Material Participation for Lease Arrangements
Farm Business Management Update, October 1997
By Frank E. Smith of the Department of Agricultural and Applied Economics, Virginia Tech
One landowner wants his farm income to count toward self-employed earnings because he wants to pay more into Social Security so that he will receive a bigger retirement income. Another landowner does not want her farm income to count as self-employed earnings because she doesn't want the income to decrease her Social Security benefits. Still another landowner cannot decide whether or not to materially participate because he doesn't want his Social Security benefits to be cut, but wants to have his estate qualify for current use valuation. Material participation will be the determining factor in all cases.
If you do not materially participate in the farming operation, the rent that you receive from a lease arrangement is considered to be investment income; no Social Security tax is paid and the income does not cut your Social Security benefits. If you do materially participate, the rent is considered to be earnings from self-employment; Social Security tax is paid and the income received can reduce your Social Security benefits if your earned income is above the amount allowed by the Social Security Administration. (Currently, persons 65 to 69 years of age can have $11,520 of earned income from self employment or wages without losing any Social Security benefits; 62 to 64 years of age, $8,820; 70 years of age and older, unlimited.)
A problem may arise when a farmer retires and starts drawing Social Security while his son continues in the farming operation. It is sometimes hard to convince Social Security that the father is not still actively involved in the operation. They may want to reduce the father's Social Security benefits, especially if he continues to live on the place and has daily contact with the son. Thus, it becomes quite important for the father to prove that he is not materially participating in the farming operation.
It is wise to explain whether you plan to materially participate in the written lease. The following four tests will allow you to determine your material participation status.
Test Number 1
You do any three of the following:
The direct costs of farm production of a commodity include such items as seeds, plants, feed, fertilizer, fuel, machinery repair, pesticides, and farm supplies. Living expenses for the tenant, taxes, depreciation, insurance and unpaid tenant's labor are not considered costs of production.
Inspections that are done to promote production will count toward material participation. Any visit during spring planting, cultivation, or harvesting seasons will count -- especially if no other visit is made during the year. Advising and consulting which answer the questions what, where, when, or how tasks are to be performed in producing the commodities are also considered material participation.
Test Number 2
You regularly and frequently make or take an important part in making management decisions that substantially contribute to or affect the success of the enterprise(s).
Making decisions such as what, when, and where to plant, cultivate or spray, or when to harvest the crop; what goods to buy, sell, or rent; and what records to keep implies material participation.
Test Number 3
You work 100 hours or more spread over a period of 5 weeks or more (not necessarily consecutive) in activities connected with crop production.
Landowners may be materially participating if they are contributing significantly to production, even though they are not working over 100 hours or more spread over a period of 5 weeks. They do not have to actually be plowing, planting, cultivating, or operating a combine to be considered materially participating. They may keep farm records, build or repair fence, buildings, and farm equipment used in connection with farm commodity production. Just because the retired farmer works as an employee of his son's operation and is paid separately, does not necessarily mean that wages would count toward material participation.
Test Number 4
You do things which, considered in their total effect, show that you are materially and significantly involved in the production of the farm commodities.
Even though individual work and decisions may not indicate material participation, different situations and combinations based on the total picture may indicate material participation.
Material participation rules can be hard to define in particular situations. Therefore, if there is any reason to question whether material participation is indicated in a particular lease arrangement, you should check with your local Social Security office or your attorney. It would be wise to obtain their answer in writing, if possible. If you want to materially participate, keep a daily record of your activities such as the dates you made farm visits, the hours worked and the type of work performed, and any planning sessions that you made with the tenant.
For further information see Neil Harl's Farm Estate and Business Planning; Dunaway and Dunteman's Farm and Ranch Lease Guide; and IRS Publication 225 Farmer's Tax Guide.
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