Playing Chicken with the IRS

Sorry for the title of this post. I can't resist a good pun. (Or even a bad one!)

Charles and Laura M. own a poultry farm in Texas, where they raise chickens for the third largest poultry producer in the US, Sanderson Farms. In 2005 the M’s formed an LLC (CL Farms) and elected to be taxed as an S-Corp. CL Farms entered into an agreement with Sanderson Farms to raise chickens exclusively for Sanderson Farms. Under the terms of this agreement Sanderson Farms would deliver live chickens and feed to CL Farms, CL Farms would house, feed, and raise the chickens using Sanderson’s proprietary methods, and Sanderson Farms would retrieve the chickens when they were grown.

The M’s leased their poultry farm to their S-Corp, CL Farms. Under the terms of the lease agreement CL Farms had to pay rent (at a fair market rate) to the M’s regardless of income or profits from poultry production. The M’s also paid themselves a reasonable salary from their S-Corp, worked for CL Farms, and hired additional labor as needed to raise the chickens.

In 2008 and 2009 the M’s claimed their salaries from CL Farms as self-employment income and paid self-employment taxes on their salaries. They also claimed the rental income paid to them by CL Farms, but did not pay self-employment taxes on it, as income from rents is passive and not subject to self-employment taxes.

Upon examination (audit) the IRS did not agree that the rental income paid by CL Farms to the M’s qualified as rent. The IRS determined all the M’s income was self-employment income paid to them by Sanderson Farms to produce chickens. (The IRS was essentially saying the M's were contract labor to Sanderson Farms.) The IRS sent the M’s notices of deficiency for $13,409 (2008) and $15,408 (2009) - the self-employment taxes on the income the M's had claimed as rent income. The M’s disagreed and petitioned the Tax Court for relief.

The written opinion of Judge Paris in this case is long and somewhat ponderous. The (legal) problem was there had been a similar prior case in which the Tax Court had found in favor of the IRS, but the Tax Court's ruling was later overturned on appeal by the 8th Circuit Court of Appeals. In their case against the M's, the IRS was asking the Tax Court to follow the Tax Court's precedent, and the petitioners (The M’s) were asking the Tax Court to follow the 8th Circuit Court of Appeals.

In the end there were two primary issues to consider:

1. Whether the contract with Sanderson Farms required the M’s to work in the production of poultry.
2. Whether the lease between CL Farms and the M’s required the M’s to materially participate in the operation of the farm.

After reviewing the documents and listening to arguments in the case, Judge Paris concluded that while the M's did in fact participate in the farming operations, neither agreement required the M’s to materially participate in farming. Judge Paris even takes a little poke at the IRS in his opinion, writing (emphasis mine), “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 [proof] shifts to [The IRS] to show a nexus between the rents and the agricultural arrangement requiring petitioners’ material participation…But despite petitioners’ presentation and the Court’s previous application of the well-reasoned nexus requirement … [The IRS] did not brief this issue…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.”

Put this down as a W for the good guys.

While Bigger Pockets isn’t a website for poultry farmers, I think there are some valuable lessons real estate investors can learn from this Tax Court case.

1. The M’s dotted their i’s and crossed their t’s. Which is to say they used professionals (lawyers and CPAs) to help them structure their business entity as well as the agreements they and their S-Corp entered. This gave them immediate credibility in Tax Court. The judge could readily determine the M’s were serious about the business of running their farm, and they weren’t just working some dubious angle to avoid self-employment taxes.
2. The M’s maintained good records. Prior to 2008 the M’s had investigated whether they could profitably operate their farm as a completely passive activity. They decided they could be more profitable if they participated, but the M’s kept the documentation showing their analysis and how it ultimately influenced the lease agreement with CL Farms. This apparently influenced Judge Paris, who mentioned it specifically in the court’s opinion.

The M’s embarked on a business strategy that reduced their tax bill, but they did not go about it haphazardly. They used the expertise of professionals and conducted their business like it was a business. Those simple steps enabled them to both save on taxes and weather the storm when the IRS came after them. It doesn’t get any better than that!