Material Participation under 2032A

Although the primary source of analysis for this Memorandum has been gleaned from a Dickinson Law Review article entitled "Material Participation Under Section 2032A: It Didn’t Save the Family Farm But it Sure Got Me Tenure", pp. 561-604, written by Marin D. Begleiter in 1990, I have checked most of the citations and they are still good law. I also sheppardized the cases which also appear to still be good law, and according to RIA Tax Desk Analysis (hereinafter "RIA") ¶771,020 are still cited as most authoritative. A review of RIA ¶771,020 affirms much of what is set forth in this Memorandum. Finally, I confirmed much of what is in this Memorandum with the treatise by Neil E. Harl (an imminent authority in this area) entitled Farm Estate & Business Planning (16^th Ed.). Therefore, in the interest of time and keeping the costs down, little other in depth case law research was performed, other than to do searches for federal cases using the search terms "2032A" and "material participation" which proved unproductive in finding better or more current authority for the analysis set forth herein.

If the requirements of section 2032A are met, real property used in a farm for farming purposes is valued for estate tax purposes at its value as a farm or business. I.R.C. § 2032A(a)(1), (b)(2)(A). I will not detail the (at least) eight requirements unless asked to do so; they are obvious from a reading of the Code provision. I will draw attention to one requirement of relevance:

I.R.C. § 2032A(b)(1)(c).

In addition, the statute has a recapture provision that is activated under certain conditions. If, within ten years of the date of the decedent’s death and before the death of the qualified heir, the qualified heir disposes of his interest in the qualified real property (other than by disposition to a member of the qualified heir’s family), or ceases to use the property for the qualified use, and additional estate tax (or recapture tax) is imposed in order to recapture the savings made possible by special use valuation. I.R.C. § 2032A(c)(1). One method of ceasing to use the property for a qualified use is if, during any eight year period ending after the decedent’s death, there are periods aggregating three years or more during which the decedent or a member of his family (before the decedent’s death) failed to materially participate in the operation of the farming business. I.R.C. § 2032A(c)(7)(B).

Passively collecting rents, salaries, draws, dividends, or other income from the farm is not material participation. Nor is merely advancing capital and reviewing a crop plan or other business proposal and financial reports each season or business year. Treas. Reg. § 20.2032A-3(a); RIA ¶771,020.

Section 2032A(e)(6) provides: "Material participation shall be determined in a manner similar to the manner used for the purposes of paragraph (1) of section 1402(a) (relating to net earnings from self-employment). I.R.C. § 2032A(e)(6). The legislative history does not elaborate on this definition. Therefore, attention must be given to Code section 1402(a).

Code section 1402(a) defines net earnings from self-employment for the purposes of imposing the tax on self-employment income. See I.R.C. § 1401 (imposes a tax on self-employment income and prescribes the rates). Rental income from real estate is excluded from the definition unless the rental income is derived from an arrangement with the tenant which "provides ... that there shall be material participation by the owner ... in the production or the management of the production" in the agricultural commodities produced and such material participation actually takes place. I.R.C. § 1402(a)(1). If such is the case, the rental income derived in included in the owner’s self-employment income and is subject to tax.

Both an arrangement providing for material participation and actual material participation by the owner in the production or management of production are required. Treas. Reg. § 1.1402(a)-4(b)(1) (1986). Services performed by an employee or agent are excluded for this purpose. Thus, the test for material participation will focus on the meaning of production and management of production.

Production:

Production is composed of two major elements: physical work and the furnishing of resources. Treasury Reg. § 1.1402(a)-4(b)(3)(ii) (1986) provides:

Although physical work alone may constitute material participation, the regulation provides that the furnishing of materials and being responsible for expenses alone cannot. (However, this part of the regulation has been rejected in dictem. Henderson v. Flemming, 283 F.2d 882, 888-89 (5^th Cir. 1960).) The furnishing of resources and expenses becomes important in cases when the physical work does not rise to the level of material participation.

Management of Production:

Management of production is a term employed primarily to refer to the responsibility for and the actual making of decisions, and other regulations list a number of decisions that will be taken into account; these decisions and activities are:

Treas. Reg. § 1.1402(a)-4(b)(3)(iii) (1986). The regulations single out as particularly important making inspections of the production activities and advising and consulting with the actual producer, which together will create a "strong inference" of material participation. Id. Selection of crops, machinery, or implements and deciding on crop rotation are downplayed, but may become significant in the overall determination of material participation. Id.

Few cases exist under Code Section 1402(a), but the Social Security Act Section 211(a)(1), which mirrors the language of Section 1402(a)(1) of the Code, including the material participation test, is fertile ground for analogy. Both require an arrangement for and actual material participation and both require participation in either production or management of production, or both. 20 C.F.R. 404.1082(c) (1979).

The existence of material participation "is a factual determination that can only be made on a case-by-case consideration." Hoffman v. Ribicoff, 305 F.2d 1, 9 (8^th Cir. 1963). "Material" is to be given "its common and well-understood meaning" of "solid or weighty character; substantial; of consequence; not to be dispensed with; important." Foster v. Celebrezze, 313 F.2d 604, 607 (8^th Cir. 1963). As previously stated, material participation can be accomplished in either the production of the commodity, management of the production of the commodity, or a combination of the two. Treas. Reg. §§ 1.1402(a)-4(b)(3)(I), 1.1402(a)-4(b)(4) (1986); 20 C.F.R. § 404.1082(c) (1979).

The regulations indicate that some physical work is necessary to material participate in the production of a commodity. Treas. Reg. §§ 1.1402(a)-4(b)(3)(ii) (1986) (stating that production refers to "the physical work performed and the expenses incurred in producing a commodity" but further states that "the mere undertaking to furnish machinery, implements and livestock and to incur expenses is not, in and of itself, sufficient," thus implying that some physical work is required. However, this position was rejected in the oft-quoted dictum of Henderson v. Fleming, 283 F.2d 882 (5^th Cir. 1960):

In Bridie v. Ribicoff, 194 F. Supp. 809 (N.D. Iowa 1961), the owner’s only physical work consisted of watering livestock on a few occasions, helping the tenant load the cattle for market, driving the tractor during haying, and helping the tenants innoculate soybeans. Id. at 813. These activities alone were not deemed to have come close to material participation. However, other factors were viewed as satisfying material participation. The owner/plaintiff leased the farm (a livestock operation in which the crops grown on the land were fed to the livestock) on a stock share basis. Id. at 810. Although the tenant furnished the machinery, the owner/plaintiff was required to furnish one-half of the expenses of threshing, combining of soybeans, twine and other associated expenses. Owner/plaintiff advanced all the money to buy the feeder cattle and sows and the tenants did not reimburse him until the animals were sold. Id. The court held that the plaintiff’s furnishing of expenses and advancement of capital, combined with his periodic advice and consultation with the tenants, periodic inspection of livestock, and involvement in management decisions constituted material participation. Id. at 815-16.

In Celebrezze v. Miller, 333 F.2d 29 (5^th Cir. 1964), plaintiff was eighty-two years old and spoke no English. Id. at 30. His physical activities had been greatly reduced seven years prior ot the years in question. Id. at 31. Two tenants cultivated the cotton, corn, and sweet potatoes on the 121-acre farm and received two-thirds of the crop. The oral arrangement requiring plaintiff to inspect the crops three or four times a month, pay one-third of the costs of fertilizer, poisons, and labor hired, absorb one-third of the losses, and advise and consult with the tenants during the inspections as to where to plant the crops and the application of fertilizer and poisons. Id. at 30-31. The tenants conducted the farm operation, furnished the seed, tilled the crops, arranged for additional hired labor when necessary, and applied the fertilizer and poisons. Id. at 31. In a short opinion, the court held that the plaintiff materially participated in the production. This decision stands for the proposition that the furnishing of one-third of the expenses, together with periodic inspection of the crop, constitutes material participation.

Many other decisions could be discussed. It should be noted that many of the cases have focused in some way on the risk assumed by the owner. Begleiter, M.D., Material Participation under Section 2032A: It Didn’t Save the Family Farm But it Sure Got Me Tenure (1989). One example of the origin of this analysis is Henderson v. Flemming, 283 F.2nd 882 (5^th Cir. 1960) which involve Mrs. Poole, a ninety-one year-old invalid confined to a wheel chair. The arrangement required her to break ground and to plant the crop, which she did through a family member (her son) on a contract basis. Id. at 885. The court held that the physical work involved was apparently insufficient to constitute material participation. Id. at 887-88. The owner was required to furnish seed, to pay one-half of the cost of insecticide, to pay the fuel costs, and to absorb the depreciation on the machinery. These costs were substantial, especially in relation to her income from the farming operation. Id. at 855-86. Although the responsibility for the expenses combined with the physical work of her son could have been the basis for a finding of material participation, the court based its decision on the risk taken by the owner. Id.

After noting in Henderson v. Flemming the significance of capital in operating a modern farm, the court emphasized the importance of this risk:

Id. at 885.

Management in the production–decision making–is also important in the determination of material participation despite the emphasis of the regulations on physical work. The courts have instead focused on the furnishing of resources and the risk undertaken by the owner. A similar process has occured in the other means of satisfying the material participation test: the management of production. The regulations specify two factors–the making of managerial decisions relating to the production of the commodity, and advising, consulting, and inspecting the production facilities–to be considered in the decision on material participation. Treas. Reg. § 1.1402(a)-4(b)(3)(iii) (1986); 20 C.F.R. § 404.1082(c)(2)(iii) (1979). Despite the language in the regulations, the decided cases have, on the whole, taken the more logical position that the decisive factor should be who makes the final and more important decisions and that inspections, consultation, and advice are only a factor to be considered in the determination.

Perhaps the clearest case illustrating the emphasis of the courts on decision making is McCormick v. Richardson, 460 F.2d 783 (10^th Cir. 1972). On his retirement, Id., McCormick became active in managing a 160-acre farm he owned in Illinois, which had become badly run down. Id. at 784. He hired a person to clear a woodland area, remove the timber and stumps, and prepare the land for planting. Id. He and the tenant (who farmed the land under an oral arrangement with McCormick for the past seven years) agreed that modern farm machinery was required, which was purchased by the tenant. Id. Under the arrangement, McCormick was responsible for the cost of furnishing and spreading lime and rock phosphate, the real estate taxes, insurance, building and fence repair, the cleaning and maintenance of a drainage-ditch on the farm, the cost of clover seed, nitrogen, poison and weed killer, and forty percent of the cost of fertilizer. Id. at 785

Although the court might have based its decision on the resources furnished by the owner, instead it emphasized McCormick’s management in finding he materially participated in the management of production. McCormick determined when soil tests should be made and had them done, and he carefully and regularly inspected the production activities. During his inspections each fall, he particularly focused on the production of each grain, how the ground was seeded, and the use of weed killer. Id. He also had aerial photographs made of the different fields. Id. From these inspections, McCormick determined a detailed plan for the following year’s crops. Id. Though McCormick and the tenant usually agreed, it was understood that in the event of disagreement, McCormick reserved the right to make the final decision. Id. at 785 (emphasis added). McCormick prepared a careful plan of crop rotation each fall, and decided whether a government crop plan should be used. Id. He also devised several innovative methods to deal with problems of the farm that greatly increased the farm’s production. Id. at 785-86. The court ruled that McCormick made a "very substantial and helpful contribution to the management of production, which resulted in a very large increase in the amount of crops produced," which constituted material participation. Id. at 787.

Another leading case in this area is Foster v. Celebreezze, 313 F.2nd 606 (8^th Cir. 1963). The lease provided that the tenants agreed "to put in such crops in such manner as the landlord may direct." Id. at 608. The court ruled that this provision gave the owner "broad managerial powers," including the rights to direct and supervise the preparation of the seed bed, the time and method of planting the seed, the amount of seed planted, and other matters "which would appear to be substantial managerial functions which would have a material bearing upon production." Id. Together with other lease provisions that gave the owner the rights to approve seed planted, to designate the fields on which manure was spread as fertilizer, to determine which meadows and fields were to be ploughed, to direct weed cutting and clipping of clover, and to determine participation in government support programs, the court determined that the quoted provision constituted an arrangement for material participation under the normal meaning of that term. Id. Although the court mentioned that the exercise of the owner’s reserved rights would require numerous and periodic advice and consultation, the decision is clearly based on the decision-making power of the owner. Id.

Perhaps the two most important cases to illustrate the importance of decision-making are Hoffman v. Gardner, 369 F.2d 837 (8^th Cir. 1966), and Colegate v. Gardener, 265 F. Supp. 987 (S.D. Ohio 1967).

In Hoffman, supra., the claimant lived in Missouri. His farms in Iowa were supervised by his brother-in-law, who farmed land near the claimant’s farms. Hoffman v. Gardner, 369 F.2d 837, 839 (8^th Cir. 1966). The only evidence of advice, inspections, and consultation were that the claimant consulted periodically with his brother-in-law and occasionally with the tenants directly by telephone and letter, sometimes instructing the tenant about crops, and that claimant and his daughter spent one week a year on the farms. Id. All other advice, consultation, and inspections were made by the brother-in-law, who kept claimant advised of the conditions and relayed claimant’s instructions to the tenants. Id. The leases, however, gave claimant complete managerial control; the tenants were only permitted to make suggestions. Id. The owner determined the crops to be planted, the time and location of the planting, the type of seed, the crop rotation plan, the price and time of sale of the crops, and conservation measures. Id. He kept charts showing crop information and each year sent the tenants a map showing where to fertilize, the type of fertilizer, terracing, and other matters. Id. at 839. The court had no trouble holding that the owner made important decisions concerning the production and that this constituted material participation, despite the limited inspections. Id. at 841-42.

In Colegate, the claimant owned and lived on a 65-acre farm. Colegate v. Gardener, 265 F. Supp. 987, 988 (S.D. Ohio 1967). She entered into an arrangement with a neighbor to farm most of her acres. Expenses were shared equally, except that the tenant provided the machinery. Id. At planting time, claimant made two inspections of the area, each lasting about 15 minutes. Id. at 989. She made no regular inspections during the growing season, but went "around the outside of the crops." Id. When the crop was harvested, claimant made sure that her share of the crop was put in the proper place. Id. The only evidence on managerial decisions made by the owner was that she decided what she wanted planted, a subject on which there was apparently some disagreement between the owner and the tenant. Id. at 989. The court did not view the joint nature of most decisions or the near absence of disagreement between the owner and tenant as unusual or as reflecting on the material participation of the owner’s participation. Id. The court made short work of the argument that the claimant did not materially participate because she made only two inspections of fifteen minutes each and that consultation between the owner and the tenant took place so infrequently. The court held that the owner material participated.

From the above cases, it would appear that the courts have had an expansive view of what constitutes decision-making for material participation purposes for Social Security purposes.

The above cases form a backdrop with which to view material participation under Section 2032A. The Code only provides that material participation "shall be determined in a manner similar to the manner used for purposes of paragraph (1) of section 1402(a) (relating to net earnings from self-employment). I.R.C. § 2032(e)(6). The apparent purpose of this requirement was to keep the qualified real property in farm or business use in furtherance of the statute’s purpose of preserving the family farm. H.R. Rep. No. 94-1380, 94^th Cong., 2d Sess. 22 (1976). Material participation can be accomplished either by the decedent or a member of his or her family (prior to decedent’s death) and by either the qualified heir or a member of the qualified heir’s family (after the decedent’s death). I.R.C. § 2032A(b)(1)(C)(ii), (c)(6)(B). The Internal Revenue Service has issued regulations designed to delineate the activities that will constitute material participation. Tres. Reg. § 20.2032A-3 (1986). (It should be noted, however, that the Service has ruled that material participation is a factual determination (made by the courts) and that the Service will not issue advanced ruling on whether, under a given set of facts, material participation exists. Priv. Ltr. Rul. 86-10-073 (Dec. 12, 1985).

The first test is that "[a]ctual employment of the decedent (or a member of the decedent’s family) on a substantially full-time basis (35 hours a week or more) or to any lesser extent necessary to personally manage fully the farm or business in which the real property to be valued under Section 2032A is used constitutes material participation." Treas. Reg. § 20.2032A-3(e)(1) (1986). (Note, the regulations require that, if the individual is self-employed with respect to the farm, his or her income from the farm must be earned income for self-employment tax purposes for the participation to be materially participating. However, nonpayment of the tax creates a presumption of lack of material participation and requires that the executor demonstrate to the Service that material participation occurred and explain the reason for why taxes were not paid. In addition, all self-employment taxes due must be paid. Id.) The activities of agents or employees (other than family members) are not considered in the determination of material participation. The income tax regulations are similar. Treas. Reg. § 1.1402(a)-4(b)(5) (1986).

If the involvement is less that full-time, the activities "must be pursuant to an arrangement providing for actual participation in the production or management of production where the land is used by any non-family member, or any trust or business entity, in farming or another business." Treas. Reg. § 20.2032A-3(e)(1) (1986) (emphasis added). (It is important to note that the same words, production or management of production, as are used in the regulations under § 1402 and in the Social Security Act, are used here.)

At the heart of the regulations is section 20.2032A-3(e)(2), which enumerates the factors considered in determining material participation:

Therefore, the same tests are used in section 2032A regulations (participation in the production or management of production) as are used in the regulations under section 1402 of the Code. All of the factors enumerated in section 2032A regulations are contained in the section 1402 regulations or have been recognized by case law under the Social Security Act. The sole difference is that section 2032A regulations appear to contemplate involvement in several of the enumerated activities in order to constitute material participation. As shown in the early cases under section 2032A, there appears to be an unstated element or provision that even if, for example, the decedent and the qualified heir (or members of their families) made most of the final management decisions, this would not be enough to constitute material participation without inspections or advice and consultation, or the assumption of financial responsibility for a substantial portion of the risk, or the maintenance of a home on the farm. (See, e.g., Estate of Coon v. Commissioner, 81 T.C. 602 (1983) (a poorly decided case where the court found no material participation despite the fact that the landlords assumed a substantial portion of the operating expenses of the farms and that decedent’s brother did participate in management decisions, ostensibly because the tenants made many of the operating decisions); Estate of Coffing v. Commissioner, 53 T.C. Memo (CCH) 1314 (1987) (relying exclusively on seciton 2032A regulations, although some of the decisions were made by the decedent, almost all decision-making powers were delegated to a corporate farm operator, the court found no material participation–as should be the case); Estate of Ward v. Commissioner, 89 T.C. 54 (1987) (Although the court found material participation, it required a higher standard than evidenced by the case under section 1402. The court emphasized that decedent consulted with the tenant directly, rather than using a farm manager or other agent [which is correct in this regard].). As shown above, this is not in keeping with the cases under section 1402 or its regulations.

Later cases under section 2032A take the position that management of operations in the typical crop share arrangement [if indeed there is one] is sufficient for material participation. See Mangels v. United States, 828 F.2d 1324 (8^th Cir.1987), rev’g, 632 F. Supp. 1555 (S.D. Iowa 1986). Some attention need to be paid to both the district court case and ruling, and that of the circuit court which reversed the district court’s ruling.

Decedent, Mangels, died in 1980. From 1966 until her death, decedent was physically and mentally incapacitated and unable to handle her own affairs. Id. at 1325. She was a ward of a voluntary conservatorship. From 1974 until her death, Northwest Bank served as decedent’s court-appointed conservator, the Lage, a vice-president of the bank, performing all acts for the conservator relating to the management of the farm. Neither decedent (or a family member) resided on the farm during the eight years preceding her death. Id. at 1555. The farm income was not reported as self-employment income on decedent’s tax returns because the conservator did not understand the "complex provisions of the Internal Revenue Cod and related regulations." Id. At least two tenants were experienced farmers. All machinery and implements used on the farm were furnished by tenants, but decedent, through the conservator, paid one-half of the costs of fertilizer, seed, pesticide, and herbicide and the full cost of installing tile lines. Id. at 1557, 1560. From 1974 until 1980, Lage’s activities respecting the farm were:

Almost all decisions regarding the operation of the farm were made jointly by Lage and the tenants.. Major conservation practice decisions, the marketing of the conservator’s share of the crop, and installation of the tile lines were the exclusive responsibility of the conservator. Id. at 1557. Lage stated that though there were few disagreements with the tenant as to operating decisions, the conservator did override the tenant’s suggestions on occasion. Id. at 1558.

In short opinion, the District Court held that the conservator’s activities did not constitute material participation, emphasizing that the frequency of consultation with the tenant was low, the inspections did not take much time, and that no agent of the conservator lived on the farm, did any physical work on the farm, or furnished any machinery used in production. The court stated: "In short, the conservator’s participation appears to have been no greater than that of the landlord in the typical crop-share lease arrangement.

The court of appeals reversed and remanded for entry of a judgment in favor of the estate. 828 F.2d 1324, 1325-26 (8^th Cir. 1987). The court stated that the major factors in determining material participation were advising and consulting with the tenant on the operations of the farm and participation in a substantial number of final management decisions. Id. at 1327. The court found that the monthly and annual conferences between the conservator and the tenant and the joint decision-making process as to crop patterns and rotation, fertilizer application, chemical, weed, and insect control, fence repair, plowing and minimum tillage techniques, seed purchasing, and crop planting and harvesting met these minimum standards. Id. at 1327-28. The court also noted that of the four other factors listed in the section 2032A regulations, two were present in this case. Id. To the IRS’s contention that the inspections were inadequate because they took only two hours each, the court responded that the sufficiency of the inspections is to be measured against the need for inspections; regularity does not necessarily mean time consuming. Id. at 1328. The court also ruled that the failure to pay self-employment taxes on the farm income was not fatal when the failure was explained and material participation is demonstrated. Id.

Perhaps most importantly, the court of appeals repudiated the district court’s statement that the typical activities of a landlord under a crop-share lease are insufficient to constitute material participation. Id. at 1327. In order to materially participate, a decedent need not perform acts exceeding those of a landlord in a typical crop share lease, which is consistent with the case law under the Social Security Act previously discussed (and, indeed, the court in Mangels used the standards of the Social Security cases.) See id. at 1326-30. Mangels strongly implies that the Social Security Act cases will be regarded as presidents in cases under 2032A. Mangels v. United States, 828 F.2d 1324, 1327 n.7 (8^th Cir. 1987).

From some of the cases above, and according to Neil Harl (a renowned expert in the area of estate and business planning and taxation) in his treatise "Farm Estate & Business Planning at 48 (16^th Ed.): "Material participation cannot be attained through an agent for those producing agricultural or horticultural commodities." Also, the activities of an agent or employee other than a family member my not be considered in determining material participation. Treas. Reg. §20.2032A-3(e)(1); RIA ¶771,020 n. 5. However, the use of a farm manager does not preclude a finding of material participation by the owner/landlord who qualifies in his or her own right. Treas. Reg. §20.2032A-3(e)(2); RIA ¶771,020 n. 3.

"Active Management" of a farm or other business by an "eligible qualified heir" (but not by a member of the heir’s family) is treated as material participation (or an alternative to material participation that qualifies for special use valuation) by that qualified heir for purposes of the recapture rules. I.R.C. § 2032A(c)(7)(B). An eligible qualified heir includes only:

In the case of an eligible qualified heir who has not attained the age of 21 or who is disabled, the active management may be that of a fiduciary (e.g., a guardian or trustee, but not an agent).

In the case of a surviving spouse, if real property qualified for special use valuation in the estate of a decedent spouse and that property was acquired from or passed from the decedent spouse to his or her surviving spouse, then active management of the farm by the surviving spouse is treated as material participation by the surviving spouse in the operation of the farm for purposes of determining whether the real property qualifies for special use valuation in the estate of the surviving spouse. I.R.C. § 2032A(b)(5)(A); RIA ¶771,024. The alternative active management test also applies for purposes of applying the recapture rules in the case of the surviving spouses estate. I.R.C. § 2032A(b)(5)(A).

Active management means making business management decisions other than daily operating decisions. I.R.C. § 2032A(e)(12). The determination of whether active management occurs is factual, and the requirement can be met even though no self-employment tax is payable by the spouse with respect to income derived from the farm or other trade or business operation. Among the farming activities, various combinations of which constitute active management, are inspecting growing crops, reviewing and approving annual crop plans in advance of planting, making a substantial number of the management decisions of the business operation, and approving expenditures for other than nominal operating expenses in advance of the time the amounts are expended. Examples of management decisions are decisions such as what crops to plant or how many cattle to raise, what fields to leave fallow, where and when to market crops and other business products, how to finance business operations, and what capital expenditures the trade or business should make. H Rept No. 97-201 (PL 97-34) p. 170; RIA ¶771,025.

By analogy to cases under I.R.C. § 1402 and those under the Social Security Act, as well as the more recent cases under I.R.C. § 2032A, material participation may be evidenced either by production activities or the management of production activities, or both, rising to the level of at least the typical crop share lease. The factors considered are as varied as the cases and the courts decide each case on the facts and circumstances at hand. However, it is clear that material participation cannot be made through the production or management of production activities of a farm manager.