Eighth Circuit Overturns Tax Court Ruling that CRP Payments Were Self-Employment Income When Paid to a Non-Farmer, IRS Announces Nonacquiesence

An IRS Tax Court victory in the case of Morehouse v. Commissioner, ( original decision at 14 TC No. 16), was overturned on appeal in a split decisions by a panel of the Eighth Circuit in Case No. 13-3110, 114 AFTR 2d ¶ 2014-5340.

The case in question involved whether payments received under the U.S. Department of Agriculture’s Conservation Reserve Program (CRP) represented income subject to the self-employment tax.  

Mr. Morehouse owned farmland in South Dakota, though he resided in Minnesota.  He had been renting out the farmland to tenants for a number of years to farm, but he decided in 1997 to participate in the program described above.  In that program the taxpayer would be paid by the government to keep the land out of production and to follow a conservation plan.

He reported such income as exempt rental income under IRC §1402(a) arguing either that a) such payments represented income not from the active conduct of a trade or business or b) that the payments represented payments for rental of real estate exempt under IRC §1402(a)(1).

The Tax Court noted that IRC §1402(a)(1), while generally exempting rental real estate from the definition of self-employment income, the provision “shall 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 (including livestock, bees, poultry, and fur-bearing animals and wildlife) 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…”

As well, generally §1402 applies self-employment tax to net income “trade or business carried on by such individual” so both tests will look at Mr. Morehouse’s activity with regard to the business.  The court noted, in describing this test that first we look for the existence of a trade or business, noting that “to be engaged in a trade or business with respect to which deductions are allowable under section 162, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer's primary purpose for engaging in the activity must be for income or profit.”

So the question becomes is whether Mr. Morehouse’s involvement was sufficient to meet the general test for a trade or business and the special rule for farm rentals.

Mr. Morehouse entered into a contract with the government and agreed that certain actions would take place, including the planting of certain plants and other maintenance on the property.  While Mr. Morehouse entered into the contract each year and would visit from time to time to inspect the property, most of the actual work was done by Mr. Redlin, a person he contracted with to perform such services.

The Tax Court found the proper test was to look at the services performed both by Mr. Morehouse and his agent, Mr. Redlin, to determine if there was a trade or business.  The court noted that “[r]egardless of whether some or all of these activities qualify as farming, we find that petitioner was engaged in the business of participating in the CRP and that he enrolled, maintained, and managed multiple properties subject to CRP contracts with the primary intent of making a profit.”

On the rental question, the Tax Court noted that the IRS had taken the position in Notice 2006-108 that CRP payments should be subject to self-employment tax.  The Sixth Circuit, in the case of Wuebker v. Commissioner held that CRP payments are not exempted under the rental real estate classification, even though the Department of Agriculture labels the payments as rents.  The Tax Court went on to note that following this case Congress passed provisions exempting CRP payments from self-employment tax if paid to individuals receiving Social Security or disability payments—indicating Congress did not intend to remove all such payments from taxation as self-employment income.

Thus, the Tax Court found that Mr. Morehouse was subject to self-employment tax on the payments.

A majority of the Eighth Circuit panel, however, rejected that view.  The Court found that the facts in Wuebker were significantly different from those in this case.  The majority found the Sixth Circuit’s reasoning “not abundantly clear” but determined that case turned on the fact that the acts the taxpayer performed in that case for the CRP payment were intrinsically similar to those performed in their active farming operation, leading the Sixth Circuit to conclude the payments were not rental activities.  The obligations did not rise to the level of “occupancy or use” by the government.

However, the majority noted, the Sixth Circuit did not comment on or reject the view, outlined in Revenue Ruling 60-32, that such payments to non-farmers did not represent self-employment income.

The panel comments on Notice 2006-108, cited above, that contained a proposed revenue ruling that, if adopted, would obsolete Revenue Ruling 60-32.  The Court notes that the IRS has not gone ahead and actually formalized that proposed ruling, concluding the IRS now had “doubts” about extending the Wuebeker holding this far.

Thus, the majority held the IRS to the position stated in Revenue Ruling 60-32 and reversed the Tax Court.

However, Judge Gruender in his dissent points out an issue that the Court seemed to glance over—are these payments rents?  Wuebeker found that the payments failed to meet the definition of rents, since the federal government neither occupied nor used the property in question.  If the payments are not rental payments, then the exclusion does not apply and the only real question becomes the “active conduct of a business” issue—which was an issue the majority did not deal with.

The dissent eventually decides that Notice 2006-108 should not be totally ignored, as the majority did, but agrees that the IRS’s inconsistent position limits its influence.  However the dissent goes on to simply decide that even if no deference is granted, the payments simply aren’t rent.

A single circuit’s split decision to overturn a Tax Court decision is a unique situation that complicates the practical problem of dealing with this issue outside of the Eighth Circuit.

Technically the decision only is binding in the Eighth Circuit.  The Tax Court, who felt they were responding to the demands of another Circuit in the original decision, will likely continue to treat such payments as self-employment income outside of the Eighth Circuit and it seems likely the IRS will as well.

Advisers with non-farmers who are in receipt of such payments will need to discuss the implications of this issue with their clients and decide what steps may make sense both in taking original return positions and/or considering filing claims for refund for previously paid self-employment tax.

The IRS weighed in with their view of the Morehouse case in Action on Decision 2015-02—and, not unexpectedly, the IRS disagrees with the Eighth Circuit’s analysis in this case.  While noting the Service will “follow Morehouse within the Eighth Circuit only with respect to cases in which the CRP payments at issue were both (1) paid to an individual who was not engaged in farming prior to or during the period of enrollment of his or her land in CRP and (2) paid prior to January 1, 2008 (i.e., the effective date of the 2008 amendment to section 1402(a)(1)).”  However the IRS will litigate the issue when those are not the facts inside the Eighth Circuit and on all such facts outside that Circuit.