McNamara v. Commissioner

T.C. Memo. 1999-333

UNITED STATES TAX COURT

MICHAEL & NANCY MCNAMARA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7537-98. Filed October 4, 1999.

Garry A. Pearson and Jon J. Jensen, for petitioners.

Blaine C. Holiday, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PAJAK, Special Trial Judge: Respondent determined

deficiencies in petitioners' Federal income taxes in the amounts

of $2,507, $3,191, and $2,963, for the taxable years 1993, 1994,

and 1995, respectively. All section references are to the

Internal Revenue Code in effect for the years in issue.
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FINDINGS OF FACT

The sole issue for decision is whether rental payments

received by petitioners from McNamara Farms, Inc. (McNamara

Farms), a corporation solely owned by petitioner Michael McNamara

(Mr. McNamara), are includible in petitioners' net earnings from

self-employment under section 1402(a)(1) and thus subject to

self-employment taxes.

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

Petitioners resided in Bird Island, Minnesota, at the time the

petition was filed.

Mr. McNamara began farming in 1977. Mr. McNamara has farmed

for approximately 21 years. Mr. McNamara operated the farm as a

joint venture with his wife until he incorporated the farm on

January 17, 1992. Mr. McNamara is the sole shareholder, officer,

and director of McNamara Farms. During the farming seasons,

McNamara Farms employed 10 to 20 employees and laid them off

during the off-season.

McNamara Farms carries on its business on approximately

1,250 acres of farmland. McNamara Farms rents the farmland from

three landlords. Petitioners are one set of landlords, and Mr.

McNamara's father is one of the other landlords.

During the taxable years at issue, McNamara Farms rented 460

acres of farmland, including a house, from petitioners under a

lease characterized as a Cash Rent Farm Lease. Petitioners owned
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the 460 acres of farmland equally as joint tenants. McNamara

Farms paid petitioners rent in the amounts of $45,620, $56,168,

and $57,000 in 1993, 1994, and 1995, respectively.

McNamara Farms used the land rented from petitioners in its

farming operation to produce agricultural commodities such as

corn, soybeans, seed corn, sweet corn, and sugar beets.

On February 1, 1992, Mr. McNamara entered into a purported

Employment Agreement with McNamara Farms, signed by Mr. McNamara

as President. The Employment Agreement provided that Mr.

McNamara was to be the general manager of the business, that he

was to do field work, that he was to do marketing, that he had

the responsibility for security of machinery and inventory, that

he was to manage other employees, and that he was to do such

other usual and customary duties required by the agricultural

production operation of McNamara Farms. In essence, the

Agreement memorialized almost the same duties Mr. McNamara had

done since he began farming. The Employment Agreement further

provided that any portion of compensation not paid in kind (e.g.,

grain crops) "will be subject to required FICA social security

tax and income tax withholding." The Employment Agreement

provided that Mr. McNamara could participate in the McNamara

Farms medical reimbursement plan and that he would be provided

with medical insurance for himself and his dependents.
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Mr. McNamara would have continued to do the same farming

jobs even if there had been no lease agreement.

On February 1, 1992, Mrs. McNamara also entered into a

purported Employment Agreement with McNamara Farms, signed by Mr.

McNamara as President. The Employment Agreement provided that

Mrs. McNamara was to perform the following duties for the farming

business: Bookkeeping, preparation of meals for employees, field

work, assistance in providing security for machinery and

inventory, and such other usual and customary duties as may be

delegated by the employer from time to time. In essence, the

Agreement memorialized almost the same duties that Mrs. McNamara

had been performing since Mr. and Mrs. McNamara began farming

together. The Employment Agreement further provided that any

portion of compensation not paid in kind (e.g., grain crops)

"will be subject to required FICA social security tax and income

tax withholding." The Agreement also provided that Mrs. McNamara

could participate in the McNamara Farms medical reimbursement

plans and that she would be provided medical insurance coverage

for herself and her dependents.

For all 3 years in issue, petitioners filed their Forms 1040

income tax returns as married individuals filing joint returns.

Mr. McNamara stated his occupation was "farmer" and Mrs. McNamara

stated her occupation was "bookkeeper". On their Schedules E,

Supplemental Income and Loss, petitioners reported that they
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received net rental income in the amounts of $19,180, $24,442 and

$22,671 in 1993, 1994, and 1995, respectively. On line 7, Wages,

salaries, tips, etc., of their Forms 1040, petitioners reported

that they received wages in the amounts of $30,603, $30,466, and

$31,252 for 1993, 1994, and 1995, respectively. Elsewhere on

their 1993, 1994, and 1995 returns, Mr. McNamara and Mrs.

McNamara reported earnings from McNamara Farms of $28,019 and

$2,584, respectively (total of $30,603), $27,775 and $2,691,

respectively, (total of $30,466) and $28,561 and $2,691,

respectively (total of $31,252). Contrary to the terms of the

Employment Agreements, McNamara Farms failed to withhold Federal

income taxes and State income taxes from their earnings.

McNamara Farms withheld Federal Insurance Contribution Act taxes

and Medicare tax for all 3 years from their earnings.

In the notice of deficiency, respondent determined that the

real estate rental payments petitioners received from McNamara

Farms during the taxable years at issue are includible in

petitioners' net earnings from self-employment under section

1402(a)(1), and thus subject to self-employment tax income.

Respondent divided the amounts equally between petitioners with

respect to self-employment income and self-employment tax.

Respondent also allowed petitioners a deduction for one-half of

the self-employment taxes imposed for the taxable years at issue.
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OPINION

Section 1401 provides that a tax shall be imposed on the

self-employment income of every individual. Generally, rentals

from real estate are excluded from the computation of net

earnings from self-employment. Sec. 1402(a)(1). However,

section 1402(a)(1) also provides that rentals derived by the

owner or tenant of land are not excluded from the computation of

net earnings from self-employment 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 * * *
commodities * * * on such land, and that there shall be
material participation by the owner or tenant * * * in the
production or the management of the production of such
agricultural * * * commodities, and (B) there is material
participation by the owner or tenant * * * with respect to
any such agricultural * * * commodity;

In other words, as the regulations under section 1402(a)(1)

provide in pertinent part, there is a special rule when:

The income is derived under an arrangement between the owner
* * * of land and another person which provides that such
other person shall produce agricultural * * * commodities on
such land, and that there shall be material participation by
the owner * * * in the production or the management of the
production of such agricultural * * * commodities; and * * *
There is material participation by the owner * * * with
respect to any such agricultural * * * commodity. [Sec.
1.1402(a)-4(b)(1)(i) and (ii), Income Tax Regs.]

Under those circumstances, such income is characterized as

"includible farm rental income". Sec. 1.1402(a)-4(b)(1), Income

Tax Regs. The includible farm rental income received by the
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owner pursuant to the arrangement is considered earnings from

self-employment. Id.

In determining whether compensation is includible in

self-employment income under sections 1401-1403 such provisions

are to be broadly construed so as to favor coverage for Social

Security purposes. Braddock v. Commissioner, 95 T.C. 639, 644

(1990). The rental exclusion in section 1402(a)(1) is to be

strictly construed to prevent this exclusion from interfering

with the congressional purpose of effectuating maximum coverage

under the Social Security umbrella. Johnson v. Commissioner, 60

T.C. 829, 832 (1973); Gill v. Commissioner, T.C. Memo. 1995-328.

Petitioners contend that the written lease agreement does

not require material participation by petitioners in the farming

operations. Petitioners further contend that the rental income

that petitioners received from McNamara Farms was cash rent from

real estate, and therefore should be excluded in determining

whether petitioners had any net earnings from self-employment as

that term is used in section 1402(a)(1).

This Court has held that cash rental payments were

includible in self-employment income in Gill v. Commissioner,

supra. This is the same conclusion this Court reached in two

similar cases, decided after this case was heard. Bot v.

Commissioner, T.C. Memo. 1999-256, and Hennen v. Commissioner,

T.C. Memo. 1999-306. In Gill, this Court further held that
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payments received by husband-wife farmers from a corporation were

earnings from self-employment subject to the self-employment tax.

In light of all the facts and circumstances, we must decide

whether petitioners received rental income from McNamara Farms

pursuant to an "arrangement" between the parties to produce

agricultural commodities on the farm within the meaning of

section 1402(a)(1)(A).

In Mizell v. Commissioner, T.C. Memo. 1995-571, this Court

explained that:

The word "arrangement" is defined as an agreement.
Webster's Third New International Dictionary 120 (1993).
While the concept of an agreement certainly includes a
contractual agreement, it is a broader concept that would
also include other forms of agreements not necessarily
arising from strict contractual relationships. Consistent
with its dictionary definition, in most of the instances
where it is 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. * * *

McNamara Farms used the farmland to produce agricultural

commodities such as corn, soybeans, seed corn, sweet corn, and

sugar beets. With respect to whether under the arrangement

petitioners were to materially participate in the farming

operations, we look not only to the obligations imposed upon them
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by the written lease, "but to those obligations that existed

within the overall scheme of the farming operations which were to

take place" on their property. Mizell v. Commissioner, T.C.

Memo. 1995-571. (Emphasis supplied.) These include petitioners'

obligations as longstanding participants in the farming business

as well as the "general understanding between * * * [petitioners

and McNamara Farms] with respect to the production of

agricultural products". Id. Viewed in this light, the

arrangement between petitioners and McNamara Farms provided, or

contemplated, that petitioners materially participate in the

production of agricultural commodities on the farmland.

Mr. McNamara was candid as is evident from the following

question during direct examination:

Q. And what do you do for McNamara Farms?

A. I operate the farm. I run the farm from planting to

harvest.

Mr. McNamara claimed he made all the management decisions. Mr.

McNamara asserted that his wife "was a homemaker and ran when she

was needed for, you know, meals or parts." Before incorporation,

Mrs. McNamara did not do the bookkeeping, but otherwise performed

the duties outlined above. Mr. McNamara tried to downplay his

wife's participation. Mrs. McNamara did not appear in Court,

even though petitioners' trial memorandum stated that both

parties would testify. Under these circumstances, we are not
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required to accept the self-serving testimony of Mr. McNamara as

gospel. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Although petitioners contend that the written lease agreement did

not require them to materially participate in the farming

operations, the record supports a finding that petitioners played

a material role in the production of agricultural commodities

under an arrangement with McNamara Farms.

For about 21 years through the taxable years at issue, Mr.

McNamara performed general farming services on the farm on a

regular and intermittent basis, as we detailed in the findings of

fact. Mrs. McNamara failed to testify, but it is clear that for

a good number of years she did the same. In our view, these

"regularly performed services are material to the production of

an agricultural commodity, and the intermittent services

performed are material to the production operations to which they

relate." Sec. 1.1402(a)-4(b)(6), Example (1), Income Tax Regs.

The regulations provide in pertinent part, that if the

rental income is derived under an arrangement between the owner

of land and another person which provides that such other person

shall produce agricultural commodities on such land, and that

there shall be material participation by the owner in the

production or the management of the production of such

agricultural commodities, and there is such material

participation by the owner, then the rental income received by
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the owner pursuant to the arrangement is considered earnings from

self-employment. Sec. 1.1402(a)-4(b), Income Tax Regs.

Accordingly, we find that the rental income is includible farm

rental income that is part of petitioners' net earnings from

self-employment under section 1402(a)(1) for each of the taxable

years at issue.

We have considered all of the arguments presented by the

parties, and, to the extent not discussed above, they are without

merit or not relevant.

To reflect the foregoing,

Decision will be entered

for respondent.