In Martin v. Commissioner, 149 T.C. 12 (2017), the court concluded that S corporation shareholders can avoid self-employment taxes by holding their farming operations in their S corporation. While the court case considered farming operations, its holding is not limited to farming operations. The case provides authority shareholders may cite in support of similar but different types of arrangements involving their S corporations.
Facts and Procedural History
The taxpayers were husband and wife. They owned a chicken farm.
The taxpayers entered into an agreement with, Sanderson Farms, one of the largest poultry producers in the U.S. The agreement provided that Sanderson Farms would provide chickens and feed to the taxpayers and they would feed and house the chickens and then return the chickens to Sanderson Farms after a period of time.
The taxpayer husband worked on the farm. The taxpayer wife managed the books for the farm. The taxpayers hired other workers to help with some of the farming duties.
After entering into the agreement with Sanderson Farms, the taxpayers assigned their farm and agreement to a newly formed S corporation that they owned. The S corporation then entered into a lease with the taxpayers for the farm. The specified rent was in an amount that was fair market value.
The IRS determined that the rental income was self-employment income for the taxpayers.
S Corporations and Self-Employment/Employment Taxes, Generally
To understand the IRS’s position and the court’s ruling, a little background on S corporations and self-employment and employment taxes may help.
Taxpayers can elect to have their legal entity taxed as an S corporation. There are requirements to do so, but for most taxpayers with typical fact patterns, the S corporation requirements are of little consequence.
One of the differences between sole proprietor businesses and S corporations is how they report and pay employment taxes–i.e., Social Security and Medicare taxes.
Sole proprietor businesses report the net income on the owners individual tax returns and the net earnings are subject to income tax and self-employment tax. Self-employment tax consists of Social Security and Medicare taxes.
S corporations generally pay shareholders wages subject to employment taxes and the balance of the income is considered distributions not subject to employment taxes.
The ability to avoid self-employment/employment taxes on distributions is one of the reasons why many taxpayers elect to be taxed as S corporations (although, it is often more advantageous for many businesses to be taxed as a partnership or C corp. for other tax reasons, which is a topic beyond the scope of this short article).
But this helps explain the IRS’s position. The IRS argued that the taxpayers were carrying on a separate farming business in their own individual name as sole proprietors and that the payment from the S corporation was not rent, but rather, earnings from self-employment for their services.
The Court’s Holding
The court considered and adopted prior case law from the Eighth Circuit in deciding this case. The IRS has previously filed an action on decision to note that it did not agree with this Eighth Circuit case.
The general holding of the Eighth Circuit case law is that a rental agreement in this context will generally be respected as long as (1) the shareholders are not expressly obligated to perform the work for the S corporation, (2) the rental arrangement does not appear to be a scheme to avoid employment taxes, and (3) the rent that is paid to the shareholders is at fair market value.
The first factor is satisfied by showing that the S corporation hired others to perform various duties for the S corporation. Put another way, it is satisfied by showing that the S corporation did not only have workers who were also shareholders.
It should be noted the case was appealable to the Fifth Circuit and not the Eighth Circuit. So the Eighth Circuit case law cited in the court opinion was merely non-binding persuasive authority and could not be relied on by taxpayers outside of the Eighth Circuit prior to this decision. Given this case and that the U.S. Tax Court is a court of national jurisdiction, taxpayers may be able to rely on this court case even if they reside outside of the Eighth or Fifth Circuits.