McNamara v. Commissioner , 236 F.3d 410 ( 2000 )

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
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No. 99-3876
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Michael McNamara; Nancy B. *
McNamara *
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Appellants, *
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v. *
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Commissioner of Internal Revenue, *
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Appellee. *
Appeals from the United States
Tax Court.
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No. 99-3891
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Vincent E. Bot; Judy Bot, *
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Appellants, *
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v. *
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Commissioner of Internal Revenue, *
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Appellee. *
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No. 99-3968
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John P. Hennen; Teresa Hennen, *
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Appellants, *
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v. *
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Commissioner of Internal Revenue, *
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Appellee. *
Submitted: September 13, 2000
Filed: December 29, 2000
Before McMILLIAN, HEANEY, and BOWMAN, Circuit Judges.
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HEANEY, Circuit Judge.
These cases are appeals from Tax Court rulings that cash rental income received
by taxpayers was includible farm income and therefore constituted earnings from self-
employment under I.R.C. § 1402(a)(1). We reverse and remand.
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I. BACKGROUND
A. I.R.C. § 1402
In order to fund Social Security benefits for the self-employed, the Internal
Revenue Code taxes self-employment income. Generally, taxable self-employment
income excludes sources that do not depend on an individual’s labor, including rentals
from real estate. Section 1402(a)(1), however, creates an exception to that exclusion
for rents that are
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 . . . in the production
or the management of the production of such agricultural or horticultural
commodities, and . . . there is material participation by the owner or
tenant . . . with respect to any such agricultural or horticultural
commodity[.]
Rents falling within § 1402(a)(1)’s exclusion are characterized as includible farm rental
income, and considered earnings from self-employment.
B. The McNamaras
Michael McNamara began farming in Minnesota in 1977. He operated the farm
as a joint venture with his wife Nancy McNamara until 1992, when he incorporated the
farm under the name McNamara Farms. Mr. McNamara is the sole shareholder,
officer, and director. McNamara Farms operates on approximately 1,250 acres, a
portion of which is rented from the McNamaras. During 1993, 1994, and 1995--the tax
years at issue--McNamara Farms rented under a written lease 460 acres of land and a
house that was owned by the McNamaras. Pursuant to the lease, in the years 1993,
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1994, and 1995, McNamara Farms paid the McNamaras between approximately
$45,000 and $57,000.
In February 1992, Mr. McNamara entered into an employment agreement with
McNamara farms. The agreement provided that Mr. McNamara was to serve as
general manager, responsible for field work and marketing, security of machinery and
inventory, management of other employees, and other usual and customary duties
associated with agricultural production. In essence, the agreement memorialized the
duties Mr. McNamara had performed since he began farming. At the same time, Mrs.
McNamara also entered into an employment agreement with McNamara Farms. The
agreement provided that Mrs. McNamara would be responsible for bookkeeping,
employee meal preparation, field work, assistance with machinery and inventory, and
other duties as assigned. Mrs. McNamara’s employment agreement also memorialized
the duties she had been performing since she began farming with Mr. McNamara.
For each tax year at issue, the McNamaras filed a Form 1040 as married persons
filing jointly, identifying their occupations as “farmer” (Mr. McNamara) and
“bookkeeper” (Mrs. McNamara). For 1993, 1994, and 1995, they reported on
Schedule E (Suppplemental Income and Loss), that they received net rental income
between approximately $19,000 and $23,000. Each year, the McNamaras also
reported wages of roughly $30,000. Each year, Mr. McNamara reported earnings from
McNamara Farms of roughly $28,000, and Mrs. McNamara indicated earnings from
McNamara Farms of roughly $2,500.
The Commissioner determined the real estate rental payments the McNamaras
received from McNamara Farms were includible in their net earnings from self-
employment under § 1402(a)(1), and as a result the McNamaras owed self-employment
taxes for 1993, 1994, and 1995. The McNamaras contested the Commissioner’s
determination in the Tax Court, which ruled in the Commissioner’s favor. Looking
beyond the terms of the lease to the McNamaras’ obligations “within the overall
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scheme” of their farming operation, the Tax Court determined that “the arrangement
between [the McNamaras] and McNamara farms provided, or contemplated, that [the
McNamaras] materially participate in the production of agricultural commodities on the
farmland.” McNamara v. Comm’r, 78 T.C.M. (CCH) 530, 532-33 (1999). Further,
the court ruled that both the McNamaras had, pursuant to that scheme, materially
participated in agricultural production. The court concluded that the rental income was
therefore includible farm rental income subject to taxation as self-employment earnings.
See id.C. The Bots
Vincent E. and Jody Bot have been farming for thirty-eight years. During the tax
years in issue--1993, 1994, and 1995--Mr. Bot owned 160 acres of the farm, and Mrs.
Bot owned 240 acres. Mr. Bot rented Mrs. Bot’s acreage pursuant to an oral
agreement. In 1992, Mrs. Bot entered into an employment agreement with Mr. Bot.
The agreement provided that Mrs. Bot was to perform various farm-related tasks, such
as assisting with hog production and operating field machinery. The agreement
essentially memorialized the tasks Mrs. Bot had performed since she began farming
with Mr. Bot.
Like the McNamaras, the Bots filed jointly as a married couple. They reported
on Schedule E for each year at issue that Mrs. Bot received net rental income of
approximately $18,000. They also reported that Mrs. Bot received wages of roughly
$15,000. The Commissioner determined that the rental payments Mrs. Bot received
from Mr. Bot were includible as net earnings from self-employment under § 1402(a)(1)
and thus subject to self-employment tax. The Bots contested the Commissioner’s
determination in the Tax Court, which rejected the Bots’ arguments in an opinion
echoing its ruling against the McNamaras.
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D. The Hennens
John P. and Teresa Hennen have farmed together for thirty-eight years. During
1994, 1995, and 1996--the years at issue--Mr. Hennen operated an 1,100-acre crop and
livestock farm in Minnesota as a sole proprietor. Mrs. Hennen owned approximately
two hundred of those acres, which she rented to Mr. Hennen under an oral agreement.
For each of the years at issue, Mrs. Hennen provided--pursuant to employment
agreements with Mr. Hennen--services to the farming operation including bookkeeping,
running errands, and help with livestock chores and fieldwork. The employment
agreements essentially memorialized the duties Mrs. Hennen had performed since she
began farming with Mr. Hennen.
The Hennens also filed jointly as a married couple. They reported on Schedule
E for each year at issue that Mrs. Hennen received net rental income of approximately
$12,000 to $14,000. They also reported that Mrs. Hennen received wages from Mr.
Hennen of roughly $3,000. The Commissioner determined that the rental payments
Mrs. Hennen received from Mr. Hennen were includible as net earnings from self-
employment under § 1402(a)(1) and thus subject to self-employment tax. The Hennens
contested the Commissioner’s determination in the Tax Court, which rejected the
Hennens’ arguments in an opinion echoing its ruling against the McNamaras.
The McNamaras, Bots, and Hennens all appeal.
II. DISCUSSION
We have jurisdiction pursuant to 26 U.S.C. § 7482 (2000). We review the Tax
Court’s legal conclusions de novo and its factual determinations for clear error. See
Campbell v. Comm’r, 164 F.3d 1140, 1142 (8th Cir. 1999).
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As an initial matter, we disagree with taxpayers that § 1402(a)(1) applies only
to rental payments derived from sharecropping or share-farming. No such restriction
appears in the Code, and we are unpersuaded that the legislative history compels an
interpretation not apparent from the face of § 1402(a)(1). We also reject taxpayers’
contention that the instructions accompanying Form 4835 (Farm Rental Income and
Expenses) contradict and therefore override § 1402(a)(1).
Further, we cannot say the Tax Court clearly erred in concluding, as a factual
matter, that Mrs. McNamara, Mrs. Bot, and Mrs. Hennen were required--by their
respective employment agreements or by more informal “arrangements”--to materially
participate in agricultural production and management, and that all three did in fact
materially participate in those activities. See Treas. Reg. § 1.1402(a)-4(b) (as amended
in 1980).
More promising, however, is taxpayers’ argument that the lessor-lessee
relationships should stand on their own apart from the employer-employee
relationships. To this end, taxpayers insist that the rents in question were consistent
with market rates for agricultural land. In fact, the transcripts of each trial contain
uncontradicted testimony that the rents were at or slightly below fair market value.
(McNamara Supp. App. at 7; Bot Supp. App. at 6-7; Hennen Supp. App. at 4.) The
Tax Court’s decision, however, contains no factual finding in this regard. Moreover,
the Commissioner apparently did not pursue the issue at trial because, as it contended
at oral argument, the amount of the rent is irrelevant. We disagree.
What is missing from both the Commissioner’s and the Tax Court’s analyses is
any mention of a nexus between the rents received by Taxpayers and the “arrangement”
that requires the landlords’ material participation. We believe this omission overlooks
§ 1402(a)(1)’s requirement that rents be “derived under” such an arrangement. That
is to say, the mere existence of an arrangement requiring and resulting in material
participation in agricultural production does not automatically transform rents received
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by the landowner into self-employment income. It is only where the payment of those
rents comprise part of such an arrangement that such rents can be said to derive from
the arrangement.
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. Although the
Commissioner is correct that, unlike other provisions in the Code, § 1402(a)(1)
contains no explicit safe-harbor provision for fair market value transactions, we
conclude that this is the practical effect of the “derived under” language.
At this point, the only evidence in the record is that the rents in question were
at or below market rates. However, we believe the Commissioner is entitled to an
opportunity to show a connection between those rents and the production arrangement
it identified.
Accordingly, these matters are remanded to the Tax Court for further
proceedings not inconsistent with this opinion.
A true copy.
Attest:
CLERK, U. S. COURT OF APPEALS, EIGHTH CIRCUIT.
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