Rental Income or Self-Employment Income?
November 06, 2017
Skirting Employment Tax?
The Code imposes the self-employment tax on the net earnings from self-employment derived by an individual during any taxable year.
In general, the term “net earnings from self-employment” means the net income derived by an individual from any trade or business carried on by such individual, plus his distributive share (whether or not distributed) of net income from any trade or business carried on by a partnership of which he is a member.
The shareholders of an S corporation are not subject to self-employment taxes on their distributive share of the corporation’s net income, though they and the corporation are subject to employment taxes on any wages paid to them by the corporation.
Over the years, many taxpayers have sought to reduce the exposure of their business income to employment tax.
Many taxpayers, for example, have organized their business as an S corporation, rather than as a partnership: they avoid entity-level tax; the corporation pays them a salary that is subject to employment tax but that may be considered low relative to the value of the services rendered; because the shareholders’ distributive share of S corporation income (after being reduced by their salary) is not subject to employment tax (in contrast to a partner’s share of partnership income), the shareholders are able to reduce their employment tax liability.
Of course, the IRS seeks to compel S corporations to pay their shareholder-employees a reasonable salary for services rendered to the corporation, so as to prevent the “conversion” of taxable income into investment income that is not subject to employment tax.
There are other items of income that are excluded from the reach of the employment tax, and which may be “manipulated” by some taxpayers in a manner similar to the payment of wages by some S corporations.
Among these exclusions is the rental income from real estate.
In contrast to wages, however, where the IRS’s concern is that the S corporation-employer may be paying an unreasonably low salary for the services rendered, thereby leaving the shareholder-employee with more “distributive share income” that is exempt from employment taxes, the concern as to rental payments is that a taxpayer-owner’s business may be paying an unreasonably large amount for the use of the owner’s separately-owned property, thereby reducing the taxpayer-owner’s net earnings from self-employment and the resulting employment tax.
The Tax Court recently considered a variation on the rental situation. The question presented was whether rent payments received by Taxpayer were subject to self-employment tax.
Well Life on a Farm is Kinda Laid-Back?
Taxpayer owned a farm, and performed the farm’s bookkeeping, other management services, and a portion of the physical labor.
During the years at issue, Taxpayer entered into an agreement (“Agreement’) with an unrelated party (“Chicken-Co”) pursuant to which Chicken-Co would deliver poultry to Taxpayer to be cared for in accordance with detailed instructions. Taxpayer was allowed to hire additional laborers or employees; however, Taxpayer’s discretion ended there.
Shortly thereafter, Taxpayer organized Corp as an S corporation. Using a recent appraisal which analyzed the cost of “performing” the Agreement purely as an investment (and not as an active business), Taxpayer entered into an employment agreement with Corp, and set his salary accordingly. Taxpayer agreed to provide bookkeeping services to Corp and, along with any hired laborers or employees, would provide the requisite labor and management services.
Chicken-Co approved Taxpayer’s assignment of the Agreement to Corp; nothing in the Agreement required Taxpayer to personally perform the duties required thereunder.
Taxpayer entered into a lease agreement with Corp by which Corp would rent the farm and various structures and equipment from Taxpayer. Corp agreed to pay rent to Taxpayer; Corp was required to remit each rent payment regardless of whether it had fulfilled its requirements under the Agreement or had received sufficient income. The rental amount represented fair market rent.
Corp fulfilled its duties under the lease, making all of the necessary rent payments to Taxpayer. At no point during the years in issue did Taxpayer believe that he was obligated to render farm-related services as a condition to Corp’s obligation pursuant to the lease to pay rent to Taxpayer. Corp also fulfilled its duties to Chicken-Co under the Agreement; Taxpayer was not obligated to perform farm-related services under the Agreement. Although Taxpayer participated in Corp’s activity, Corp consistently hired numerous laborers and professionals to carry out its obligations.
Trouble in the Henhouse?
Taxpayer reported: (i) rental income from Corp, which was excluded from self-employment tax; (ii) wages on which employment taxes had been paid; and (iii) a distributive share of Corp’s net income, which was not subject to self-employment tax.
The IRS determined that the “rental income” was subject to self-employment tax because, according to the IRS, it actually constituted net earnings from self-employment.
Taxpayer sought redetermination of the resulting deficiencies in the Tax Court, where the sole issue was whether the rent payments Taxpayer received were subject to self-employment tax; in other words, whether they represented something other than rental income.
Under the Code, the term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less any allowable deductions. In computing such gross income and deductions, rental income from real estate is excluded.
The IRS contended that the rent payments Taxpayer received were subject to self-employment tax because, taking into account all the facts and circumstances, there existed an “arrangement” between Taxpayer and both Corp and Chicken-Co that required Taxpayer to materially participate in Corp’s farming activities under the Agreement.
Conversely, Taxpayer contended that the rent payments were not subject to self-employment tax because the rent payments were consistent with market rates, there was no nexus between the lease agreement, on the one hand, and either the Agreement or Taxpayer’s employment agreement with Corp, on the other, and neither of these agreements required Taxpayer’s material participation in Corp’s business.
“What’s It All About, Boy? Elucidate.” – Foghorn Leghorn
The Court agreed with Taxpayer, stating that a rental agreement may stand on its own in certain circumstances, even despite the existence of a separate employment agreement requiring a taxpayer’s material services.
The fact that the rents in question, the Court stated, were consistent with market rates for farmland “very strongly” suggested that the rental arrangement stood “on its own as an independent transaction” and could not be said to be part of an “arrangement” for participation in the farming business activity. The same could be said where the rents in question were at, or below, fair market value.
The Court explained that Congress intended to apply the self-employment tax so as to provide benefits for individuals “based upon the receipt of income from labor, which old age, death, or disability would interrupt; and not upon the receipt of income from the investment of capital, which these events would presumably not affect.”
Therefore, Congress was careful, the Court continued, to exclude from self-employment income any amounts received as “rentals from real estate”; accordingly, the courts have interpreted this intent “to exclude only payments for use of space, and, by implication, such services as are required to maintain the space in condition for occupancy.”
However, when the tenant’s payment includes compensation for substantial additional services – and when the compensation for those services constitutes a material part of the payment – the “rent” consists partially of income attributable to the performance of labor not incidental to the realization of return from passive investment. In these circumstances, the Court stated, the entire payment is included in “net earnings from self-employment.”
The issue, then, becomes one of separating return of investment from compensation for services performed.
Did the Rent Stand on its Own?
Self-employment income generally is defined as “the net earnings from self-employment derived by an individual”. The Code defines “earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual.”
The term “derived” necessitates a “nexus,” the Court stated, “between the income and the trade or business actually carried on by the taxpayer.” Under the “nexus” standard, according to the Court, income must arise from some income-producing activity of the taxpayer before that income is subject to self-employment tax.
The Code generally excludes rental real estate income from the computation of a taxpayer’s earnings from self-employment. This exclusion does not apply, however, if the income is derived under an “arrangement” pursuant to which the owner is required to, and actually does, materially participate in a farming activity (i.e., provide services in an active business activity) on his land.
In accordance with general tax concepts, the Court noted that the self-employment tax provisions are to be construed broadly in favor of treating income as earnings from self-employment, while the rental income exclusion is to be strictly construed.
Certain farming-related rental income is properly included in a taxpayer’s earnings from self-employment if the rental income is derived under an arrangement between the owner and tenant that specifies that the tenant will farm the rented land, and the owner will materially participate in the farming activity.
The Court interpreted the term “arrangement” broadly, finding that although the Taxpayer’s rental and employment agreements were separate, the Court would view the Taxpayers’ obligations within the overall scheme of the farming operations; the Court acknowledged that the income derived by one who owns and operates his own farm is often partially attributable to income of a rental character.
However, the Court added that, regardless of a taxpayer’s material participation – actual or required – if the rental income is shown to be less than or equal to fair market rental value, the rental income is presumed to be unrelated to any employment agreement or other business arrangement to which the taxpayer is a party; it does not “convert” included business income into excluded rental income. In that case, the rental agreement stands on its own, separate from the taxpayer’s farming/business activity.
As shown by the evidence, the rent payments Taxpayer received represented fair market rent. This, the Court found, was sufficient to establish that the lease agreement stood on its own. What’s more, Taxpayer had obtained a detailed analysis of the costs of operating the farm as an investment; in turn, Taxpayer priced Corp’s activities, including labor and management costs, to exceed the projected costs. The Court observed that these amounts were not merely remainder payments to Taxpayer after the rent checks were cashed. They were appropriate amounts for Corp to spend for the services required under the Agreement. The structuring of these expenses further illustrated the lengths to which Taxpayer went to operate Corp as a legitimate business, and not as a method to avoid self-employment tax.
Thus, the Court concluded that the rental agreement was separate and distinct from Taxpayer’s employment obligations and, therefore, the rental income was not includible in Taxpayer’s net self-employment income.
Where an agreement calls for rent payments that exceed what the market would bear, that excess may be evidence that there is an arrangement in which compensation for services is being disguised as rent, so that self-employment tax may be improperly avoided.
On the other hand, an agreement that calls for rent payments at fair market value, may be evidence that the arrangement does not involve disguised compensation for services, and may be relevant to the question of whether there is an arrangement linking rent and services.
The Court indicated that below-market rent is excluded from self-employment income because it does not “convert” taxable income into non-taxable income.
However, is it possible that a lower rent may act as an inducement for a larger payment elsewhere? Does the form of the transaction reflect its economic substance?
Regardless of the business, regardless of the circumstances, and regardless of the tax, the guidance is the same: if a taxpayer wants to avoid “tax surprises,” the taxpayer should treat with others on as close to an arm’s-length basis as possible. In most cases, this will in fact occur; where it doesn’t, the taxpayer has to understand the associated risks.