Martin v. Comm'r ( 2017 )


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  • CHARLES D. MARTIN AND LAURA J. MARTIN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
    Martin v. Comm'r
    Docket No. 15810-13
    United States Tax Court
    2017 U.S. Tax Ct. LEXIS 46;
    September 27, 2017, Filed

    Decision text below is the first available text from the court; it has not been editorially reviewed by LexisNexis. Publisher's editorial review, including Headnotes, Case Summary, Shepard's analysis or any amendments will be added in accordance with LexisNexis editorial guidelines.


    *46 Docket No. 15810-13. Filed September 27, 2017.

    Ps owned a farm, renting a portion of the land to wholly owned S corporation C. C contracted with unrelated entity S to raise chickens according to S' exacting specifications. Ps followed S' specific instructions to build structures designed only to raise S' chickens. C paid Ps wages for their labor and rent for the use of the farm and structures. R asserts that the rent is subject to self-employment tax pursuant to I.R.C. sec. 1402(a)(1).

    Held: The facts of the instant case are not materially dis-tinguishable from the facts of McNamara v. Commissioner, T.C. Memo. 1999-333, rev'd, 236 F.3d 410">236 F.3d 410 (8th Cir. 2000). The U.S.

    Court of Appeals for the Eighth Circuit in McNamara also reversed Hennen v. Commissioner, T.C. Memo. 1999-306, and Bot v.Commissioner, T.C. Memo. 1999-256. In the light of the reversals by the Court of Appeals for the Eighth Circuit, the Court reconsiders its holdings.

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    Held, further, Ps established that the rent received was at or below fair market value. R failed to show a sufficient nexus between the rental income and petitioners' obligations to participate in the production or management of the production of agricultural com-modities. Therefore, the rent Ps received pursuant to the lease is not includible in their net self-employment income. To the extent McNamara v. Commissioner, T.C. Memo 1999-333">T.C. Memo. 1999-333, Hennen v.Commissioner, T.C. Memo. 1999-306, and Bot v. Commissioner, T.C. Memo 1999-256">T.C. Memo. 1999-256, are inconsistent with this*47 holding, they are not followed.

    Charles D. Martin and Laura J. Martin, pro se.

    Lewis A. Booth II, for respondent.

    PARIS, Judge: The Internal Revenue Service (IRS or respondent)

    determined deficiencies in petitioners' 2008 and 2009 Federal income tax of

    $13,409 and $15,408, respectively. The question presented is whether rent

    payments petitioners received are subject to self-employment tax under section

    1402(a)(1).1

    1Unless otherwise indicated, all section references are to the Internal Revenue Code as in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

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    FINDINGS OF FACT

    Some of the facts have been stipulated and are so found. The stipulation of

    facts, the exhibits attached thereto, and the exhibit admitted at trial are

    incorporated by this reference. Petitioners resided in Texas when they timely

    petitioned this Court. They were married during the years in issue.

    Charles Martin holds a degree in agricultural engineering from Texas A&M

    University. Since July 1999 Mr. and Mrs. Martin have owned a farm consisting of

    more than 300 acres of land, various agricultural and horticultural structures, and

    their personal residence. Mrs. Martin performed*48 the farm's bookkeeping; Mr.

    Martin performed a portion of the physical labor and other management services

    as necessary.2

    In late 1999 petitioners began constructing the first of eight poultry houses

    in which they would raise young chickens designated as broilers.3 The poultry

    houses were built in accordance with detailed specifications provided by

    Sanderson Farms, Inc. (Sanderson Farms)--a Fortune 1000 company and the third

    2During 2000, 2001, and 2010 Mr. Martin spent most of the year away from the farm performing consulting services.

    3These houses were specifically designed and built to raise broilers. Webster's Third New International Dictionary Unabridged 281 (2002) defines "broiler" as: "a chicken or other bird fit for broiling; esp : a young chicken weighing up to 2 1/2 pounds dressed".

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    largest poultry producer in the United States. The poultry houses were substantial

    in size as each offered over 22,000 square feet of usable space. Petitioners also

    installed specialized equipment for the broilers, including heating and air

    conditioning, among numerous other improvements. The costs of these

    improvements to petitioners' farm totaled more than $1.2 million.

    In 2000 petitioners entered into*49 a Broiler Production Agreement (BPA) with

    Sanderson Farms.4 This 15-year agreement contained extensive instructions and

    requirements for petitioners, as the "growers" of broilers. In essence, Sanderson

    Farms would deliver to petitioners a flock of broilers--along with the daily

    necessary proprietary blend of feed for the birds--and 49 days later, it would return

    to pick them up. The process would be repeated four or five more times each year.

    Over the course of those 49-day cycles, petitioners were responsible for the

    care of each flock of broilers using good poultry husbandry practices. In carrying

    out Sanderson Farms' detailed instructions, petitioners were allowed to hire

    additional laborers or employees. However, petitioners' discretion ended there.

    Not only did Sanderson Farms retain ownership of the broilers, but it also retained

    ownership of all feed consumed or unconsumed by the flock. Sanderson Farms

    4Although Mr. Martin performed consulting work away from the farm during 2000, 2001, and 2010, the BPA obligations were fulfilled without exception.

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    required the broilers to be cared for according to the standards of its proprietary

    broiler growing program, and its employees checked on*50 the broilers daily

    throughout the 49-day cycle. This program restricted the diet of the broilers to the

    proprietary blend of feed delivered to each poultry house and other items

    necessary for their health and wellbeing; it also required prior notice for any

    deviation from the flock's engineered diet to be specifically approved by

    Sanderson Farms.

    In 2003 petitioners obtained an agricultural appraisal of their farm. The

    appraisal not only detailed the value of the land and structures but also analyzed

    the cost of running the broiler operation as an investment (and not as active

    participants). On November 19, 2004, petitioners organized C L Farms, Inc. (CL

    Farms), as an S corporation.5 Using the appraisal as a guide for the cost of labor

    and management services and incorporating information gathered from other

    broiler growers, petitioners entered into oral employee agreements with CL Farms

    and set their salaries at amounts consistent with those of other growers.6 Mrs.

    Martin would provide bookkeeping services to the corporation, and Mr. Martin,

    5The Court takes judicial notice of this date, which is found in the records of the Texas secretary of state. SeeFed. R. Evid. 201.

    6The 2003 appraisal suggests that the cost*51 of labor and management to run petitioners' farm is approximately $52,900 per year.

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    along with any hired laborers or employees, would provide the requisite labor and

    management services.

    In January 2005 Sanderson Farms approved petitioners' assignment of the

    remainder of their BPA to CL Farms. Like petitioners' BPA, CL Farms' BPA

    anticipated relying on employees to meet the requirements of good poultry

    husbandry and the Sanderson Farms broiler growing program. CL Farms, rather

    than petitioners, would be responsible as the grower; nothing in the BPA required

    petitioners to personally perform the duties of grower.7 Sanderson Farms retained

    title to the broilers and proprietary feed and--in addition to daily check-ins--was

    willing and able to take over utility payments or the day-to-day care of a flock if

    CL Farms failed to perform its duties.

    On January 20, 2005, petitioners entered into a five-year lease agreement

    with CL Farms by which CL Farms would rent from petitioners their farm

    (excluding their residence, access to the residence, and 10 acres), structures,

    176,000 square feet of poultry houses, and equipment.8 Over the course of the

    7Mr. Martin signed the corporate signature page, personally*52 guaranteeing the growing obligations of CL Farms. Mrs. Martin did not.

    8CL Farms used approximately 10 acres of land surrounding the broiler houses in conjunction with its BPA. The rest of the farm was actively used for grazing and other cattle-related activity. The amount of revenue generated by this

    (continued...)

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    five-year lease, CL Farms agreed to pay rent of $1.3 million to petitioners.9 The

    agreement required CL Farms to remit each rent payment irrespective of whether it

    had fulfilled its requirements as grower to Sanderson Farms or received sufficient

    income. This amount represented fair market rent and was consistent with

    amounts paid by other Sanderson Farm growers for the use of similar premises.

    For 2008 and 2009 CL Farms fulfilled its duties under the lease, making all

    of the necessary rent payments to petitioners, which petitioners reported as rental

    income, excludable from self-employment income. At no point during the years in

    issue did petitioners believe that they were--nor were they actually--obligated or

    compelled to perform farm-related activities as a condition to CL Farms'

    obligation pursuant to the lease to pay rent to petitioners. For 2008 and 2009 CL

    Farms also fulfilled*53 its duties as grower to Sanderson Farms; petitioners were

    similarly not obligated to perform farm-related activities in CL Farms' production

    of agricultural commodities. Although petitioners materially participated in the

    broiler production activity, CL Farms consistently hired numerous laborers to

    8(...continued)

    other activity during the years in issue was not insignificant, representing 11.5% of CL Farms' income for each of the years in issue.

    9This amount was paid in installments following Sanderson Farms' payment for each grown flock of broilers; it was structured in that way to accommodate CL Farms' operational cashflow requirements.

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    clean and reset the houses between flocks. CL Farms also hired professional and

    legal counsel in conjunction with the farm's management. For 2008 and 2009 CL

    Farms paid for labor, employee benefits, and professional services $77,796 and

    $86,389, respectively.

    Petitioners jointly filed Forms 1040, U.S. Individual Income Tax Return, for

    2008 and 2009, reporting rental income from CL Farms of $259,000 and

    $271,000, respectively. The IRS determined that these amounts were subject to

    self-employment tax because they constituted net earnings from self-employment*54

    under section 1402(a)(1). Petitioners timely sought redetermination of the

    resulting deficiencies in this Court.

    OPINION

    The sole issue in this case is whether the rent payments petitioners received

    are subject to self-employment tax under sections 1401 and 1402(a)(1) for the

    years in issue. Section 1401 imposes a tax upon self-employment income; section

    1402 provides instructions for calculating the amount. As relevant to this case,

    section 1402(a) provides:

    SEC. 1402(a). Net Earnings From Self-Employment.--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 the deductions allowed by this subtitle * * *

    except that in computing such gross income and deductions * * *

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    (1) there shall be excluded rentals from real estate and from personal property leased with the real estate * * * except that the preceding provisions of this paragraph 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 * * *

    poultry * * *) on such land and that there shall be*55 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 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 * * *

    Respondent contends that the rent payments petitioners received are subject

    to self-employment tax because, taking into account all the facts and

    circumstances, there existed an arrangement between petitioners and both CL

    Farms and Sanderson Farms that required petitioners to materially participate in

    the production of agricultural commodities on their farm. Conversely, petitioners

    contend that the rent payments are not subject to self-employment tax for two

    reasons. First, the rent payments were consistent with market rates, and there was

    no nexus between the lease and either the BPA or the employment agreements.

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    Second, their material participation was not required by either CL Farms' BPA or

    their oral employment agreements with CL Farms.

    I. *56 McNamara v. Commissioner

    The parties base their arguments primarily on McNamara v. Commissioner

    (McNamara I), T.C. Memo. 1999-333, rev'd, 236 F.3d 410">236 F.3d 410 (8th Cir. 2000), where

    this Court held--in virtually identical circumstances--that rental income from a

    wholly owned corporation was received pursuant to an arrangement between the

    parties to produce agricultural commodities on the farm within the meaning of

    section 1402(a)(1)(A), and on McNamara v. Commissioner (McNamara II), 236

    F.3d 410 (8th Cir. 2000), rev'gT.C. Memo. 1999-333, and rev'g Hennen v.

    Commissioner, T.C. Memo. 1999-306, and rev'g Bot v. Commissioner, T.C.

    Memo. 1999-256, where the U.S. Court of Appeals for the Eighth Circuit reversed

    this Court on the grounds that there was no nexus between the rental agreement

    and any arrangement requiring the taxpayers' material participation.10

    The McNamaras owned and operated their farm as a joint venture for a time

    until they incorporated the farm under the name McNamara Farms. McNamara I,

    10The U.S. Court of Appeals for the Eighth Circuit consolidated with McNamara I two other cases: Hennen v. Commissioner, T.C. Memo 1999-306">T.C. Memo. 1999-306, and Bot v. Commissioner, T.C. Memo. 1999-256. Although this Court's discussion is generally directed towards the McNamara cases, the analysis and conclusions also apply to both Bot and Hennen.

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    slip op. at 2. Pursuant to a written lease, McNamara Farms paid the McNamaras*57 a

    varying amount of rent each year; the land was used to produce agricultural

    commodities. Id., slip op. at 2-3. The McNamaras entered into employment

    agreements with McNamara Farms. Id. at 3. Mr. McNamara would serve as

    general manager, responsible for field work, marketing, security, employee

    management, and other usual and customary duties required by the agricultural

    production operation of McNamara Farms. Id. Mrs. McNamara would provide

    bookkeeping services, as well as prepare meals for the farm's employees, do field

    work, and perform such other usual and customary duties as might be delegated by

    the employer from time to time. Id. at 4. In essence, these agreements provided

    that the McNamaras would continue to perform their then-current duties. Id.

    at 3-4.

    The McNamaras reported their rental income, but they did not report it as

    subject to self-employment tax. Id. at 5. The Commissioner determined that the

    payments were properly includible in their net earnings from self-employment

    under section 1402(a)(1). Id. The McNamaras contested this determination, and

    in McNamara I this Court held in the Commissioner's favor, looking beyond the

    terms of the lease to the McNamaras' obligations within the overall scheme of

    their farming operation. Id. at 8-9. In arriving at this*58 conclusion, the Court took

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    into account all the facts and circumstances and applied a broad interpretation of

    "arrangement", noting that

    where 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. Generally, it is not limited only to contractual relationships, or used in a way that suggests that its terms and conditions must be included in a single agreement, contractual or otherwise. Congress obviously recognized a distinction between a contract and the broader concept of an "arrangement", as is evident from those sections of the Internal Revenue Code that make reference to both. [Id. at 8 (quoting Mizellv. Commissioner, T.C. Memo. 1995-571).]

    The Court found 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." Id. at 9. The Court further ruled that both the McNamaras had,

    pursuant to that arrangement, materially participated in agricultural production and

    concluded that the rental income was therefore farm rental income subject to

    taxation as self-employment*59 earnings. See id. at 10.

    The U.S. Court of Appeals for the Eighth Circuit reversed, holding that

    despite the existence of a separate employment agreement requiring the taxpayers'

    material participation--and despite their actual material participation--a rental

    agreement may stand on its own in certain circumstances. McNamara II, 236 F.3d

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    at 412-413. In arriving at this conclusion, the Court of Appeals noted the

    McNamaras' uncontradicted testimony that the rents in question were consistent

    with market rates for agricultural land and held that "[r]ents 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 case

    was remanded to provide the Commissioner an opportunity to prove that there

    existed "a nexus between the rents received by * * * [the McNamaras] and the

    'arrangement' that requires the landlords' material participation." Id.

    On remand, the McNamaras and the Commissioner submitted supplemental

    briefing. After careful consideration, an order and decision was entered, finding

    that the rents in question were*60 at or below fair market value and, accordingly,

    there were no deficiencies in the McNamaras' Federal income tax for the years in

    issue. McNamara v. Commissioner, T.C. Dkt. No. 7537-98 (July 10, 2002).11

    Respondent has not argued that the instant case is distinguishable from

    McNamara I. Instead, his argument is based solely upon this Court's following its

    11Substantially similar orders were entered in Bot v. Commissioner, T.C. Dkt. No. 7970-98 (July 10, 2002), and Hennen v. Commissioner, T.C. Dkt. No. 7535-98 (July 10, 2002).

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    earlier analysis and holdings in McNamara I, Bot, and Hennen.12 Petitioners,

    however, argue that McNamara II was correctly decided and urge this Court to

    adopt the approach used by the Court of Appeals in analyzing their situation.

    Upon reconsideration of this Court's opinion in McNamara I, and its

    reversal by the Court of Appeals, this Court concludes that it did not give

    sufficient consideration to the requirement of section 1402(a)(1) that the rent in

    question be "derived under" an arrangement requiring the landlord's material

    participation. In other words, there was insufficient consideration given to the

    "nexus between the rents received by [the] taxpayers and the 'arrangement' that*61

    requires the landlords' material participation." McNamara II, 236 F.3d at 413.

    This issue will be reviewed accordingly in the context of the instant case. And the

    parties' contentions will be examined, taking into account the burden of proof,

    12This Court has twice followed the Court of Appeals' decision in McNamara II. See Johnson v. Commissioner, T.C. Memo. 2004-56 (applying the nexus test and finding that the rent in question was not subject to self-employment tax); Solvie v. Commissioner, T.C. Memo. 2004-55 (applying the nexus test and finding that the rent in question was subject to self-employment tax). Each of these cases, however, was properly appealable in the Eighth Circuit; thus, in following McNamara II, the Court cited Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742, 757 (1970) (holding that this Court would follow a Court of Appeals opinion which is squarely on point where appeal from the decision would lie to that Court of Appeals and that court alone), aff'd, 445 F.2d 985">445 F.2d 985 (10th Cir. 1971). The instant case, however, is properly appealable to the U.S. Court of Appeals for the Fifth Circuit; this Court is therefore not bound by McNamara II and may decide whether to follow the analysis of the U.S. Court of Appeals for the Eighth Circuit.

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    which rests upon petitioners. SeeRule 142(a). Petitioners do not contend--nor

    does the Court find--that the burden of proof shifts to respondent*62 under section

    7491 as to any issue of fact. Respondent's determinations are presumed to be

    correct; petitioners must prove them erroneous in order to rebut the presumption

    and satisfy their burden of proof. See id.; Welch v. Helvering, 290 U.S. 111">290 U.S. 111, 115

    (1933).

    II. Social Security and Self-Employment

    In reexamining this Court's earlier analysis, it is best to understand the

    intent behind section 1402(a)(1). To do so, it is helpful to examine the history of

    the Social Security provisions in title 42 of the United States Code, which have

    identical counterparts in title 26. These sets of statutes are often viewed in pari

    materia, see, e.g., Ramsay v. Commissioner, T.C. Memo. 1983-590, and should be

    construed to promote "a symmetrical parallel between the social security eligibility

    provisions for self-employed persons and the corresponding income tax provisions

    for taxing self-employed persons for social security purposes". Johnson v.

    Commissioner, 60 T.C. 829">60 T.C. 829, 833 (1973).

    Self-employed individuals were first brought under the Old Age and

    Survivors Insurance Program (Program) in 1950. Social Security Act

    Amendments of 1950 (SSA 1950), ch. 809, sec. 104(a), 64 Stat. at 502 (adding

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    what is presently 42 U.S.C. sec. 411(a)); id.sec. 208(a), 64 Stat. at 541 (adding

    what is presently section 1402(a)). In doing so, Congress deemed these

    individuals entitled to benefits and the incidence of the self-employment tax

    "based upon the receipt of income from labor, which old*63 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." Delno v. Celebrezze, 347 F.2d

    159, 161 (9th Cir. 1965). Self-employed farmers, however, were excluded from

    coverage (and self-employment taxation). This exclusion was accomplished by

    excepting from "net earnings from self-employment" income derived by a self-

    employed individual from a business which if carried on by employees would

    constitute agricultural labor. SSA 1950, secs. 104(a), 208(a).

    In 1954 the exception was removed from each provision, bringing self-

    employed farmers under the protection of the Program. Congress was careful,

    however, to continue to exclude from net self-employment income any amounts

    received as "rentals from real estate and from personal property leased with the

    real estate" regardless of the method of payment. Social Security Act

    Amendments of 1954, ch. 1206, secs. 101(g), 201(a), 68 Stat. at 1055, 1087.

    These provisions were amended again in 1956 to broaden coverage to include

    farm owners or farm tenants if there was a "material participation by the owner or

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    tenant in the production or the management of the production of * * * agricultural

    * * * commodities." Social Security Act Amendments of 1956,*64 ch. 836, secs.

    104(a), 201(e), 70 Stat. at 824, 840.

    In 1960 the U.S. Court of Appeals for the Fifth Circuit in Henderson v.

    Flemming, 283 F.2d 882">283 F.2d 882, 885 (5th Cir. 1960), commented on this revision, noting

    that

    [i]t was, to be sure, stated somewhat awkwardly by an exception to an exclusion. But we regard this as of no moment and treat it as another instance of Congressional English as Congress weaves and rips the Penelopean tax garment to meet the undulating underlying changes in legislative policy. [Citations omitted.]

    In any event, the 1956 amendment was intended to bring a new and major group of

    individuals under the Program. Id. at 887.

    "Coverage of the program should be as nearly universal as is practicable. * * * Modifications would be made in the coverage requirements for farmers and farm workers to take into account the practical problems that have arisen since they were brought into the program by the 1954 amendments. Changes would be made in the provisions on insured status and benefit computations to give the newly covered groups equitable treatment as compared with those brought in earlier." Senate Calendar No. 2156, 84th Cong., 2d Sess., Rpt. 2133, p. 1. [Id. n.7.]

    This amendment "show[ed] a benevolent intent to protect citizens whose income

    diminishes or*65 is wiped away because of old age or disability, and on the other

    hand to exclude income which continues in spite of old age or disability such as

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    the fruits of someone else's labor." Celebrezze v. Miller, 333 F.2d 29">333 F.2d 29, 30 (5th Cir.

    1964).

    Courts have accordingly interpreted this intent to be that these provisions

    "should be applied to exclude only payments for use of space, and, by implication,

    such services as are required to maintain the space in condition for occupancy."

    Delno, 347 F.2d at 163. 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. Id. In these circumstances, the

    entire payment is included in "net earnings from self-employment." Id.

    The issue of separating return of investment from compensation for services

    performed has long been identified. In fact, most self-employed individuals

    receive income that is a combination of income from labor and invested capital.

    Congress chose not to attempt the task of separating one from the other. Instead,

    42 U.S.C. sec. 411(b)(1) imposed a ceiling*66 on the total annual net earnings from

    self-employment that may be included in determining eligibility for benefits. See

    alsosec. 1402(b)(1). This ceiling served to circumvent the income distortion that

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    might otherwise result. Social Security: Hearings on H.R. 2893 Before the H.R.

    Comm. on Ways and Means, 81st Cong. 1362-1365 (1949).

    In the early 1960s several Courts of Appeals found that material

    participation could be attributed to an individual through the efforts of an

    employee or agent. See, e.g., Harper v. Flemming, 288 F.2d 61">288 F.2d 61 (4th Cir. 1961)

    (holding that the activities of a bank, as agent for the owner, in management of the

    owner's farm, constituted "material participation" by the owner in the production

    and management of the farm within the Social Security Act provisions);

    Henderson, 283 F.2d 882">283 F.2d 882 (holding that where the landowner, through her son as

    her agent, made a "material participation" in the production or management of

    production of cotton and corn, her income was self-employment income subject to

    tax and that she was eligible for benefits);.

    These provisions were intended to afford coverage to the broadest class of

    individuals. And in 1974 Congress narrowed the exclusion by broadening the

    exception for farm-related rental income. See Act of Aug. 7, 1974, Pub. L. No.

    93-368, sec. 10(a) and (b), 88 Stat. at 422 (adding*67 "(as determined without regard

    to any activities of an agent of such owner or tenant)" after "material participation

    by the owner or tenant" each place it appeared in 42 U.S.C. sec. 411 and section

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    1402(a)(1), respectively). It is this version of section 1402 that applies to

    petitioners in this case.

    III. Self-Employment Income

    A taxpayer's self-employment income is subject to self-employment tax.

    Sec. 1401(a) and (b). Self-employment tax is assessed and collected as part of the

    income tax, must be included in computing any income tax deficiency or

    overpayment for the applicable tax period, and must be taken into account for

    estimated tax purposes. Sec. 1401; see alsosec. 1.1401-1(a), Income Tax Regs.

    Self-employment income generally is defined as "the net earnings from self-

    employment derived by an individual". Sec. 1402(b). Section 1402(a) defines

    "net earnings from self-employment" as "the gross income derived by an

    individual from any trade or business carried on by such individual, less the

    deductions allowed by this subtitle which are attributable to such trade or

    business". See alsosec. 1.1402(a)-1, Income Tax Regs. The term "derived"

    "necessitates a nexus between the income and the trade or business actually

    carried on by the taxpayer." Bot v. Commissioner, 353 F.3d 595">353 F.3d 595, 599 (8th Cir.

    2003) (involving individuals with the surname Bot distinct from those in Bot v.

    Commissioner*68 , T.C. Memo 1999-256">T.C. Memo. 1999-256), aff'g118 T.C. 138">118 T.C. 138 (2002); Newberry v.

    Commissioner, 76 T.C. 441">76 T.C. 441, 444 (1981). Under this Court's interpretation of the

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    "nexus" standard, income must arise from some income-producing activity of the

    taxpayer before that income is subject to self-employment tax. Jackson v.

    Commissioner, 108 T.C. 130">108 T.C. 130, 134 (1997).

    Section 1402(a)(1) generally excludes rental real estate income from the

    computation of a taxpayer's net earnings from self-employment. This exclusion,

    however, also provides that rent derived by the owner of land is not excluded from

    the computation of net earnings from self-employment if the income is derived

    under an arrangement pursuant to which the owner is required to materially

    participate in the agricultural production and the owner actually materially

    participates. Id.

    These self-employment tax provisions are construed broadly in favor of

    treating income as earnings from self-employment. Braddock v. Commissioner,

    95 T.C. 639">95 T.C. 639, 644 (1990); Hornaday v. Commissioner, 81 T.C. 830">81 T.C. 830, 834 (1983);

    S. Rept. No. 81-1669 (1950), 2 C.B. 302">1950-2 C.B. 302, 354. Similarly, the rental income

    exclusion in section 1402(a)(1) is to be strictly construed to prevent this exclusion

    from interfering with the congressional purpose of effecting maximum coverage

    under the Social Security umbrella. Johnson v. Commissioner, 60 T.C. at 832.

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    A. Agriculturally Related Rental Income

    As discussed, a taxpayer's net earnings from self-employment*69 generally

    exclude rental income. Sec. 1402(a)(1). However, certain agriculturally related

    rental income is properly included in a taxpayer's net earnings from self-

    employment if two requirements are met. Id. First, the rental income must be

    "derived under an arrangement, between the owner or tenant and another

    individual". Id. Such an arrangement must specify that: (1) the other individual

    "shall produce agricultural * * * commodities" on the rented land and (2) the

    owner or tenant shall materially participate in the production or management of

    the production of those commodities. Id. The second requirement is that the

    owner materially participate in that production or management of production. Id.

    This Court, in McNamara I, slip op. at 8-9, interpreted "arrangement"

    broadly, finding that although the rental and employment agreements were

    separate, the Court would view the taxpayers' existing obligations within the

    overall scheme of their farming operations. It was this view that allowed the

    Court to conclude 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." Id., slip op. at 9. This result was not*70 a novel approach; in fact, courts

    - 23 -

    have long acknowledged that the income derived by individuals who own and

    operate their own farms is often partially attributable to income of a rental

    character. See, e.g., Delno, 347 F.2d at 163; Henderson, 283 F.2d at 887-888.

    The potential for unfairness of section 1402(a)(1) in such situations is apparent.

    The U.S. Court of Appeals for the Eighth Circuit, however, took a different

    approach. In McNamara II, 236 F.3d at 413, the court focused on the "derived

    under" requirement, finding that "the practical effect of the 'derived under'

    language" was to require a nexus between the rents received by a taxpayer and the

    "arrangement" requiring the landlord's material participation. The court noted:

    [T]he mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment income. It is only where the payment of those rents comprise part of such 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*71 in agricultural production. * * *

    [Id.]

    Regardless of a taxpayer's material participation, if the rental income is shown to

    be less than or equal to market value for rent, the income is presumed to be

    unrelated to any employment agreement. Id. At that point, the burden of

    - 24 -

    production shifts to the Commissioner to show a nexus between the rent and the

    taxpayer's obligation to materially participate. Such a showing would render the

    lease and employment agreements part and parcel of a larger "arrangement". Id.

    The analysis of McNamara II tracks and resolves the issues arising in

    separating true rental income from wage income in circumstances where farmers

    receive separate payments.13 The test proffered by the U.S. Court of Appeals for

    the Eighth Circuit does not contradict congressional intent. Rather, it supplements

    existing factors for consideration and serves to implement congressional intent,

    placing farmers in the same position as their urban contemporaries.

    If the rent is at or below market value and the Commissioner can show that

    the rental agreement has a sufficient nexus with an agreement requiring the

    taxpayer's material participation, the first prong of the section 1402(a)(1) test is

    met and congressional*72 intent is protected.14 If the Commissioner cannot show a

    sufficient nexus, however, congressional intent is not frustrated. Because

    Congress provided an avenue by which the Court might determine the correct

    13This Opinion does not endeavor to resolve the more difficult issue of separating rent and wage income in situations involving a single payment.

    14Compare Celebrezze v. Miller, 333 F.2d 29">333 F.2d 29 (5th Cir. 1964), andHenderson v. Flemming, 283 F.2d 882">283 F.2d 882 (5th Cir. 1960), with Celebrezze v.Maxwell, 315 F.2d 727 (5th Cir. 1963).

    - 25 -

    amount of net self-employment income, taxpayers are afforded an opportunity to

    pay the correct amount of tax. This serves to place farmers in the same position as

    their urban contemporaries with respect to rental income that is insufficiently

    related to their trade or business.

    Congress' intent was to afford income protection to taxpayers who might

    not otherwise be able to provide for themselves in old age. The provisions were

    designed to address wage income lost in old age--not to augment a continuing

    rental income stream. In those circumstances where the two agreements are truly

    separate and distinct, the taxpayer is not in jeopardy of losing his rental income if

    he is unable to materially participate. Rather, he must only hire someone else to

    perform those tasks that he was otherwise performing.

    Because this Court finds*73 the U.S. Court of Appeals for the Eighth Circuit's

    analysis and reasoning sound, the next step is to evaluate the facts of this case in

    the light of McNamara II.

    B. Application of McNamara II

    Each of the requirements in section 1402(a)(1) operates independently.

    Because the parties stipulated that petitioners materially participated in the

    production of agricultural commodities on their farm during the years in issue, the

    - 26 -

    Court will limit its analysis to whether there existed an arrangement sufficient to

    subject petitioner's rental income to self-employment tax.

    With respect to the statute's first requirement--that income be derived under

    an arrangement--section 1.1402(a)-4(b)(2), Income Tax Regs., explains:

    In order for rental income received by an owner or tenant of land to be treated as includible farm rental income, such income must be derived pursuant to a share-farming or other rental arrangement which contemplates material participation by the owner or tenant in the production or management of production of agricultural or horticultural commodities.

    Such an arrangement may be oral or written, but it "must impose upon such other

    person the obligation to produce one or more agricultural or horticultural

    commodities (including * * * poultry * **74 *) on the land of the owner or tenant".

    Id. subpara. (3). The arrangement must also require material participation by the

    owner; in its contemplation of the owner's material participation, the arrangement

    may consider the sum of the participation in connection with the production or the

    management of the production of agricultural or horticultural commodities. Id.

    subparas. (1), (3). Under such circumstances, rental income is characterized as

    includible farm rental income and accordingly considered earnings from

    self-employment. Id. subpara. (1).

    - 27 -

    Irrespective of a taxpayer's material participation--actual, required, or

    otherwise15--the taxpayer may establish that the rental agreement stands on its

    own, unrelated to the taxpayer's farming activity. McNamara II, 236 F.3d at 413.

    If the rental income received was at or below market value, the burden of

    production then shifts to the Commissioner to show a nexus between the rent and

    the agricultural arrangement requiring the taxpayer to materially participate. Id.

    Such a showing would render the lease and employment agreements part and

    parcel of a larger "arrangement". Id.; see also Johnson v. Commissioner, T.C.

    Memo. 2004-56 (following McNamara II and finding an insufficient*75 nexus);

    Solvie v. Commissioner, T.C. Memo. 2004-55 (same but finding a sufficient

    nexus).

    As shown by the evidence, the rent payments petitioners received

    represented fair market rent and were consistent with amounts paid by other

    Sanderson Farms growers for the use of similar premises. This is sufficient under

    15Because the Court finds that the rental income is not includible in petitioners' net self-employment income because it was consistent with fair market rent and because respondent did not show a nexus between the rent and the arrangement requiring petitioners' material participation, there is no need to address petitioners' alternative contention that none of the agreements or contracts actually required their material participation.

    - 28 -

    McNamara IIto establish that the agreement stands on its own, but the Court finds

    that additional facts further support the Court's conclusion.

    Petitioners invested a significant amount of money--over $1.2 million--in

    the eight 22,000-square-foot broiler houses and other improvements, which were

    all built according to the exacting specifications of Sanderson Farms. And

    although the rental agreement covered petitioners' farm (excluding their residence,

    access to the residence, and 10 acres), structures,*76 176,000 square feet of poultry

    houses, and equipment, CL Farms used approximately 10 acres and these single-

    use structures for purposes of the BPA. Practically speaking, this agreement

    functions as a return on investment rather than a method of income

    recharacterization.

    As part of their agricultural appraisal, petitioners obtained a detailed

    analysis of the costs of operating their farm purely as an investment. Petitioners,

    in turn, priced CL Farms' activities, including labor and management costs, to

    exceed the appraisal's projected costs. These amounts were not merely remainder

    payments to petitioners after the rent checks were cashed. They were appropriate

    amounts for CL Farms to spend for the services required to operate its broiler

    - 29 -

    houses as well as its grazing and other agricultural activities.16 The structuring of

    these expenses further illustrates the lengths to which petitioners went to operate

    CL Farms as a legitimate business and not as a method to avoid self-employment

    tax.

    These facts--supported by petitioners' testimony, documentation, and

    briefing--provide strong evidence that the rental agreement should stand on its

    own. Thus, the burden of production shifts to respondent to*77 show a nexus

    between the rents and the agricultural arrangement requiring petitioners' material

    participation.

    This Court has previously evaluated the nexus between the rental income

    and the taxpayer's production arrangement. See, e.g., Bot v. Commissioner, 118

    T.C. 138 (finding value-added payments reported as rental income includible in

    net self-employment income where the payments were directly related to the

    volume of corn acquired and delivered by taxpayers); Solvie v. Commissioner,

    T.C. Memo. 2004-55 (same when rent payments were tied directly to the number

    of pigs raised). But see Johnson v. Commissioner, T.C. Memo. 2004-56 (finding

    an insufficient nexus). But despite petitioners' presentation and the Court's

    16Although the lease payments were structured to follow each flock, CL Farms earned only 88.5% of its annual income through the BPA. Neither party addressed CL Farms' other agricultural activity, so it will not be discussed further.

    - 30 -

    previous application of the well-reasoned nexus requirement in Solvie and

    Johnson, respondent did not brief this issue.

    Instead, respondent puts all of his proverbial eggs in the McNamara I

    basket, noting in his brief the Commissioner's nonacquiescence in the Court of

    Appeals' decision, citing AOD 2003-03, 2003-2 C.B. xxiii,*78 and arguing for the

    Court to interpret "arrangement" broadly to include any and all contracts related to

    CL Farms.

    Without alternative, this Court must conclude that the rental agreement is

    separate and distinct from petitioners' employment obligations and, therefore, the

    rental income is not includible in their net self-employment income.

    IV. Conclusion

    Using the McNamara II analysis, the Court finds that petitioners'

    agriculture-related rental income is not included in their net self-employment

    income under section 1402(a)(1). Petitioners have shown that the rent payments

    were at or below market value, and respondent failed to show--and the record does

    not contain sufficient evidence showing--a nexus between the rents and the

    agricultural arrangement requiring petitioners' material participation.

    - 31 -

    To reflect the foregoing and the concessions of the parties,

    Decision will be entered

    under Rule 155.

    Reviewed by the Court.

    MARVEL, FOLEY, VASQUEZ, GALE, THORNTON, GOEKE, HOLMES, MORRISON, KERRIGAN, BUCH, and PUGH, JJ., agree with this opinion of the Court.

    - 32 -

    GUSTAFSON, J., dissenting: The outcome determined in the opinion of

    the Court is attractive, but its reasoning is based on a fair-market safe harbor that

    is not warranted*79 by the actual text of section 1402(a)(1) as enacted by Congress;

    and for that reason I join Judge Nega's dissent. I write separately to criticize the

    resulting evidentiary regime that the majority creates ex nihilo.

    The majority adopts the holding of McNamara v. Commissioner, 236 F.3d

    410 (8th Cir. 2000), see op. Ct. pp. 27-28, which it interprets as follows, see op.

    Ct. pp. 23-24:

    Regardless of a taxpayer's material participation, if the rental income is shown to be less than or equal to market value for rent, the income is presumed to be unrelated to any employment agreement. * * * At that point, the burden of production shifts to the Commissioner to show a nexus between the rent and the taxpayer's obligation to materially participate. * * * [Emphasis added.]

    In fact, the McNamara opinion says nothing about any "presum[ption]" nor about

    the "burden of production" or any shift therein. Rather, this regime is newly

    announced today by the Tax Court, and it is not warranted.

    Where an agreement calls for rent payments that exceed what the market

    would actually bear, that excess is evidence that things may not be what they

    seem, and may be evidence that there is an arrangement in which compensation for

    labor is being*80 disguised as rent, so that self-employment tax may be improperly

    - 33 -

    avoided. On the other hand, where an agreement calls for rent payments at fair

    market value (so that, as an economic matter, the rental agreement might plausibly

    stand on its own),1 I assume, along with the majority, that the fair-market rent is

    evidence that the arrangement may not involve disguised compensation for labor.

    That is, the fact of fair-market rent may be relevant to the question of whether, for

    purposes of section 1402(a)(1), there is no arrangement linking rent and labor.

    But relevancy should not be equated with sufficiency. It is entirely possible

    (as the opinion of the Court effectively admits, by inviting the IRS to offer

    counter-evidence) that, notwithstanding the ostensibly reasonable rent, a fair-

    market rental agreement could be part of an "arrangement" under which the rental

    agreement is contingent on (and is therefore linked to) an agreement providing

    compensation for labor. Given that possibility, there is nothing in the statute, in

    logic, in custom, or in common experience that makes the absence of an

    1The opinion of the Court indiscriminately refers to rent "at or below market value" (emphasis added); but rent below*81 market value implicates other questions. If rent is being underpaid, is the recipient seeking to maximize his Social Security benefits by inflating his compensation for labor? Or is the bargain rent an inducement to the payor to hire the recipient to perform labor for which he might otherwise not be hired (clearly an "arrangement" under section 1402(a)(1))? I believe the majority is plainly wrong if, as it appears, it holds, see op. Ct. pp. 27-28 that where "the rental income received was at or below market value," it should be presumed that the taxpayer has "establish[ed] that the rental agreement stands on its own". (Emphasis added.) On the contrary, proof that rent is set at a rate below market value indicates that the rental agreement does not stand on its own.

    - 34 -

    arrangement so probable that, on the taxpayer's mere showing of a fair-market

    rent, we necessarily relieve him of the burden of producing additional evidence of

    such absence unless the Commissioner can come forward with some evidence that

    there is an arrangement--but that is the nature of an evidentiary presumption, and

    the opinion of the Court gives no reason for it.

    To show the absence of an "arrangement", the reasonableness of the rent is

    only one of the pieces of evidence that a taxpayer might present, along with, for

    instance, his own or the tenant's testimony that there is no arrangement. There is

    no reason to select the reasonableness of the rent as a special fact that somehow

    gives rise to a presumption and shifts the burden of production.

    ASHFORD, J., agrees with this dissent.

    - 35 -

    NEGA, J., dissenting: The opinion of the Court chooses to apply the Court

    of Appeals for the Eighth Circuit's reasoning in McNamara II outside the Eighth

    Circuit. I believe that the plain reading of the statute is inconsistent with the Court

    of Appeals' reading. Consequently, I would*82 not extend its reading to the instant

    case.

    The relevant Internal Revenue Code provision is section 1402(a)(1). For

    the determination of net earnings from self-employment (which are generally

    subject to self-employment tax), this section provides an exclusion for "rentals

    from real estate and from personal property leased with the real estate * * *

    together with the deductions attributable thereto, unless such rentals are received

    in the course of a trade or business as a real estate dealer". However, this

    exclusion, by its terms,

    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 com-modities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participa-tion 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*83 without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity * * * [Id.]

    - 36 -

    On its face the statute does not provide a special rule for "at or below fair

    market rents". Had Congress wanted to provide such a special rule, I see no

    reason for its absence from the current statute.

    Focusing only on the plain wording of the Code, I do not believe that the

    Court of Appeals' interpretation is the best reading. Under our caselaw, I would

    still treat McNamara II as binding in the circuit in which it was decided. See

    Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742, 757 (1970), aff'd, 445 F.2d 985">445 F.2d 985 (10th Cir.

    1971). I would not, however, expand its application beyond the Eighth Circuit.

    In McNamara II, 236 F.3d at 413, the Court of Appeals faulted the Tax

    Court's opinion for failing to take into account the "nexus between the rents

    received by Taxpayers and the 'arrangement' that requires the landlords' material

    participation." The Court of Appeals focused on the two words "derived under" in

    the statute to enunciate a new standard, stating that

    the mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment*84 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 sug-gest 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

    - 37 -

    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.

    [Id.]

    I think that the words "derived under" are too slender a reed to support such

    a construction of the tax law. I believe the better reading of the statute is that the

    entire arrangement is what determines the tax consequences for self-employment

    purposes. In that regard I would endorse the jurisprudence in Mizell v.

    Commissioner, T.C. Memo. 1995-571. Section 1402(a) provides a comprehensive

    structure for defining "net earnings from self-employment." We must not forget

    that there can be other streams of income besides "rents" in many single

    transactions to which the other paragraphs of section 1402(a) must be applied to

    reach*85 an accurate determination of an individual's "net earnings from self-

    employment." A better reading of section 1402(a)(1), including the words

    "derived under", is that the arrangement as a whole must be the focus instead of

    what the parties define as falling within two or more income streams (in this case

    payments for personal services and for the use of real estate and personal

    property). I will have more to say below about the hazards of relying on the

    parties to a contract for purposes of characterizing amounts eligible for an

    - 38 -

    exception from self-employment tax, when only one of those parties will have

    self-employment tax liability.

    While we will never know exactly what Congress intended in regard to this

    provision, it is entirely plausible that Congress declined to include such a safe

    harbor because it had concerns about the practical limitations of a "market rate

    rental" exception from self-employment tax. All taxpayers have an interest in

    legally seeking to maximize their after-tax profits. Surely that would include self-

    employment tax costs once enough such tax had been paid to ensure coverage for

    the taxable year under Social Security. The facts of this case clearly illustrate that

    a single transaction*86 between a taxpayer and another individual may result in

    multiple types of income. In this case the contract anticipates at least personal

    service income and income paid for the use of real estate and personal property.

    Not readily apparent in the facts of the instant case, but often involved in other

    transactions involving the determination of net earnings from self-employment,

    are other types of income such as dividends, interest, and capital gains.

    There are examples too numerous to count where the existence of a tax-

    indifferent party leads to an agreement between two parties to mischaracterize a

    transaction to provide an unjustified tax result for the non-tax-indifferent party.

    For example, if Sanderson Farms gets the same tax outcome for its payments

    - 39 -

    under a contract with a producer (e.g., petitioners) regardless of the proportion of

    contract payments subject to self-employment tax to the producer, then Sanderson

    Farms may not have any reason to dispute the producer's characterization of the

    amount of the contract payments for which the producer is subject to self-

    employment tax. Further, if Sanderson Farms' competitors were also tax

    indifferent and agreed to such a favorable characterization,*87 then Sanderson Farms

    might be competitively disadvantaged if it did not follow suit. Indeed, both parties

    to such an arrangement could share in any tax reduction resulting from the

    mischaracterization of an amount by slightly reducing the overall contract price

    under the arrangement.

    While the record in the instant case does not readily provide an answer to

    the question whether this transaction had a tax-indifferent party as to petitioner's

    self-employment tax liability, that is unimportant. What is important is whether

    one believes that concerns such as this could have led Congress to decline to

    provide a safe harbor for "at or below market rents" under section 1402(a)(1).

    Again, I am not aware of legislative history either for or against such a notion. I

    would only say that such a concern is compelling justification for the absence of

    such a statutory safe harbor and is a compelling argument against the judicially

    imposed safe harbor under McNamara II.

    - 40 -

    GUSTAFSON, LAUBER, and ASHFORD, JJ., agree with this dissent.