00% Taxpayer B: Variation (No Avg) Year 1: Year 2: Year 3: Year 4: Total Average Tax Rates: Income Income Income Income Income Rate 30% $0 $0 $0 $100,000 $100,000 15% $0 $0 $0 $10,000 $10,000 0% $0 $0 $0 $10,000 $10,000 Total Income $0 $0 $0 $120,000 $120,000 Total Tax $0 $0 $0 $31,500 $31,500 26.25% Variation + $60K Averaging Year 1: Year 2: Year 3: Year 4: Total Tax Rates Income Income Income Income Income Tax Rate 30% $0 $0 $0 $40,000 $40,000 15% $10,000 $10,000 $10,000 $10,000 $40,000 0% $10,000 $10,000 $10,000 $10,000 $40,000 Total $20,000 $20,000 $20,000 $60,000 $120,000 Tax $1,500 $1,500 $1,500 $13,500 $18,000 15.00% $20K allocated to Y1-Y3, capturing 10% and 15% rates “lost” in prior years 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 Key Limitations: Cont‟d • 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. Eligibility: Farming 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 don‟t speak to custom feeding of animals – a common arrangement for livestock production Some jurisdictions take food production more seriously than others. 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 don‟t count (but S Corporation salaries do! See Reg. 1.1301-1(e)(1)) 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? Electible Farm Income: Cont‟d • 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.) 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. 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. 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)) 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) Federal Government Receipts 3,000,000 2,500,000 Dollars in Millions 2,000,000 Other Excise Taxes 1,500,000 Social Insurance Taxes Corporate Income Taxes 1,000,000 Individual Income Taxes 500,000 0 90 93 96 99 02 05 08 19 19 19 19 20 20 20 Fiscal Year •Federal Government Receipts 1990-2004, 2005-10 (est.) (Source White House Budget Office, FY 2006 Budget Historical Tables) Self-Employment Taxes: Overview Social Security Earnings Base $100,000 $90,000 $80,000 $70,000 $60,000 Base $50,000 Earnings Base $40,000 $30,000 $20,000 $10,000 $0 1976 1981 1986 1991 1996 2001 2006 1937-50 1968-71 Year Indexing base to wage growth > CPI (productivity gains in index) 2003 Individual Income Taxes 50.00% 40.00% % of Returns 30.00% % of AGI 20.00% % of Tax 10.00% 0.00% 0-25 25-50 50-100 100-200 200-500 500- Over 1000 1000 AGI ($000s) (Source: IRS Statistics of Income, Fall 2005). 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 employer‟s 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. 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 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. 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 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 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.) What Do Benefits “Cost”? Annual Tax Cost: Rate Base Annual Tax High 12.40% $94,200 $11,681 Middle 12.40% $40,000 $4,960 Tax Difference $6,721 Estimated Investment Growth: Estimated Future Value of Tax Savings With Lower SS Base Due to Planning: Annual Interest Rate 8% Number of Payments 23 Amount of Payment -$6,721 Future Value $409,252 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. 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. 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 “Fickle Finger of Fate” • Material participation requirement was originally added to help farmers by getting them into the social security system. • Times have changed. 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)) 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. When you sense trouble, sometimes you just need to keep your head down and keep moving. 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 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 req‟d. – Corporation pays rent for farmland, with net rental income of $19-23K 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. Case Examples • Hennen – Similar arrangement to Bot – with Mrs. leasing her acres to Mr. and employment arrangement with Mrs. – Lease silent on participation. Tax Court: Arrangement > 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.” 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.” 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”? 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. 8th Circuit • Remanded to hear proof on FMV. No one chose to retry issue. TC holds for taxpayers – no deficiency. • IRS: Nonacquiescence. 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.” 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) 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. 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) 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. 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). Alternative Partnership Approach: • Section 1402 is clear that self-employment income includes “[a partner‟s] 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. Partnership Approach: Cont‟d • 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 partner‟s distributive share of ordinary income.” 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). 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 Court‟s 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. Bot – cont‟d • 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. Bot- cont‟d • 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. 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, aff‟d 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)? 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). 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). 199 Basics cont‟d • 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). 199 Basics – cont‟d • 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. 199 Basics – cont‟d • 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.) 199 Basics – cont‟d • 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. 199 Basics- cont‟d • 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). 199 Basics- cont‟d • 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. Some Important Issues for Farmers • Wage Limitation. • Contract production may not count. • Sole proprietors may get nothing if they don‟t 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. 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. 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.