Definition of rental income not always clear

The term “rent” recently came under the scrutiny of the Tax Court in a self-employment tax case.

Self-employed individuals, including farmers, are subject to self-employment tax, which includes both the employer’s and the employee’s share of Social Security and Medicare taxes. But self-employment tax doesn’t generally apply to rental income from real estate.

In Rollin J. and Maureen B. Morehouse v. Commissioner, 140 T.C., No. 16, June 18, 2013, the Tax Court concluded that payments received under the Conservation Reserve Program (CRP) were subject to self-employment tax. The CRP is sponsored by the U.S. Department of Agriculture (USDA).

Under one facet of the Conservation Reserve Program, the USDA pays “rent” to owners of highly erodible cropland. The owners voluntarily agree to take the land out of agricultural production and maintain the land in accordance with the CRP contract.

Rollin Morehouse applied to the USDA and had several properties accepted into the conservation program. He raised two arguments in support of his contention that he should not be subject to self-employment tax on the CRP payments he received:

1. He was not engaged in a trade or business.

2. The payments were rental income from real estate.

As to the first argument, the court concluded that Morehouse’s activities with respect to the CRP contract were legally significant. The contract requires the landowner to engage in property maintenance activities for the benefit of the enrolled properties with regularity. It also required the landowner to perform periodic administrative and reporting duties to satisfy his obligations under the contract and receive CRP payments.

The contractual obligations are substantial and require more than de minimis action to satisfy them. These activities included the performance of duties not usually or customarily rendered in connection with the mere rental of farmland. The court found that Morehouse was engaged in a trade or business, and there was a nexus between his trade or business and the CRP payments he received.

The court also concluded that the Conservation Reserve payments were not rental income from real estate. Rather, the payments that Morehouse received appeared to be proceeds from his own use of the land rather than rent for allowing another entity to use his land. Morehouse did not relinquish control of the land to the USDA, and the USDA did not engage in any activities with respect to the land that constitute “use” of the land by the USDA.

Note that Congress amended the exclusion for “rentals from real estate,” effective for CRP payments received after 2007, to exclude from the calculation of net earnings from self-employment any CRP payments made to taxpayers who are receiving Social Security retirement or disability payments.