Often, farmers and other landowners enter into crop-share arrangements for the rental of their land. The rent landlords receive in this kind of arrangement is based on a share of the crop or livestock produced on the land.
Rental income derived from real estate is generally not subject to self-employment (SE) tax. However, an exception to this rule causes farm landlords to be subject to SE tax on real estate rental income, including crop-share rents if the following criteria are met:
- The rental income is derived from an arrangement under which the lessee shall produce agricultural commodities on the land.
- The arrangement calls for the material participation of the owner in the production or management of the production of the agricultural commodity.
- The owner does in fact materially participate in the activity.
The IRS regulations provide guidance for determining whether the landlord materially participates. Factors to consider include making management decisions about (1) when and what to plant, (2) rotation of crops, and (3) the kinds of machinery to be used. In addition, the IRS provides guidance in Publication 225 “Farmer’s Tax Guide” on what constitutes material participation.
According to IRS Regulations and Publication 225, a landlord materially participates and is subject to SE tax if just one of the following conditions is met:
- The landlord does any three of the following: (a) pays or stands for at least half of the direct costs of producing the crop; (b) furnishes at least half of the tools, equipment, and livestock used in the producing of the crop; (c) advises or consults with the tenant; or (d) inspects the production activities periodically.
- The landlord regularly and frequently makes or takes an important part in making management decisions that contribute substantially to the success of the enterprise.
- The landlord works for 100 hours or more over a period of five weeks or more in activities connected to the production of the crop.
- The landowner’s activities demonstrate that he is materially and significantly involved in the production of farm products.
To illustrate the above test:
Gary owns 5,000 acres of farmland. During 2016 he enters into an agreement with Ryan whereby Gary leases Ryan 1,000 acres to grow corn in exchange for 20% of the corn harvest for the year. Gary does not materially participate in the production or management of the crops.
Ryan harvests 200,000 bushels of corn in 2016 and delivers to Gary his 20% share or 40,000 bushels. Gary subsequently sells his bushels by Dec. 31 of 2016. Gary would recognize income of 40,000 bushels at $3.85 per bushel or $154,000 of income from crop-share rentals in 2016. Gary will report the income on his tax return (Form 4835 – Farm Rental Income and Expenses). Since Gary did not materially participate, his income is not subject to SE tax.
Assume the same facts as Example 1, except Gary provides the all the equipment to Ryan to plant the corn, advises with Ryan on when and what crop to plant in the field, and after the crop was planted, Gary frequently walked the field to inspect the crop for potential insects and disease.
In this example, Gary would be considered materially participating since he met three of the four conditions (mentioned above) defined in the IRS regulations Publication 225. Gary would report income $154,000 and the income would also be subject to self-employment tax of approximately $19,500.
Problems self-employment tax may cause:
- Landowners under the age of 66 or 67 may see a reduction in their Social Security benefits. Landowner’s who have not attained full retirement age are limited to the amount of active (self-employed or W-2) income a person can make (2016 it is $15,720). For every $2 over the limit, $1 is withheld from benefits.
- In addition, if the income is significant enough, then the landowner will be subject to an additional 0.9% Medicare tax on the portion of self-employment income in excess of $250,000 for joint filers, $125,000 for married filing separately and $200,000 for all others.
Therefore, Crop-Share arrangements should be carefully considered and documented as to not rise to the level that creates material participation. You should consult with your accountant and attorney if you believe you need to strengthen your Crop Share contracts.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com