118 T.C. No. 8
UNITED STATES TAX COURT
RICHARD J. BOT AND PHYLLIS BOT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14155-98. Filed February 15, 2002.
Ps maintained active memberships in an agricultural cooperative, which processed and sold corn produced by its members. As active members, Ps were obligated to produce and deliver corn to the cooperative regularly, and, during 1994 and 1995, they met that obligation with corn they acquired from a “pool” maintained by the cooperative. The cooperative processed and sold the corn for Ps’ benefit and paid to Ps value-added payments for the corn. For Federal tax purposes, Ps reported the value-added payments they received during 1994 and 1995 as proceeds from the sale of capital assets and did not treat the amounts received as self-employment income. Held: During 1994 and 1995, Ps were engaged in the business of acquiring and selling corn and corn products for a profit. The value-added payments were derived from Ps’ business and must be included in the calculation of Ps’ net earnings from self-employment for purposes of determining Ps’ liability for self- employment tax. - 2 -
Kathryn J. Sedo, for petitioners.
Blaine C. Holiday, for respondent.
MARVEL, Judge: Respondent determined deficiencies in
petitioners’ Federal income tax for 1994 and 1995 of $7,239 and
$13,716, respectively.
The sole issue for decision is whether petitioners are
liable for self-employment tax under section 14011 on value-added
payments that they received in 1994 and 1995 from an agricultural
cooperative of which they were active members.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts is incorporated in our opinion by this
reference. Petitioners resided in Marshall, Minnesota, when the
petition in this case was filed.2
During all relevant years, Richard J. Bot (Mr. Bot) and
Phyllis Bot (Mrs. Bot) owned and lived on a 700-acre farm in
Minnesota. Before 1988, petitioners ran their farm operation,
growing crops such as corn, alfalfa, and soybeans and raising
livestock. In the fall of 1987, however, petitioners decided to
1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. Monetary amounts are rounded to the nearest dollar where appropriate. 2 Petitioners live in Texas from November to April. - 3 -
retire from daily farming and entered into a written farm
agreement (the 1987 farm agreement) with two of their sons,
Richard F. Bot and Bennett Bot (hereinafter referred to as the
sons). This agreement was renewed orally each year. The 1987
farm agreement required the sons to operate petitioners’ farm “in
a good and husband-like manner, and according to the usual course
of husbandry” and required petitioners to compensate the sons by
paying them with a “one-half part or share of all grains,
vegetables, corn, soy beans and other crops so raised and secured
upon said farm”.
The 1987 farm agreement required petitioners to pay for half
of the costs of seed, fertilizer, and weed sprays and to provide
land and machinery for the farming operation. The 1987 farm
agreement also gave petitioners the option of making major
repairs to or replacing equipment, when necessary, but did not
require them to do so. The 1987 farm agreement required the sons
to pay for half of the costs of seed, fertilizer, and weed
sprays; to furnish all labor and pay all operating costs; to haul
and deliver crops for petitioners; and to keep petitioners’ farm
implements in good repair. Under the 1987 farm agreement,
petitioners and the sons were supposed to divide all Government
program aid equally.
The arrangement between petitioners and the sons during 1994
and 1995 followed the basic parameters of the 1987 farm agreement
but was broader. Under the arrangement in effect for 1994 and - 4 -
1995, petitioners and the sons contributed equally to farm
expenses and shared equally in farm profit or loss. During 1994
and 1995, crops grown on the farm were either fed to farm
livestock or sold, and any profit generated from the farm
operation, including profit from the sale of crops and livestock,
was split approximately equally between petitioners and the sons.
Petitioners delegated to their sons the authority to decide
whether crops raised on the farm were to be fed to livestock or
sold on the open market. During 1994 and 1995, the sons sold
corn and soybeans in petitioners’ names because it was
economically advantageous to do so.
Pursuant to the arrangement in effect for 1994 and 1995,
petitioners paid part of the farm expenses. In November 1994 and
again in November 1995, petitioners estimated the results of the
farming operation and wrote checks to the sons to reimburse them
for petitioners’ share of farm expenses. In November 1994,
petitioners paid $25,000 to each son; in November 1995,
petitioners paid $35,000 to each son.3 At the end of the year,
petitioners and the sons added up the income earned from the farm
operation, subtracted the farm expenses petitioners and the sons
3 Although the memo portion of each personal check written in 1994 states that the check was for “corn purchased”, petitioners admitted at trial that they paid the money to reimburse the sons for petitioners’ share of expenses incurred in the farming operation. - 5 -
had paid, and calculated how much of the farm operation’s profit
they each were entitled to receive.
With the exception of proceeds generated from the sale of
corn in 1995 that were reported as proceeds from the sale of
capital assets on Schedule D, Capital Gains and Losses,
petitioners reported their share of farm income and expenses as
farm rental income and expenses on Forms 4835, Farm Rental Income
and Expenses, attached to their 1994 and 1995 Forms 1040, U.S.
Individual Income Tax Return.
Minnesota Corn Processors
In approximately 1982, a group of Minnesota farmers formed
Minnesota Corn Processors (MCP), an agricultural cooperative
organized under the laws of Minnesota.4 MCP was incorporated to
handle all aspects of dealing with agricultural products produced
by its members and to perform services for its members.
Under its articles of incorporation, MCP was authorized to
issue 30,000 shares of common stock and 100,000 shares of
nonvoting preferred stock. Only “producers of agricultural
products * * * who reside in the territory served” by MCP could
hold shares. A producer is any person “actually engaged in the
4 MCP’s objective was to accomplish collectively what none of its members could accomplish individually–-process corn and realize profits from the increased value of that processed corn. Without MCP’s pooled funds and processing facilities, its members would have had to sell their corn, if any, to an elevator. Then, any value added to the corn by processing the corn would have been realized by others. - 6 -
production of one or more of the agricultural products handled”
by MCP and includes lessors of land who receive crop shares as
rent. A member is any producer of agricultural products who is
eligible for membership in MCP and who has acquired a minimum of
5 shares of MCP’s common stock.
Under its bylaws in effect during 1994 and 1995, MCP was
authorized to terminate any membership if an existing member was
no longer eligible for membership, a member failed to patronize
MCP for 1 year or more, a member moved from the territory served
by MCP, or died, or ceased to be an agricultural producer, or a
member violated MCP’s bylaws, breached a contract with MCP, owed
MCP a delinquent debt, or willfully obstructed MCP’s purposes or
activities. In such an event, MCP’s board of directors had the
right, at its option, to purchase the member’s stock or to
require the member to convert his common stock to either
preferred stock or a nonvoting certificate of interest.
Petitioners became members of MCP in 1982. Mr. Bot
purchased 40 shares of common stock on August 26, 1982, and Mrs.
Bot purchased 15 shares on August 28, 1982. As members,
petitioners were also required to purchase units of equity
participation and to enter into a uniform marketing agreement
(UMA) with respect to each unit. The units of equity
participation and the UMAs collectively defined the scope of
petitioners’ obligation to patronize MCP. Each unit of equity - 7 -
participation specified the maximum number of bushels of corn the
member could be required to produce and deliver to MCP each
processing year,5 and the related UMA set forth the terms
governing the production, processing, and marketing of the corn.
During 1994 and 1995, petitioners were active members of MCP who
owned MCP common stock. As active members, petitioners continued
to have ongoing production obligations to MCP and its membership.
Beginning in 1982 and continuing through and including 1995,
petitioners periodically purchased units of equity participation
as follows:
Richard J. Bot Phyllis Bot Date Units purchased Date Units purchased
8/26/82 40,000 8/28/82 15,000 12/20/85 20,000 2/1/901 20,000 2/1/90 17,500 10/1/90 30,000 10/1/90 26,250 12/1/91 5,000 12/1/91 20,000 6/1/92 30,000 6/1/92 26,250 3/1/94 10,000 3/1/94 10,000 6/1/94 62,500 6/1/94 62,500 6/1/95 79,000 6/1/95 79,000 9/18/95 16,500 9/18/95 12,750 12/1/95 20,000 12/1/95 20,000 1 Petitioners testified they purchased additional units after 1987 because they thought the units would make good investments.
As MCP members, petitioners were required to produce and
deliver corn three times each year as determined by MCP. The
timing of the deliveries was also within MCP’s discretion.
5 MCP’s processing year begins Oct. 1 and ends Sept. 30. MCP’s fiscal year begins Jan. 1 and ends Dec. 31. - 8 -
Petitioners could meet their production and delivery obligations
with corn that was grown on their farm, that they acquired
elsewhere, or that MCP already held in its option pool.6 “Option
pool corn” is corn maintained by MCP and made available for sale
only to MCP members for use in meeting their production and
delivery obligations under the UMAs. A member who wished to
satisfy his production and delivery obligation using option pool
corn completed a form to that effect and paid an acquisition fee
of 5 cents per bushel of option pool corn purchased. If either
petitioner failed to meet the production and delivery obligations
under the UMA, the UMA authorized MCP to act as that petitioner’s
agent in acquiring corn, charging all related expenses to Mr. Bot
or Mrs. Bot, as appropriate.
In 1994 and 1995, petitioners met their production and
delivery obligations under their UMAs with option pool corn. In
1994 and 1995, petitioners paid acquisition fees of $18,070 and
$16,431, respectively, for the option pool corn used to satisfy
their combined production and delivery obligations.
MCP was obligated, pursuant to the UMAs, to process the corn
produced by its members each year as dictated by the market and
in a manner MCP deemed in the best interest of the cooperative
6 Regardless of how petitioners acquired the corn they delivered to MCP, petitioners warranted to MCP that they were the producers or owners of the corn they delivered to MCP under the UMAs. - 9 -
and its membership as a whole. MCP also was obligated to market
the processed corn at the best rate obtainable on the open
market. In the UMAs, petitioners appointed MCP as their agent to
market and sell the corn they delivered to satisfy their
production and delivery obligations. MCP determined how much
corn petitioners had to produce and deliver and had “sole and
complete discretion in all phases of the marketing activity”.
In return for petitioners’ meeting their production and
delivery obligations, MCP was obligated under the UMA to pay each
petitioner: (1) At least 80 percent of the loan value per bushel
of corn delivered by each petitioner; (2) a storage fee and
interest in some cases; (3) an additional payment (“value-added
payment”) for value added to the corn as a result of its
processing, and as further compensation for corn delivered by
petitioners, if MCP determined that such a payment was warranted
after calculating the net proceeds from all of its operations for
the processing year and if MCP’s lenders approved; and (4)
payments from MCP’s earnings as patronage dividends in accordance
with MCP’s bylaws. During 1994 and 1995, petitioners received
value-added payments of $132,375 and $207,612, respectively,
attributable to the option pool corn they acquired and delivered
to MCP. - 10 -
Petitioners’ 1994 and 1995 Tax Returns
Petitioners reported the value-added payments on Schedules D
as proceeds from the sale of capital assets. Petitioners
subtracted from those proceeds the following amounts, which they
claimed represented their adjusted basis for purposes of
calculating their capital gain or loss:
Description 1994 1995
Option pool corn fees $18,070 $16,431 Payments to sons 50,000 70,000 Total basis claimed 68,070 86,431
Petitioners acknowledged during the trial, however, that they had
erroneously increased their basis by the payments made to the
sons, which had nothing to do with option pool corn purchased
from MCP but rather were to reimburse the sons, at least in part,
for petitioners’ share of farm-related expenses the sons had
paid.7
With the exception of some corn sale proceeds reported on
the Schedules D, petitioners reported their farm income and
expenses for 1994 and 1995 as farm rental income and expenses on
Forms 4835. On the Forms 4835, petitioners checked the box
acknowledging that they actively participated in the operation of
7 Although petitioners conceded at trial that they erroneously increased their basis in the option pool corn they acquired to satisfy their MCP obligations by the amounts paid to the sons for farm expenses, respondent did not move for an increased deficiency in this case. - 11 -
their farm during 1994 and 1995 although they testified at trial
that they had made a mistake in doing so.
Notice of Deficiency
In the notice of deficiency, respondent reduced petitioners’
capital gain income for 1994 and 1995 by the reported capital
gains of $64,305 and $121,180, respectively, resulting from
petitioners’ receipt of the value-added payments. Respondent
reclassified the capital gain as Schedule C, Profit or Loss From
Business, income, treated that income as net earnings from self-
employment, and determined that petitioners were liable for self-
employment tax on that income. Respondent did not determine that
the income petitioners reported as net farm rental income must be
included in calculating petitioners’ net earnings from self-
employment for 1994 and 1995.
OPINION
Self-employment tax is imposed on the “self-employment
income” of every individual. Sec. 1401(a). “Self-employment
income” is defined as “the net earnings from self-employment
derived by an individual * * * during any taxable year”. Sec.
1402(b). “Net earnings from self-employment” is “the gross
income derived by an individual from any trade or business
carried on by such individual, less the deductions allowed by
this subtitle which are attributable to such trade or business”.
Sec. 1402(a). For purposes of section 1402, “The trade or - 12 -
business must be carried on by the individual, either personally
or through agents or employees.” Sec. 1.1402(a)-2(b), Income Tax
Regs. The self-employment tax provisions are broadly construed
in favor of treating income as earnings from self-employment.8
Braddock v. Commissioner, 95 T.C. 639, 644 (1990); Hornaday v.
Commissioner, 81 T.C. 830, 834 (1983); Hennen v. Commissioner,
T.C. Memo. 1999-306; S. Rept. 1669, 81st Cong., 2d Sess. (1950),
1950-2 C.B. 302, 354.
Respondent does not directly dispute that petitioners
retired from daily farming in 1988. Respondent contends only
that petitioners engaged in a trade or business of acquiring and
selling corn and corn products for profit during 1994 and 1995
and that petitioners derived the value-added payments from that
trade or business.
Petitioners claim that they were not engaged in a trade or
business from which they derived the value-added payments.
Petitioners assert that the value-added payments constituted
investment income attributable to their ownership of MCP common
stock. Petitioners maintain they correctly reported the value-
added payments on their 1994 and 1995 tax returns as proceeds
from the sale of capital assets excludable from net earnings from
8 We do not consider the provisions of subch. T of the Code, secs. 1381-1388, pertaining to the income taxation of cooperatives and their patrons, since none of the parties to this case place any reliance on those provisions. - 13 -
self-employment under section 1402(a)(3).9 In the alternative,
petitioners argue on brief that the value-added payments are
dividends paid with respect to their MCP stock, which are
excludable from net earnings from self-employment under section
1402(a)(2).10
We examine the parties’ contentions below, taking into
account the burden of proof, which rests upon petitioners. Rule
142(a)(1).11 Respondent’s determinations are presumed to be
9 Sec. 1402(a)(3) provides that, in computing a taxpayer’s net earnings from self-employment,
(3) there shall be excluded any gain or loss-– (A) which is considered as gain or loss from the sale or exchange of a capital asset,
* * * * * * *
(C) from the sale, exchange, involuntary conversion, or other disposition or property if such property is neither-–
(i) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, nor
(ii) property held primarily for sale to customers in the ordinary course of the trade or business; 10 Sec. 1402(a)(2) provides that, in calculating a taxpayer’s net earnings from self-employment, “there shall be excluded dividends on any share of stock”. 11 Sec. 7491 does not place the burden of proof on respondent because the examination in this case began before July 22, 1998. Internal Revenue Service Restructuring & Reform Act of 1998, Pub. (continued...) - 14 -
correct; petitioners must prove that respondent’s determinations
are erroneous in order to rebut the presumption and satisfy their
burden of proof. Id.; Welch v. Helvering, 290 U.S. 111, 115
(1933).
I. Trade or Business
Because only gross income derived from a trade or business
carried on by the taxpayer is taken into account in calculating
net earnings from self-employment, we first consider whether
petitioners carried on a trade or business during the years at
issue. The term “trade or business” has the same meaning for
purposes of section 1402 as it has for purposes of section 162.
Sec. 1402(c). “Trade or business” under section 162 has been
interpreted to mean an activity that is conducted “with
continuity and regularity” and with the primary purpose of making
income or a profit. Commissioner v. Groetzinger, 480 U.S. 23, 35
(1987).
Courts have sometimes struggled to differentiate a trade or
business from a passive investment. E.g., Hendrickson v.
Commissioner, T.C. Memo. 1987-566 (“It is often difficult to
distinguish a ‘trade or business’ from passive investments held
for the production of income.” (citing Higgins v. Commissioner,
312 U.S. 212, 217 (1941))). Whether a taxpayer is engaged in a
11 (...continued) L. 105-206, sec. 3001(c), 112 Stat. 685, 724. - 15 -
trade or business must be ascertained from a review of all the
relevant facts and circumstances. Commissioner v. Groetzinger,
supra (“in the absence of guidance, * * * We would defer * * * to
the Code’s normal focus on what we regard as a common-sense
concept of what is a trade or business”).
Neither party addressed directly whether petitioners’ rental
of their farm to the sons (rental activity), standing alone,
constituted a trade or business for purposes of the self-
employment tax. However, respondent appears to have accepted the
proposition that income generated by petitioners’ rental activity
is not subject to self-employment tax, presumably because of the
provisions of section 1402(a)(1).12 Consequently, we focus our
analysis on petitioners’ activities with respect to MCP in order
to decide whether petitioners were engaged in a trade or business
12 Sec. 1402(a)(1) provides that excludable farm rental income includes rent paid in crop shares. Sec. 1.1402(a)-4, Income Tax Regs., provides:
Rentals paid in crop shares include income derived by an owner or lessee of land under an agreement entered into with another person pursuant to which such other person undertakes to produce a crop or livestock on such land and pursuant to which (1) the crop or livestock, or the proceeds thereof, are to be divided between such owner or lessee and such other person, and (2) the share of the owner or lessee depends on the amount of the crop or livestock produced. * * *
Presumably because the sons leased petitioners’ farm during 1994 and 1995 and paid petitioners a portion of what was produced on the farm as rent, respondent did not determine that the income petitioners reported as farm rental income on Form 4835 was subject to self-employment tax. - 16 -
for purposes of the self-employment tax.
Petitioners originally purchased stock and units of equity
participation in MCP and executed their first UMAs to enhance
their ability to profit from the corn they grew on their farm.
Their membership in MCP enabled them to arrange for cost-
effective processing of the corn they grew and for the marketing
and sale of their corn and corn products through MCP. The
relationship apparently was so beneficial that, over the years,
petitioners continued to buy additional units of equity
participation, thereby increasing the amount of corn they would
be required to produce under the UMAs but also increasing the
amount of money they would be entitled to receive under the UMAs.
Although petitioners retired from daily farming in 1987 and
turned over their farm operation to the sons, petitioners
nevertheless continued to maintain their membership in MCP from
1987 through at least 1995. As active members of MCP during 1994
and 1995, petitioners, either directly or through the sons as
their agents,13 regularly and continuously (1) maintained their
status as producers under the UMAs, (2) made decisions regarding
how to satisfy their production and delivery obligations to MCP
under the UMAs, (3) acquired option pool corn which they used to
satisfy their production and delivery obligations to MCP several
13 Petitioners testified that the sons acted on their behalf and do not dispute that the sons operated as their agents in delivering and selling corn and other produce for their benefit. - 17 -
times each year, and (4) sold corn and corn products for profit
through MCP.
Under the UMAs, once petitioners satisfied their production
obligations by supplying corn they had either grown or acquired
from the option pool to MCP, MCP processed the corn and then
marketed and sold the corn and resulting products on behalf of
petitioners and its other members. In fact, the UMAs
specifically appointed MCP as petitioners’ agents to market and
sell the corn and corn products.
Respondent argues that petitioners’ involvement with MCP is
more than sufficient to qualify as a trade or business.
Moreover, respondent contends that MCP’s actions in processing,
marketing, and selling corn on behalf of its members can be
attributed to petitioners for purposes of this analysis because
the UMAs expressly designated MCP as petitioners’ agent to market
and sell the corn and corn products and because the contractual
designation is controlling.
Petitioners disagree, arguing their involvement with MCP was
so limited that it cannot qualify as a trade or business and that
MCP’s actions in processing, marketing, and selling the corn and
corn products cannot be attributed to them. Specifically,
petitioners contend that whether MCP was petitioners’ agent is
not controlled by the UMAs but must be decided by reference to
State law. According to petitioners, the law of agency in - 18 -
Minnesota requires a principal to retain some measure of control
over the agent for a valid agency relationship to exist. See
Jurek v. Thompson, 241 N.W.2d 788 (Minn. 1976). Petitioners
claim they retained no control over the processing of the corn
and the marketing and sale of the resulting corn products;
therefore, MCP was acting on its own account and not as
petitioners’ agent. According to petitioners’ analysis, unless
MCP was petitioners’ agent, petitioners’ limited involvement in
acquiring and delivering corn to satisfy their production
obligations is insufficient to constitute a trade or business
generating income subject to the self-employment tax.
We disagree with petitioners for several reasons. First,
whether MCP qualified as petitioners’ agent in processing,
marketing, and selling the corn petitioners acquired and
delivered to MCP in 1994 and 1995 is not essential to our
holding. Regardless of whether MCP acted as petitioners’ agent,
the record establishes that petitioners, by satisfying their
production obligations under the UMAs during 1994 and 1995,
regularly and continuously purchased and sold corn with the
intention of making a profit. Although petitioners may have
retired from daily farming in 1987, they did not cease to
function as dealers in corn following their retirement. In fact,
in 1990, 1991, 1992, 1994, and 1995, petitioners bought
additional units of equity participation and entered into - 19 -
additional UMAs, thereby obligating themselves to produce greater
quantities of corn to MCP each year. Petitioners’ argument
regarding control fails to adequately acknowledge petitioners’
expanding role as dealers who bought and sold corn to customers
for a profit.
The second reason is grounded in the unique nature of a
cooperative and its relationship to its members. In Puget Sound
Plywood, Inc. v. Commissioner, 44 T.C. 305, 306-309 (1965), we
examined the nature and attributes of a cooperative in general in
order to decide whether a workers cooperative association was a
nonexempt cooperative association entitled to exclude patronage
distributions from its gross income for Federal income tax
purposes. In so doing, we quoted the following description of a
cooperative contained in 7 Ency. Am. 639 (1959):
“A cooperative is an organization established by individuals to provide themselves with goods and services or to produce and dispose of the products of their labor. The means of production and distribution are those owned in common and the earnings revert to the members, not on the basis of their investment in the enterprise but in proportion to their patronage or personal participation in it. Cooperatives may be divided roughly into consumer cooperatives and producer cooperatives.
Producer [cooperative] organizations operate for the benefit of the members in their capacity as producers. Their function may be either the marketing or processing of goods produced individually (as in fishermen’s or farmers’ marketing associations, or associations which make butter or cheese from farm products received from farm members), or the marketing - 20 -
of goods processed or produced collectively (as in the so-called workers’ [cooperative] productive associations operating factories or mills).” [Emphasis supplied.]
Puget Sound Plywood, Inc. v. Commissioner, supra at 306-307.
We noted that three fundamental principles underlie a
cooperative: (1) Subordination of capital; (2) democratic control
by the cooperative’s members; and (3) the allocation among
members of the economic results in proportion to the members’
active participation in the cooperative endeavor. Id. at 308.
Regarding the second element, we stated that a cooperative
effects democratic control by requiring the members to
“periodically assemble in democratically conducted meetings at
which each member has one vote and one vote only, and at which no
proxy voting is permitted; and these * * * [members] there deal
personally with all problems affecting the conduct of the
cooperative.” Id.
MCP was an agricultural cooperative characterized by
subordination of capital, democratic control by its members,14
and the distribution of its operational proceeds on the basis of
patronage. MCP’s bylaws confirm that members had substantial
control over its operations. Moreover, petitioners failed to
introduce evidence to support a finding that, as cooperative
14 Under MCP’s articles of incorporation, each MCP member was entitled “to only one vote on each matter submitted to a vote at any meeting of the members regardless of the number of shares of common stock held by such member.” - 21 -
members, they could not influence MCP’s operations. Petitioners’
argument that they did not have a sufficient level of control
under Minnesota law to support the explicit contractual
designation of MCP as petitioners’ agent, even if relevant to our
analysis, is unsupported by any convincing proof in the record.
Finally, petitioners have failed to convince us that
Minnesota law invalidates an express contractual agency
designation when both the designated agent and the designated
principal adhere to the terms of the contract. Petitioners
voluntarily entered into multiple UMAs with MCP, which were in
effect for 1994 and 1995. Each of those UMAs clearly designated
MCP as petitioners’ agent for the marketing and sale of the corn
petitioners had acquired and delivered pursuant to the UMAs.15
There is no dispute that petitioners produced corn as required by
the UMAs, or that MCP marketed and sold petitioners’ corn and
corn products as required by the UMAs, thereby generating the
value-added payments. Given these undisputed facts, petitioners’
argument that the contractually based agency designation may be
15 Petitioners also argue that, because they designated MCP as their agent for the marketing and sale of corn but not for its processing, no agency relationship was created. This argument makes no sense and we reject it. Petitioners appointed MCP as their agent to market and sell the corn they had acquired and delivered to MCP under the UMAs. Whether MCP was operating as petitioners’ agent in processing the corn does not control our analysis of whether petitioners were in the business of acquiring, marketing, and selling corn and corn products for profit. - 22 -
disregarded under State law simply does not ring true.
Petitioners rely primarily on Hansen v. Commissioner, T.C.
Summary Opinion 1998-91, which has no precedential value, see
sec. 7463(b), and Felber v. Commissioner, T.C. Memo. 1992-418,
affd. without published opinion 998 F.2d 1018 (8th Cir. 1993),
for the proposition that the value-added payments are not subject
to self-employment tax. In Felber, we held that a wheat farmer
was not liable for self-employment tax on income received by him
and generated from the sale of wheat by a tenant farmer under a
crop-sharing agreement because we found that the taxpayer was
retired and was only minimally involved in the production of
wheat. The issue, however, was whether the exclusion from net
earnings for rentals from real estate applied.16 See sec.
1402(a)(1); sec. 1.1402(a)-4(b), Income Tax Regs. We did not
address any argument that the taxpayer operated a trade or
business of acquiring and selling agricultural products through
the cooperative as his agent, and/or through the tenant farmer as
his agent, employee, or partner.
Unlike the parties in Felber v. Commissioner, supra, the
parties in this case have raised and argued issues focusing on
whether petitioners, after they retired from daily farming,
continued to carry on a trade or business by acquiring,
16 Petitioners do not contend that the value-added payments qualify for this exclusion. - 23 -
delivering, and selling corn. The facts support a conclusion
that petitioners continued to acquire, market, and sell corn and
corn products either directly to MCP or through MCP as their
agent. Consequently, our decision in Felber simply is not
applicable with respect to whether petitioners carried on a trade
or business during 1994 and 1995 involving MCP. We hold that
petitioners were engaged, during 1994 and 1995, in continuing and
regular efforts to reap a profit from the acquisition, marketing,
and sale of corn and corn products and that those efforts
constituted a trade or business.
II. Income Derived From a Trade or Business
When faced with whether a taxpayer must treat a particular
item of income as net earnings from self-employment, we have
consistently stated that the taxpayer must derive the income in
question from a trade or business carried on by the taxpayer.
Newberry v. Commissioner, 76 T.C. 441, 444 (1981); Ray v.
Commissioner, T.C. Memo. 1996-436. In other words, there must be
a nexus between the trade or business and the income that the
taxpayer has received. Newberry v. Commissioner, supra at 444.
We are satisfied that the value-added payments were derived
from petitioners’ trade or business. Petitioners, either
directly or through the sons as their agents, regularly acquired
and delivered option pool corn to MCP which MCP processed and
then marketed and sold for petitioners. Under the UMAs, MCP was - 24 -
required to make value-added payments as further consideration
for the corn delivered by petitioners. The amount of value-added
payments petitioners received from MCP was based on petitioners’
patronage; i.e., the amount of corn acquired and delivered by
petitioners to MCP during the processing year.
In Shumaker v. Commissioner, T.C. Memo. 1979-71, affd. on
this issue and revd. on another ground 648 F.2d 1198 (9th Cir.
1981), we concluded without discussion that patronage
distributions were subject to self-employment tax under sections
1401 and 1402. On appeal, the Court of Appeals for the Ninth
Circuit affirmed our conclusion, holding that “patronage
dividends from farmer’s cooperatives was properly subject to
self-employment tax.” Shumaker v. Commissioner, 648 F.2d at
1200.
Because the value-added payments were directly related to
the volume of corn acquired and delivered by petitioners to MCP
and were paid in consideration for petitioners’ patronage, the
value-added payments had a direct nexus to petitioners’ trade or
business and, consequently, were derived from that trade or
business. Therefore, unless the exclusion under either section
1402(a)(3) or (2) applies to the value-added payments, those
payments must be included in calculating petitioners’ net
earnings from self-employment. - 25 -
III. Exclusions Under Section 1402
A. Introduction
Section 1402 contains several provisions which exclude
specified types of income from the calculation of net earnings
from self-employment. Petitioners contend that the value-added
payments are excludable under either section 1402(a)(3) or (2).
B. Section 1402(a)(3)
Section 1402(a)(3) excludes from the calculation of net
earnings from self-employment any gain or loss (1) from the sale
or exchange of a capital asset, or (2) from the sale, exchange,
or other disposition of property if the property is neither stock
in trade or other property of a kind normally includable in
inventory if on hand at the close of the taxable year nor
property held primarily for sale to customers in the ordinary
course of the taxpayer’s trade or business.
Although their argument is not entirely clear, petitioners
seem to contend that, because they acquired their MCP stock for
investment purposes, the corn they acquired during 1994 and 1995
and delivered to MCP for processing, marketing, and sale was a
capital asset. Petitioners’ argument is confusing and erroneous,
and we reject it.
Petitioners did not sell their MCP stock. They sold option
pool corn acquired from MCP. Petitioners’ motivation in
acquiring their MCP stock has no bearing on whether the option - 26 -
pool corn they purchased to satisfy their production and delivery
obligations under the UMAs qualifies as a capital asset. Rather,
it is the character of the property sold that controls the
analysis under section 1402(a)(3).
Section 1221 defines capital asset broadly as “property held
by the taxpayer (whether or not connected with his trade or
business)” but excludes from that definition property described
in section 1221(a)(1) through (5). The exclusions include stock
in trade of the taxpayer, other property of a kind normally
includable in inventory if on hand at the close of the taxable
year, and property held primarily for sale to customers in the
ordinary course of the taxpayer’s trade or business. Sec.
1221(a)(1); see also sec. 1402(a)(3)(C).
In this case, the property sold was corn and corn products.
The corn in question was acquired by petitioners to satisfy their
production and delivery obligations under the UMAs so that the
corn and any resulting corn products could be sold by MCP on
petitioners’ behalf to customers in the ordinary course of
petitioners’ business. The value-added payments resulted from
those sales. We hold, therefore, that the value-added payments
are not excludable under section 1402(a)(3) in calculating
petitioners’ net earnings from self-employment.
C. Section 1402(a)(2)
Petitioners alternatively argue that, if the exclusion under - 27 -
section 1402(a)(3) does not apply, the exclusion under section
1402(a)(2) operates to exclude the value-added payments because
those payments were really dividends paid with respect to
petitioners’ MCP stock. Section 1402(a)(2) excludes from the
calculation of net earnings from self-employment dividends on
stock.
Ordinarily, “dividend” is a term of art used to describe a
distribution of property made with respect to a shareholder’s
stock out of the current or accumulated earnings of a
corporation, which is taxed to the shareholder as ordinary
income. See secs. 61(a)(7), 301(c), 316(a). By its nature, a
dividend paid with respect to stock is a return on a
shareholder’s capital investment. In contrast, a patronage
distribution17 is a payment of a cooperative’s net income
calculated by reference to a member’s participation in, or
patronage of, the cooperative’s activities.
17 Patronage distributions are described by a variety of different names such as patronage dividends, patronage refunds, and value-added payments. No matter what words are used to describe a particular distribution, the controlling characteristic appears to be whether the payment is determined by the level of a member’s participation in a cooperative. See also sec. 1388(a), which defines “patronage dividend” for purposes of subch. T as an amount paid to a patron by a qualifying cooperative on the basis of quantity or value of business done with or for that patron under a preexisting obligation of the cooperative to pay that amount, and the amount is determined by reference to the cooperative’s net earnings from business done with or for its patrons. - 28 -
In this case, petitioners have offered no evidence to
support their alternative argument that the value-added payments
were really dividends paid with respect to their MCP stock. In
fact, the record contains compelling evidence against
petitioners’ argument. For example, MCP’s articles of
incorporation provided that “No dividends shall be paid on the
common stock of this association” and permitted noncumulative
dividends, which could not exceed a specified percentage, only
with respect to MCP’s preferred stock.18 The articles also
provided that “All net proceeds (savings) of this association in
excess of dividends, if any, shall be distributed to patrons
annually or oftener on the basis of patronage”. These provisions
reinforce other evidence in the record that establishes the
value-added payments were paid in consideration for the quantity
of business petitioners conducted with MCP. The value-added
payments were calculated on the basis of the corn petitioners
acquired and delivered to MCP during 1994 and 1995.
On the evidence before us, we conclude that the value-added
payments were paid with respect to and as additional
consideration for the corn petitioners acquired, delivered to
MCP, and sold; they were not paid with respect to petitioners’
MCP stock. We hold, therefore, that the value-added payments are
18 Petitioners did not own any of MCP’s preferred stock during the years at issue. - 29 -
not excludable under section 1402(a)(2) in calculating
IV. Conclusion
We find that petitioners were engaged in the business of
acquiring, marketing, and selling corn and corn products during
1994 and 1995, and that they derived the value-added payments
from that business. We hold, therefore, that the value-added
payments of $132,375 and $207,612 in 1994 and 1995, respectively,
reduced by petitioners’ acquisition costs of $18,070 and
$16,431, respectively, constitute petitioners’ net earnings from
self-employment under section 1402. However, because respondent
did not move for an increased deficiency in this case, any
deficiency determined as a result of this opinion may not exceed
the deficiencies determined in the notice of deficiency.
We have considered the parties’ other arguments and, to the
extent not herein discussed, find them to be without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.