Ask the Tax Man

Andy Biebl DTN Tax Columnist

Question:

Our family formed two LLCs last year. The first LLC holds the farm land, and is owned by all family members (brothers and their spouses, nephews, and non-farming siblings). The second LLC is the active farming entity, and is owned by those who are actively involved in production. The operating LLC pays rent to the real estate LLC under a straight cash rent arrangement. Our attorney thinks that perhaps the wives do not have to pay self-employment Social Security tax on their share of the rent income from the real estate LLC, but that those who are active in the operation should pay Social Security tax on their share of the rent. Is that correct?

Answer:

First, congratulations on your structure. You've recognized that all in the family can share in the return on the land investment (the rent), but only those involved in production participate in that income. As to your question, your attorney might be confusing the passive loss restrictions in the income tax part of the code with the self-employment Social Security tax (SE tax) rules. As a starting point, real estate rentals are exempted in the tax code from SE tax. A landlord, including an entity, collecting cash rent and providing no other services to the tenant entity, even a related party, would meet that exemption from SE tax for all partners/members of the LLC. That matter was cleared up in the Eighth Circuit McNamara decision 12 years ago.

Your attorney is probably thinking of the "self-rental" regulations built into the passive loss restrictions. Passive losses are generally only deductible to the extent of passive income. To prevent taxpayers from too easily creating passive income on self-rentals, the regulations say that leasing land to a business in which you materially participate does not create passive rental income that can offset other passive losses. Those rules are generally unimportant to farm landlords, as most do not have other passive loss activities. But the SE tax exemption is important, and all of the LLC land entity owners will receive that exemption on their share of the rent.