The recent non-acquiescence issued by the IRS in the decision of the U.S. Court of Appeals for the Eighth Circuit in Morehouse v. Comr. has raised a question among some as to whether Form 8275 should be filed with the tax return of a non-farmer if the Conservation Reserve Program (CRP) rents are not reported on Schedule F.
Filing Form 8275 avoids negligence penalties associated with the tax return (if the position is not frivolous). The main issue behind such a concern is whether taking a position on a return that is contrary to an IRS non-acquiescence rises to the level of negligence or disregard as required by I.R.C. §6662 for penalties to apply.
Brief History of Self-Employment Tax Treatment of Government Payments
We have detailed the historic treatment of the self-employment tax treatment of government program payments more fully elsewhere, but a brief discussion is in order. In Revenue Ruling 60-32, the IRS ruled that payments to non-farmers for land idled under the Soil Bank program were not subject to self-employment tax. Similarly, in Rev. Rul. 65-149, the IRS ruled that grain storage fees paid under a CCC loan program were subject to self-employment tax only in the hands of an active farmer. Non-farmers (those not materially participating in a farming operation), the IRS determined, did not have a self-employment tax liability on the payments.
When the CRP was created as part of the 1985 Farm Bill, the IRS consistently applied its historic position on self-employment tax to non-farmers receiving CRP rents. Every single IRS ruling from 1987 until 2003 reiterated the IRS position that CRP rents were subject to self-employment tax only when there was a tie, or nexus, to an existing farming operation of the taxpayer. Non-farmers, in the IRS view, did not owe self-employment tax on CRP rental income.
The Tax Court, in 1996, supported this view in Ray v. Comr. However, in 2003, the Chief Counsel’s Office of IRS announced a complete change in the IRS position. In Chief Counsel Advice 200325002, the Chief Counsel’s Office took the position that a taxpayer is engaged in the trade or business of participating in the CRP simply by signing the CRP contract, agreeing to fulfill the maintenance and other terms of the contract.
In 2006, the IRS gave notice of proposed rulemaking that it would be going through the formal procedure to issue a new Revenue Ruling that would obsolete the 1960 Revenue Ruling which held to the contrary. It never did issue that ruling, and to this day, Rev. Rul. 60-32 remains the official IRS position on the self-employment tax treatment of CRP rental payments in the hands of non-farmers – they are not subject to self-employment tax. Congress included a provision in the 2008 Farm Bill removing self-employment tax liability for farmers receiving CRP rents who were also receiving Social Security retirement or disability payments.
Committee Report language concerning the provision clearly states that the Congress was not changing the self-employment taxation of CRP rents with respect to other taxpayers (but the Committee Report did not state what that taxation is). In other words, the nexus test still applied for farmers receiving CRP rents that were not receiving Social Security retirement or disability payments, and Rev. Rul. 60-32 still applied with respect to non-farmers.
The Morehouse Case
In Morehouse, the taxpayer lived in Texas where he worked at a non-farm job. He inherited farmland in South Dakota, and subsequently bought out the farmland interests of the other heirs. He initially rented the land to a local farmer, but ultimately put the bulk of the land in the CRP. At no time did the taxpayer have any Schedule F farm income. He later moved to Minnesota and arranged for the local farmer to perform the CRP contract requirements and received cost-share for the required maintenance. Consistent with the 1960 IRS position, the taxpayer did not report the CRP payments for the years in issue (2006 and 2007) as subject to self-employment tax, reporting them instead on Schedule E.
The IRS audited and took the position that the CRP payments were subject to self-employment tax based on Announcement 83-43, the U.S. Court of Appeals for the Sixth Circuit decision in Wuebker v. Comr., CCA 200325002 and its 2006 Notice of proposed rulemaking. None of the authorities cited by the IRS constituted substantial authority that was directly applicable to the taxpayer’s facts.
Note: A key point is that, even in the Morehouse matter, the IRS did not assert negligence penalties for the failure of Mr. Morehouse, a non-farmer, to file Form 8275 with the return.
While the Tax Court agreed with the IRS, the U.S. Court of Appeals for the Eighth Circuit reversed. The appellate court determined that the CRP is the modern-day version of the Soil Bank Program and that Rev. Rul. 60-32 controlled. The court refused to give the IRS deference on its 2006 Notice of Proposed Rulemaking, and noted that “The Sixth Circuit neither recognized nor rejected the IRS’s position in Rev. Rul. 60-32 that similar payments to non-farmers were not self-employment income.” The court also held that the CRP payments were received for the government’s use and occupancy of the taxpayer’s land and, as such, constituted rental payments that were not subject to self-employment tax.
As a result of the Eighth Circuit’s opinion in Morehouse, non-farmers in the Eighth Circuit do not owe self-employment tax on CRP rents for payments made before 2008. For post-2007 payments, the case stands for the proposition that a non-farmer is not engaged in the trade or business of farming and would also not owe self-employment tax on CRP rents. The Eighth Circuit’s opinion is persuasive authority in the Eighth Circuit.
The IRS Non-Acquiescence
In late September of 2015, the IRS issued a non-acquiescence to the Eighth Circuit’s Morehouse opinion.It claimed that the Eighth Circuit “misapplied” the law, asserted that Rev. Rul. 60-32 did not apply and took that position that a taxpayer who receives CRP rents who is neither a farmer or a landlord is to be treated for self-employment tax purposes as someone who personally operates a farm. Thus, there is no separate category for a non-farm investor or a person who is a non-farmer that inherits farmland that is either already enrolled in the CRP or later enrolls it. The IRS made no mention of the statutory requirement that self-employment income must derive from a trade or business that the taxpayer conducts.
Reporting CRP Payments – Non-Farmers
Clearly, the IRS is looking for all CRP payments to be reported on Schedule F. However, that is only the correct way to report CRP payments for active farmers (as well as material participating farm landlords) where a nexus with the farming operation can be established. For other taxpayers, especially those within the jurisdiction of the U.S. Court of Appeals for the Eighth Circuit, CRP payments should not be reported on Schedule F. So where should a non-farmer who has CRP rental income report the CRP payments? Here are some thoughts:
- Perhaps the IRS matches the 1099-G and looks for self-employment income without trying to match on Schedule F or Form 4835.
- CRP rents don’t really fit on Form 4835 because a trade or business is not involved. The concern with reporting the CRP payments received by a non-farmer is that Form 4835 is viewed in the I.R.C. §469 regulations as a trade or business. Granted, the self-employment tax statute is I.R.C. §1402, but the concern is that the IRS could argue that a trade or business has been admitted
- Perhaps the best approach is to report the CRP rents on Schedule F, back them out, and then report them on Schedule E as cash rent. This is consistent with the manner in which a Form 1099 received in error would be reported. It will be difficult for the IRS to find the tax return, if the CRP rental income is reported on the Schedule F and backed out with an explanation that cites Rev. Rul. 60-32 and Morehouse.
Form 8275 and Disclosure
If CRP payments are not reported on Schedule F where the IRS claims they should be reported, is there any potential for penalties to apply? For any portion of an underpayment of any income tax required to be shown on a return that is attributable to negligence or disregard of rules or regulations, a 20 percent penalty is added to the underpayment amount. However, the penalty for disregarding rules or regulations does not apply if the position taken on the return was made in good faith, had a reasonable basis and was adequately disclosed.
Similarly, if a position with respect to an item (that is not a reportable transaction) is contrary to a revenue ruling or notice (other than a notice of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin, this penalty does not apply if the position has a realistic possibility of being sustained on its merits.
Note: It is critical to note that an IRS notice of proposed rulemaking is of no consequence with respect to the potential for a penalty to apply. Thus, in the CRP context, IRS Notice of proposed rulemaking 2006-108 can be ignored. The same holds true for the IRS non-acquiescence in Morehouse. It can also be ignored for purposes of a potential penalty.So what is “negligence” for purposes of the penalty provision?
Among other things, it includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. “Disregard of rules or regulations” means any careless, reckless or intentional disregard of the provisions of the Internal Revenue Code, temporary or final regulations and revenue rulings or notices (other than notices of proposed rulemaking). However, a taxpayer who takes a position contrary to a revenue ruling or notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.
A position taken on a return is deemed to have a reasonable basis if it is reasonably grounded on one or more of the authorities set forth in §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments). In addition, the reasonable cause and good faith exception in §1.6664-4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard.
In addition, no penalty is imposed on any portion of an underpayment that is attributable to a position contrary to a rule or regulation if the position is disclosed and, in case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the regulation. This disclosure exception does not apply, however, in the case of a position that does not have a reasonable basis.
So how is an adequate disclosure to be made? Disclosure is adequate for purposes of the penalty for disregarding rules or regulations if it is made in accordance with the provisions of Treas. Regs. §§1.6662-4(f)(1), (3), (4) and (5), which permit disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate. In addition, the statutory or regulatory provision or ruling in question must be adequately identified on the Form 8275 or 8275-R, as appropriate.
Application to CRP payments to non-farmers. As applied in the CRP situation, clearly IRS remains insistent that all CRP rental payments be reported on a Schedule F, regardless of whether the taxpayer is a farmer or a non-farmer. While this is contrary to the official IRS position in Rev. Rul. 60-32 and is inconsistent with caselaw and all of the IRS private letter rulings on the matter before the IRS unofficially changed its position in 2003, it is the IRS audit and litigating position. But, is that a position that taxpayers must abide by so as to avoid penalties?
In other words, should a non-farmer taxpayer (who is also not receiving Social Security retirement or disability payments) that doesn’t report CRP rents on Schedule F disclose the position by filing Form 8275? If so, any disclosure would be premised on a position that disagreeing with an IRS non-acquiescence represented a position contrary to a rule or regulation per I.R.C. §6662. The regulations under I.R.C. §6662 defining negligence or disregard don’t go anywhere near that far.
The IRS position on the self-employment taxation of CRP rents since 2003 is contrary to I.R.C. §1402, caselaw and the agency’s own official position as stated in Rev. Proc. 60-32. Given that the IRS has become “penalty happy” in recent years, the reporting of CRP rents gives heartburn to some practitioners and taxpayers. However, there is certainty in following the law and historic IRS position regardless of what the agency’s unofficial position might be.
Clearly, for taxpayers within the Eighth Circuit, a Form 8275 is not necessary. The Wuebker and Ray cases are distinguishable, and the Eighth Circuit rejected the Tax Court’s reasoning in Morehouse. While IRS may audit the issue even in the Eighth Circuit, and it has said in the non-acquiescence that it would, that doesn’t mean that penalties will apply if the 8275 is not filed. The IRS has no substantial authority inside the Eighth Circuit on this issue at all.
For other taxpayers, the Tax Court opinion in Wuebker controls outside the Sixth Circuit, and the Sixth Circuit opinion controls within the Sixth Circuit. In other circuits, the Eighth Circuit’s decision is persuasive authority. So, for taxpayers in circuits other than the Eighth Circuit, practitioners should give consideration to filing Form 8275 and disclosing those authorities.
In the CRP situation, is there a downside risk of reporting the CRP rents for non-farmers in a location other than on Schedule F and disclosing on Form 8275? Taxpayers have been audited as a result of filing Form 8275. While the amount of tax involved in any given situation might factor into consideration, if the IRS is looking for an audit candidate, filing Form 8275 certainly provides it with one.
Remember, Form 8275 is used when a position is taken on the return that is contrary to substantial authority, not when the position on the return is contrary to the IRS position when that position is contrary to substantial authority. The bizarre effect of the IRS audit position is that if CRP rents received by a non-farmer are reported on Schedule F and no Form 8275 is attached disclosing that reporting the payments in that manner is contrary to Rev. Rul. 60-32 (and the Morehouse decision in the Eighth Circuit), the IRS would have the authority to levy a penalty.
If the IRS wishes to apply self-employment tax to CRP rental payments in the hands of non-farmers, it should formally adopt a Revenue Ruling that obsoletes Rev. Rul. 60-32. Absent doing that, perhaps the IRS should file Form 8275 with itself.