Richard J. Bot v. Internal Revenue ( 2003 )

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
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No. 02-2956
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Richard J. Bot; Phyllis Bot, *
*
Appellants, *
* Appeal from the United States
v. * Tax Court.
*
Commissioner of Internal Revenue, * [PUBLISHED]
*
Appellee. *
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Submitted: May 15, 2003
Filed: December 22, 2003
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Before MORRIS SHEPPARD ARNOLD and HANSEN, Circuit Judges, and
READE,1 District Judge.
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HANSEN, Circuit Judge.
Richard J. Bot and Phyllis Bot appeal from the tax court's2 decision upholding
the Internal Revenue Service's assessment of self-employment tax on the value-added
payments the Bots received from the Minnesota Corn Processors Cooperative
1
The Honorable Linda R. Reade, United States District Judge for the Northern
District of Iowa, sitting by designation.
2
The Honorable L. Paige Marvel, Judge, United States Tax Court.
Association ("MCP") in 1994 and 1995. The Bots argue that the tax court erred in
finding that they earned the value-added payments from the carrying on of a trade or
business. We agree with the tax court and affirm its judgment.
I.
The Internal Revenue Code imposes self-employment tax on the self-
employment income earned by an individual, 26 U.S.C. (I.R.C.) § 1401, which is a
corollary to the Federal Insurance Contributions Act, or FICA, tax paid by employers
and employees to fund social security benefits. The sole issue in this case is whether
the value-added payments that the Bots received from MCP were derived from a trade
or business carried on by the Bots, and thus were subject to self-employment tax, or
if the payments represented investment income not subject to self-employment tax.
Richard and Phyllis Bot are a married couple who filed joint tax returns for
1994 and 1995, the years at issue in this case. The Bots are retired farmers who own
700 acres of farmland in Minnesota that they have sharecropped with two of their
sons since 1987, when the Bots retired from daily farming activities. The crop share
agreement effective for the years at issue provided that the Bots were entitled to one-
half of the crops grown on the farm.
The Bots were members of MCP at all times relevant to this appeal. They
bought common stock in MCP in 1982, which stock can only be held by "producers
of agricultural products," including lessors of land who receive part of the crops
produced on their land as rent. (Appellants' App. at 88, Art. V § 2.) In various years
since 1982, they also entered into numerous Uniform Marketing Agreements (UMA)
with MCP which obligated the Bots to supply to MCP one bushel of corn for each
equity unit the Bots owned. The Bots purchased the equity units at an average cost
of $2.06 per unit. The UMA required MCP to market and process the corn supplied
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under the UMAs into corn products to sell. The UMAs had a five-year rolling term,
such that after the first year, the agreement was automatically renewed for an
additional year, and the UMA maintained its five-year term. Upon notice of
termination, the Grower was still obligated to supply corn for a period of four years
following his or her notice of termination. (Id. at 107, ¶ 9.) Pursuant to a Supplement
to the UMA, the Bots agreed to a pro rata change in the number of bushels they were
obligated to supply depending on MCP's total corn needs. Under the UMA, the
"Grower appoints and designates the Cooperative to act as Grower's sole agent in the
sale and marketing of the corn committed to the Cooperative under this Agreement."
(Id. at 104, ¶ 1.) Members satisfied their obligation to supply corn to MCP with corn
grown by the member, corn purchased by the member on the open market, or through
MCP's "option pool corn," which is corn MCP buys on the open market and makes
available to members to use to meet their delivery obligations. If option pool corn
was used, the grower paid MCP $.05 per bushel as a service fee and MCP retained
title to the corn. Regardless of the source of the corn, the grower warranted in the
UMA that he or she was the producer or owner of the corn. (Id. at 107.)
MCP paid the members under the UMA as follows: (1) an initial payment of
at least 80% of the loan value of the non-option pool corn on delivery; (2) storage and
interest fees for corn required to be delivered after October 1; (3) a value-added
payment, which is "such payment [from MCP's net operating proceeds] . . . which will
further compensate Grower for Grower's corn and still allow [MCP] to retain its
financial integrity" (Appellants' App. at 106); and (4) patronage dividends. Because
the Bots used only option pool corn to meet their UMA obligations, the only
payments they received from MCP were the value-added payments and the separately
determined patronage dividends. The Bots reported the patronage dividends on Form
4835, Farm Rental Income and Expenses, along with the income earned under the
crop share agreement with their sons, which the Internal Revenue Service ("IRS")
does not dispute. Only the value-added payments received by the Bots from MCP are
at issue in this case.
3
As indicated above, the Bots entered the first UMA in 1982 and always
satisfied their obligation to supply corn to MCP with option pool corn. In 1994, the
Bots held 250,000 active equity units, for which they had paid $515,000. In 1995,
the Bots held 395,000 active units, at a total cost of $813,700. They delivered
325,000 bushels in 1994 (130% of the number of their equity units) and 379,200
bushels in 1995 (96% of the number of their equity units) from MCP's option pool
corn. They received $132,375 and $249,152 in 1994 and 1995, respectively, as
value-added payments. They reported those receipts as gross proceeds from the sale
of capital assets on Schedule D of their 1994 and 1995 tax returns. They reported
their basis in the assets as $68,070 in 1994 and $86,431 in 1995. The bases were
derived from the $.05 handling fee paid to MCP to use the option pool corn to meet
their obligations ($18,070 in 1994 and $16,431 in 1995) plus payments the Bots made
to their sons for their half of the seed, fertilizer, and weed spray as required by the
crop share agreement ($50,000 in 1994 and $70,000 in 1995).3 The Bots separately
reported their income from the crop share agreement on Form 4835 (Farm Rental
Income and Expense), which income is not at issue in this appeal.
On audit, the IRS determined that the Bots were in the trade or business of
producing, marketing, processing, and selling corn and that the value-added payments
should be reported on Schedule C instead of Schedule D, thus subjecting the
payments, less any allowable deductions, to self-employment tax. The IRS simply
moved the net income from Schedule D to Schedule C, allowing the Bots to deduct
the claimed bases for each year as expenses against the value-added payments
received to arrive at net income subject to self-employment tax.
3
The parties agree that the $50,000 and $70,000 payments to the Bots' sons
were not really attributable to the corn supplied to MCP under the UMA obligations,
though no adjustments were made in the audit to correct the discrepancy.
4
Upon appeal of the assessment, the Bots argued to the tax court that the value-
added payments represented investment income on their shares held in the MCP
cooperative, not income from a trade or business subject to self-employment tax. The
tax court determined that the Bots' activities of regularly and continuously acquiring
and selling corn and corn products through the MCP with the intent of making a
profit qualified as engaging in the trade or business of dealing and processing corn,
even though they retired from daily farming activities in 1987. The court also relied
on the unique nature of the relationship between a cooperative and its members to
find that the Bots engaged in the trade of dealing in corn through MCP acting as their
agent. The court found a direct nexus between the Bots' trade of dealing corn and the
value-added payments because the value-added payments were distributed based on
the number of bushels of corn delivered to MCP by the Bots. The Bots appeal.
II.
We review the tax court's legal conclusions de novo and its fact-findings for
clear error. The Bots have the burden of establishing that the IRS's characterization
of the value-added payments as self-employment income is erroneous. See Campbell
v. Comm'r, 164 F.3d 1140, 1142 (8th Cir.), cert. denied, 526 U.S. 1117 (1999).
The Internal Revenue Code imposes self-employment tax on the "net earnings
from self-employment derived by an individual." §§ 1401(a), 1402(b). The term "net
earnings from self-employment" is defined as "the gross income derived by an
individual from any trade or business carried on by such individual, less the
deductions allowed." § 1402(a). The term "trade or business" is defined only by
reference to I.R.C. § 162 (relating to trade or business expenses), see § 1402(c), but
is not otherwise defined in either section 162 or section 1402. "Self-employment
income is determined by the source of the income, not the taxpayer's status at the time
the income is realized." Schelble v. Comm'r, 130 F.3d 1388, 1392 (10th Cir. 1997)
(internal quotations omitted). The "derived from" requirement necessitates a nexus
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between the income and the trade or business actually carried on by the taxpayer.
That is, the trade or business activity must give rise to the income. Milligan v.
Comm'r, 38 F.3d 1094, 1098 (9th Cir. 1994). Treasury regulations provide that the
"trade or business must be carried on by the individual, either personally or through
agents or employees." Treas. Reg. § 1.1402(a)-2(b). Thus, the value-added payments
are self-employment income if they: 1) are derived 2) from a trade or business 3)
carried on by the Bots or their agents. The self-employment tax provisions are
broadly construed to favor treatment of income as earnings from self-employment.
See Braddock v. Comm'r, 95 T.C. 639, 644 (1990); Hornaday v. Comm'r, 81 T.C.
830, 834 (1983); see also Comm'r v. Groetzinger, 480 U.S. 23, 31 (1987) (discussing
the meaning of a "trade or business" and concluding that the "statutory words are
broad and comprehensive").
On their tax returns, the Bots claimed that the value-added payments
constituted gain from the sale of capital assets. They have abandoned that theory on
appeal and argue that the payments were the result of passive investment, similar to
dividends, rather than from the carrying on of a trade or business. Whether a taxpayer
is engaged in a trade or business–an inquiry depending on the specific facts of each
case–is a question of fact subject to review under the clearly erroneous standard.
Cent. States, S.E. & S.W. Areas Pension Fund v. Neiman, 285 F.3d 587, 593-94 (7th
Cir. 2002). "[T]o be engaged in a trade or business, the taxpayer must be involved in
the activity with continuity and regularity and . . . the taxpayer's primary purpose for
engaging in the activity must be for income or profit." Groetzinger, 480 U.S. at 35(holding that a full-time gambler was engaged in a trade or business).
As did the tax court, we believe the unique nature of the relationship between
a cooperative and it members plays a significant role in deciding this case. The Bots
analogize to corporate dividends in arguing that the value-added payments are the
result of a passive investment rather than earnings from a trade or business. Their
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choice to "invest" in a cooperative, as opposed to a corporation, however, is fatal to
their argument.
A cooperative is an organization established by individuals 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.
Puget Sound Plywood, Inc. v. Comm'r, 44 T.C. 305, 306 (1965) (internal quotations
omitted).
By contrast, the Supreme Court has explained why "[d]evoting one's time and
energies to the affairs of a corporation is not of itself, and without more, a trade or
business of the person so engaged." Whipple v. Comm'r, 373 U.S. 193, 202 (1963).
Though such activities may produce income, profit or gain in the form of
dividends or enhancement in the value of an investment, this return is
distinctive to the process of investing and is generated by the successful
operation of the corporation's business as distinguished from the trade or
business of the taxpayer himself. When the only return is that of an
investor, the taxpayer has not satisfied his burden of demonstrating that he
is engaged in a trade or business since investing is not a trade or business
and the return to the taxpayer, though substantially the product of his
services, legally arises not from his own trade or business but from that of
the corporation.
Id. Thus, a cooperative is dissimilar to a corporation, which is a wholly separate
entity from its shareholders.
Also distinguishing the value-added payments from passive investment income
is the fact that the payments did not depend on how many shares of stock or equity
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units the Bots held, but on the quantity of corn they supplied to MCP to be processed.
This distinguishes the Bots' situation from cases like Hendrickson v. Comm'r, which
involved owners of working interests in gas wells who received income based on
their share of interest in the well. See 54 T.C.M. (CCH) 1079 (1987) (holding that
an owner of a working interest in a gas well, who farmed out his responsibilities to
manage the operation of the gas well because he lacked any experience in the field,
and who owned a minority interest in the well, was a passive investor not subject to
self-employment tax). Value-added payments are tied to the quantity of corn
delivered, not the number of shares or equity units held. The Bots were required to
do more than hold the stock or equity units; they had to supply corn to MCP before
they were entitled to receive the value-added payments. We reject the Bots' attempt
to equate the value-added payments to corporate dividends.
Having rejected the Bots' argument that the value-added payments were the
result of a passive investment, we turn to the determination of whether the payments
derived from a trade or business carried on by the Bots or their agent. We must
understand the nature of the value-added payment to assess whether there is a nexus
between it and a trade or business carried on by the Bots. The value-added payment
represented "an additional payment from the value added to the corn [supplied
pursuant to the UMA] during its processing by the Cooperative . . . which will further
compensate Grower for Grower's corn." (Appellants' App. at 106.) The gain was
passed on to the members in proportion to the amount of corn supplied by the
members. The Bots received the value-added payments as consideration for fulfilling
their obligation to deliver a specified number of bushels of corn to MCP to be
processed into corn products, marketed, and sold. This consideration provides the
required nexus between the value-added payment and the trade or business of
supplying corn to be processed.
The Bots argue that the value-added payments really derived from the work
performed by MCP in processing the corn, not from work performed by them in
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merely supplying the corn. They further argue that because they had no control over
MCP's actions regarding the corn supplied under the UMA, an element they argue is
necessary for establishing an agency relationship under Minnesota law, MCP was not
their agent and MCP's trade or business of processing corn could not be attributed to
them, despite their express designation of MCP as their agent in the UMA. Again,
we find the peculiar traits of the cooperative/member relationship determinative. "It
is generally recognized that a cooperative marketing agreement may give rise to either
of two relationships with respect to the products marketed thereunder–that is, it may
be a contract of sale, or it may create the relationship of principal and agent between
the member and the association." 18 Am.Jur.2d Cooperative Associations § 39. The
Supreme Court of Minnesota has recognized these alternative relationships, looking
to the statute under which the cooperative is organized and the parties' agreement to
determine which relationship a particular cooperative shares with its members. See
Elliott v. Adeckes, 59 N.W.2d 894, 898 (Minn. 1953) (noting that it is clear that
Minnesota cooperative statutes allow a cooperative to either engage in a pooling
operation, under which the cooperative acts on behalf of its members, or to purchase
product outright from its members); Minn. Wheat Growers' Coop. Mktg. Ass'n v.
Huggins, 203 N.W. 420, 422 (Minn. 1925) (noting that a farmers' cooperative "is
merely a selling agency" for its members).
Looking to the facts surrounding the Bots' relationship with MCP, we agree
with the tax court that MCP acted as the Bots' agent. The Minnesota statutes that
authorize cooperative associations recognize that cooperatives act as agents for their
members. See, e.g., Minn. St. § 308A.201(1) ("[A] cooperative as an agent or
otherwise: (1) may perform every act and thing necessary or proper to the conduct of
the cooperative's business . . . .") (emphasis added). Further, the UMA between the
Bots and MCP clearly indicates that MCP was acting as the Bots' agent. The UMA
specifically designated MCP as the "Grower's sole agent in the sale and marketing of
the corn committed to the Cooperative under this Agreement." (Appellants' App. at
104.) The Bots agreed to "commit and deliver" corn to MCP for marketing and
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processing (id.), but the agreement never intimates a sale of corn to MCP. In fact, the
agreement is careful to refer to the corn as corn "delivered" to MCP, not sold to MCP.
The initial payment could be as low as 80% of the loan value of the corn supplied (id.
at 105), revealing that the initial payment was not a purchase of the corn at current
market value, but an advance to the member. The agreement describes the value-
added payment as "further compensat[ion] for Grower's corn." (Id. at 106.) Even
though the UMA gave MCP "sole and complete discretion in all phases of the
marketing activity" (id.), MCP was still obligated to process the corn in a manner that
served the best interests of the growers as a whole and to market the processed
products at the best price obtainable under market conditions. (Id.) We agree with
the tax court that MCP acted as the Bots' agent in processing and selling corn and
corn products under the UMA. See McAllister v. Comm'r, 42 T.C. 948, 949 (1964)
(relying on cooperative agreement's designation of taxpayer as "grower" and
cooperative as "grower's agent" in holding that income received from cooperative was
self-employment income, despite agreement giving cooperative "absolute
management, control and disposition of all citrus crops").
Finally, the Bots argue that their intent to purchase the equity units as an
investment rather than as a business should be determinative. The Bots testified that
they joined MCP as an investment and did nothing more than check a box stating that
they wanted to pay $.05 per bushel to use MCP's option pool corn to satisfy their
obligation to deliver corn. To be eligible to be a member of MCP and to purchase the
units of equity participation, however, the Bots warranted to MCP that they were
"producers of agricultural products," which included lessors under a crop share
agreement who received a share of the crops produced on the farm (Appellants' App.
at 88), and that they were "the producer or owner of the corn delivered." (Id. at 107.)
Despite their assertions that they bought the units of participation as an investment,
the program operated on the basis that they were producers or owners of the corn
delivered under the program and that MCP acted as their agent in further processing
and marketing the corn. The Bots should be held to their representations. If they
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want the benefits of the coop program, they must bear the burdens as well. Cf. Estate
of Bean v. Comm'r, 268 F.3d 553, 557 (8th Cir. 2001) ("Once chosen, the taxpayers
are bound by the consequences of the transaction as structured, even if hindsight
reveals a more favorable tax treatment.").
III.
The tax court's judgment is affirmed.
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