T.C. Memo. 1999-306
UNITED STATES TAX COURT
JOHN P. & TERESA HENNEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7535-98. Filed September 16, 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' 1994, 1995, and 1996 Federal income
taxes in the amounts of $1,583, $1,562, and $1,551, respectively.
All section references are to the Internal Revenue Code in effect
for the years in issue. All Rule references are to the Tax Court
Rules of Practice and Procedure.
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The sole issue for decision is whether rental payments
received by petitioner Teresa Hennen (Mrs. Hennen) from
petitioner John P. Hennen (Mr. Hennen) are includable in Mrs.
Hennen's net earnings from self-employment under section
1402(a)(1) and thus subject to self-employment taxes.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Petitioners resided in Minnesota at the time the petition was
filed.
Mr. and Mrs. Hennen have farmed for 38 years since they have
been married. During the taxable years at issue, Mr. Hennen
conducted farming operations in Lyon County, Minnesota. He had a
diversified farm and raised cattle, hogs, corn, soybeans,
alfalfa, and wheat. Mr. Hennen operated the farm as a sole
proprietorship, but he actually farmed with his and Mrs. Hennen's
two sons. The farm was 1100 acres in area. Their house and a
house occupied by a son and his wife were on the farm premises.
Mr. Hennen owned about 320 acres, and Mrs. Hennen owned 200
acres. The other acreage is rented from others. Mr. Hennen
rented the 200 acres of farmland from Mrs. Hennen for $16,000 per
year under an oral agreement. Mr. Hennen paid her $80 an acre,
which is comparable to the amount he paid to others. Mr. Hennen
used the land rented from Mrs. Hennen in the farming operations
to produce agricultural commodities such as livestock and crops.
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Mrs. Hennen owned the 200 acres in her own name. She
purchased the 200 acres from her Uncle in 1972. Mr. Hennen then
entered into an oral arrangement to lease the acreage from Mrs.
Hennen. Mrs. Hennen deposits the rent received from her husband
in her farm account which is separate from his account. When
petitioners entered into the oral agreement, petitioners expected
that Mrs. Hennen would perform the duties she had been performing
in the farming operations.
Since Mr. and Mrs. Hennen began farming, Mrs. Hennen has
provided general farming services to the endeavor. She bought
cattle, loaded cattle, and vaccinated cattle. She cleaned shop.
She also sprayed weeds, picked up parts, unloaded grain, and
drove a tractor. In addition, Mrs. Hennen performed the farm
bookkeeping. Mrs. Hennen carried on these duties prior to
renting the land to her husband. Mrs. Hennen did whatever it
took to make the farm run more smoothly and had done so ever
since Mr. Hennen and Mrs. Hennen were married 38 years ago. Mrs.
Hennen worked on the farm approximately 1,000 hours per year.
Mrs. Hennen did not participate in making decisions as to
the type of crop to plant, nor did she participate in other
management decisions. Mr. Hennen made the management decisions.
In each of the years in issue, Mrs. Hennen entered into a
purported Employment Agreement (Agreement) with Mr. Hennen. The
Agreement said that with respect to Mr. Hennen's business of
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farming, Mrs. Hennen was to perform bookkeeping, run errands for
the business, and help with livestock chores and field work. In
essence, the Agreement memorialized almost the same duties that
Mrs. Hennen had been performing since Mr. and Mrs. Hennen began
farming together. The Agreement also said Mrs. Hennen could
participate in her husband's Health and Accident Insurance Plan,
according to the terms and provisions of that plan. Mrs. Hennen
would have continued to do the same farming jobs even if there
had been no Agreement.
For all 3 years in issue, petitioners filed their Forms 1040
income tax returns on a married, filing jointly basis. On their
Schedules E, Supplemental Income and Loss, petitioners reported
that they received net rental income for 1994, 1995, and 1996,
from "FARM AND HOUSE", "FARMS", and "FARMS", respectively, in the
amounts of $14,322, $12,940, and $12,766, respectively. On line
7, Wages, salaries, tips, etc., of their Forms 1040, petitioners
reported that Mrs. Hennen received wages from Mr. Hennen in the
amounts of $3,137.11, $3,250, and $3,487 for 1994, 1995, and
1996, respectively, and, in 1994, petitioners also reported that
Mrs. Hennen received wages from World Book, Inc. in the amount of
$221.45. The amounts deducted as labor hired on the respective
Schedules F, Profit or Loss From Farming, for the 3 years in
issue exceeded the amounts purportedly paid to Mrs. Hennen. Mr.
Hennen failed to withhold Federal income taxes, State income
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taxes, Federal Insurance Contribution Act taxes, and Medicare tax
for all 3 years.
In the notice of deficiency, respondent, inter alia,
determined that the real estate rental payments Mrs. Hennen
received from Mr. Hennen during the taxable years at issue are
includable in Mrs. Hennen's net earnings from self-employment
under section 1402(a)(1), and thus subject to self-employment
tax. Respondent also allowed petitioners a deduction for one-
half of the self-employment taxes imposed for the taxable years
at issue.
On the Forms 4797, Sales of Business Property, attached to
their returns, Mr. and Mrs. Hennen reported gains of $24,046 from
a sale of 78 acres in 1994, and "0" gains from the sale of a
sprayer in 1995.
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 * * *
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commodities (including livestock * * *) 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 provide in pertinent
part, if the rental income is derived under an arrangement
between the owner of land (owner) 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 of such agricultural
commodities, and there is such material participation by the
owner, then the rental income received by the owner pursuant to
the arrangement is considered earnings from self-employment.
Sec. 1.1402(a)-4(b), Income Tax Regs. Such income is
characterized as "includible farm rental income". Id.
In determining whether compensation is includable in
self-employment income under sections 1401-1403 such provisions
are to be broadly construed 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).
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Petitioners contend that the oral lease agreement does not
require material participation by Mrs. Hennen in the farming
operations. Petitioners further contend that the rental income
that Mrs. Hennen received from Mr. Hennen was rental from real
estate, and therefore should be excluded in determining whether
Mrs. Hennen had any net earnings from self-employment as that
term is used in section 1402(a)(1).
In light of all the facts and circumstances, we must decide
whether Mrs. Hennen received rental income from Mr. Hennen
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. * * *
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The parties stipulated that Mr. Hennen used the land rented
from Mrs. Hennen in the farming operations to produce
agricultural commodities such as livestock and crops. With
respect to whether under the arrangement Mrs. Hennen was to
materially participate in the farming operations, we look not
only to the obligations imposed upon Mrs. Hennen by the oral
lease, "but to those obligations that existed within the overall
scheme of the farming operations which were to take place" on
Mrs. Hennen's property. Mizell v. Commissioner, T.C. Memo. 1995-
571. (Emphasis supplied.) These include Mrs. Hennen's
obligations as a longstanding participant in the farming business
as well as the "general understanding between * * * [Mr. Hennen
and Mrs. Hennen] with respect to the production of agricultural
products". Id. Viewed in this light, the arrangement between
Mr. and Mrs. Hennen provided, or contemplated, that Mrs. Hennen
materially participate in the production of agricultural
commodities on the farmland.
Mr. Hennen claimed he made all the management decisions. He
acknowledged that he had farmed with his wife for 38 years. Mr.
Hennen candidly stated in the answer to the following question:
Respondent: Q And in fact, she does materially
participate and help out and pull her share.
Mr. Hennen: A If you are familiar with the farm, sir,
that's what makes a farm successful. Everybody carries
their weight.
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Although petitioners contend that the purported oral lease
agreement did not require Mrs. Hennen to participate materially
in the farming operations, the record supports a finding that
Mrs. Hennen played a material role in the production of
agricultural commodities under an arrangement with her husband.
For 38 years through the taxable years at issue, Mrs. Hennen
performed general farming services on the farm on a regular and
intermittent basis, as we detailed in the findings of fact.
Petitioners admitted that Mrs. Hennen purchased cattle, loaded
cattle, vaccinated cattle, cleaned shop, picked up parts, and
unloaded grain. In addition, they acknowledged that Mrs. Hennen
drove a tractor and performed the farm bookkeeping. As noted,
Mrs. Hennen worked on the farm approximately 1,000 hours per
year. We deem it immaterial that Mrs. Hennen also purportedly
was paid a salary for her services with a corresponding deduction
taken on their tax returns. 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
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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
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 includable farm
rental income that is part of Mrs. Hennen's net earnings from
self-employment under section 1402(a)(1) for each of the taxable
years at issue. This is the same conclusion we reached in a
similar case, decided after this case was heard. Bot v.
Commissioner, T.C. Memo. 1999-256.
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.