In past Ohio State University surveys, it was determined that around half of all farmland in Ohio is leased. The other half of the land is owned by the farmers farming the land. There are significant tax implications as to how the owned land is incorporated into the farming operation. It is possible to have a business and leasing structure to help reduce self-employment taxes.
Farmers are well aware of self-employment taxes. This tax funds Social Security and Medicare. Every earned dollar up to $132,900 is subject to the full 15.3% tax, with all earned income over the threshold subject to only the 2.9% Medicare tax. For example, earned income of $100,000 will create $15,300 of self-employment tax liability, and earned income of $200,000 will be subject to $22,300 of self-employment tax.
Using an LLC
It is possible, in some situations, to structure the farming operation in such a way as to reduce self-employment taxes. This restructuring involves placing the owned land in a separate LLC apart from the farming operation. The lease payment received by the land LLC is usually considered unearned income and not subject to self-employment tax. By paying a lease payment for the land, income can be reclassified from earned to unearned income.
Consider the following example. John and Jane, married, operate a 1,500-acre grain operation. All assets are owned in their names, including 500 acres. The farm showed a profit of $200,000. Since the entire farm profit is earned income, John and Jane paid $22,300 in self-employment taxes.
Instead, what if John and Jane have a land LLC, which holds the 500 acres. They lease the land for $100,000, with the rent paid to the land LLC — a deductible expense to the farming operation. John and Jane will now receive $100,000 profit from the farming operation and $100,000 profit from the land LLC. The land rent is considered unearned income and is not subject to self-employment tax. Their self-employment tax liability under this scenario is $15,300, a $7,000 savings.
Importance of lease
The lease becomes very important in this analysis for two reasons. First, the land rent will only be considered unearned if there is no material participation by the LLC. This is typically easily solved by making the lease a cash-rent lease. The lease should also state that the land LLC will provide no labor to the farming operation.
Second, the lease rate must be similar to the market rate for similar land. If Bob and Jane pay $400 per acre for rent (double market rate) to try to transfer all farm profit to the LLC, they could jeopardize the rental income being considered unearned income. The IRS would likely say that the only way the farming operation would pay double the going cash rent was if the LLC was providing services in addition to the land. The services make the income earned and subject to self-employment taxes. To avoid this negative outcome, make sure the land rent is similar to the going cash-rent rate — do not be greedy.
Pay attention to new tax laws
The recent federal tax legislation passed by Congress adds an additional layer of complexity to farm leases. Pass-through entities are eligible for up to a 20% reduction in income as part of the Qualified Business Income (QBI), also known as Section 199A. In the above example, the land LLC would be eligible for the QBI deduction. However, there are two situations in which the QBI deduction is not available. First, if the entity paying the land rent is a C corporation, the QBI is not available. Second, if the lease is a triple net lease (tenant pays all costs and taxes), the QBI is not available. Any farmers who are leasing land from their own land entity should not have a triple-net lease. It should be noted that the QBI deduction has different rules when the tenant and landowner are unrelated.
Holding land in a separate LLC can help reduce self-employment tax liability. A land-holding LLC also has several business and estate planning advantages; the tax savings is really just a secondary benefit to legitimate business structuring.
As this article demonstrates, there are rules and exceptions to the rules that must be known and followed. Be sure to get legal and tax advice before beginning a restructuring of the farming operation.