The past year may have been one of the most tumultuous in the farmland lease market in many years. A dramatic farm program change delayed until April of 1996, but effective for the 1996 crop year, left most cash rent tenants with a surprise “transition payment” and the promise of an even larger payment in 1997. Plus, corn and bean price expectations were adjusted upward during 1996. These and other factors set the stage for a rise in rents with tenants out bidding their neighbors, and landowners seeking part of the farm program transition payment. Disputes developed over the rights and obligations under existing leases. Lease termination procedures were common concerns. Some cases have headed for litigation.

What Makes a Legal Lease?

Actually, very few words are needed to have a valid lease. Basics should include the following information:

1. Date of the lease.
2. Names and addresses of the land-owner and tenant.
3. Description of the lease property.
4. Beginning and ending dates.**
5. Notice requirement (if any) for termination of the lease.**
6. The cash rent or shares of cash costs and crop share and resource contributions of the landowner and tenant, including whether the landowner is materially participating.
7. When rent is paid or how land-owner’s share is handled, including tenant hardship provisions, the landowner’s right to a security interest in crops or other pro-visions for insuring the cash rent or crop share.
8. Signatures of the landowner (or landowner’s agent) and tenant. Many other matters are typically spelled-out in a modern farmland lease. These include:
9. Restrictions and requirements for the use of the land and facilities in the face of environmental liability concerns.
10. Circumstances and a formula for reimbursement of the tenant for unused portions of multiple-year applications of crop nutrients in the event a tenant is terminated or decides to give up the lease.
11. Reimbursement guidelines for fieldwork or for a growing crop when a lease is terminated.
12. Provisions for mediation and arbitration of disputes.

 Numerous other provisions may be included to fit the need. Certain matters and conduct may be implied by the law and custom of the community and need not be stated in the lease to be applicable, however, it may be wise to include all important considerations and concerns.

Oral Leases

Oral leases of farmland are legal or enforceable in Indiana courts. While transactions in real estate are generally required to be in writing, an Indiana statute permits an oral lease for up to three (3) years. [See IC 32-2-1-1]. That is, should a dispute arise over the terms of an oral lease, if for a duration not exceeding three years, the existence of such an oral lease may be introduced into evidence in an Indiana court.

Proving the specific terms of an oral lease however may be difficult unless there was an unbiased witness to the agreement. When certain matters were not discussed or agreed upon, “custom of the community” may be introduced to settle a dispute, or the court may decide what is “fair.” Also, an Indiana trial court may ask that a farm lease dispute be resolved by mediation.

Leases longer than three years must be in writing to be enforceable before an Indiana court. In the case of longer term leases, it may be wise to have the lease recorded to protect the tenant against future lessees, buyers and creditors, or mortgagees of the landowner for the same property.

Since many farmers and landowners may feel “a person is no better than their word,” they routinely rent land on a year-to-year basis with an oral agreement. This approach leads to disputes about rights, especially when a lease termination is desired.

Advance Notice for Termination

If the lease (oral or written) includes no notice or termination procedure, an Indiana statute requires a “notice to quit” be delivered three months prior to the end of the lease year. Historically, the crop year is thought to begin on March 1. Thus, under the three month rule, if the lease year ends on the last day of February, the notice would be timely if delivered before December 1st of the preceding year.

While many leases may have been terminated by an oral notice, the law appears to require a written notice when a notice is required. What should be included in a notice is in the Indiana law at IC 32-7-1-4. It may be wise to have an attorney draft and properly deliver the notice.

Date for End of the Lease Year

Indiana Code does not provide the date for the end of the lease year. A lease ending date may be determined from the original lease or from what was understood between the land-lord and tenant. The custom of the March 1st possession date may be difficult to support. Thus, it is wise to have a written agreement covering the lease term and the need for an advance notice.

A notice of five to six months before the traditional March 1st date may be fair to the tenant and the landowner and promotes good management. Ample advance notice of a termination allows a tenant to make appropriate farm management decisions.

A notice date that is after harvest may be favored by many landowners. A busy tenant may not harvest the field on which a share lease has been terminated until after his or her other fields are harvested. Tenants may be wise to bargain for an early date.

Term Leases

Leases may be for a specific term, usually for a year, and require no termination notice. [See Indiana Code Section 37-7-1- 7] Term leases are often in writing, but they may also may be oral. The term lease makes clear that it is for a specified period.

It may be wise to emphasize that a lease is for a specified term and that no termination notice is required. A term lease may encourage a discussion about needed adjustments in a lease for the coming year, since the understanding is that no lease for the following year exists until there is a new agreement.

If it is unclear that an existing lease is a term lease, and a tenant remains in possession of the leased property, they may have a lease on the same terms as the prior year. In subsequent years, the tenant may be entitled to a three month advance notice to terminate, unless they agree to a “term lease” in a subsequent agreement.

Tenant’s Rights to Growing Crops

According to Indiana case law, a former (outgoing) tenant has a right to emblements or growing crops if three conditions are present:

1. The tenancy was of an uncertain duration.
2. The tenant was terminated with-out fault.
3. The crop was planted by the terminated tenant.

Right to harvest fall seeded wheat or to share of the crop revenue is a common problem. The “doctrine of emblements” says the tenant who planted the wheat and then was legally terminated before the crop matures has (1) a right to harvest the crop for his or her share under the lease, or (2) be provided the returns from the crop less the expenses of harvest and transport of the crop to market.

However, the law does not reward the tenant who plants or performs activity toward a crop after a notice to terminate has been delivered.

Even though the doctrine of emblements may relate to a growing crop when the tenant loses possession, the law might also support the tenant who leaves mature crops at the end of the lease if they have a good excuse. Unusual weather or tenant disability may support a dili-gent, good-faith tenant under this doctrine. Another legal doctrine, “unjust enrichment,” might also favor the tenant. This doctrine is built on the premise that one party should not benefit at the expense of another.

Lien or Security Interest in a Tenant’s Crops

In case of a tenant’s financial stress, and potential bankruptcy, a land-owner with a share lease has a clear right to his or her portion of the crop as opposed to other creditors who may have a security interest in the tenant’s crops. While there may be support for the notion that the tenant’s creditor cannot take a security interest (lien) in the landowner’s share without the landowner granting such, it is clear in the common law that a tenant owns the entire crop until it comes out of the field even for a share-lease situation. Indiana is a “common law” state.

The best strategy may be for the landowner to obtain a Uniform Commercial Code (UCC) security interest in the crop to be grown on his or her land as a condition of the cash rental arrangement. Under rules in force since December 1986, there is a requirement to give the potential buyers of the tenant’s crop notice of the UCC lien to insure that a check for a sale of crops be made-out jointly to the tenant, the secured land-owner, and other creditors who have given notice of lien in the crops.

The tenant may have other creditors with a lien in the crop grown on the lessor’s land. The landowner may require the tenant’s other creditor(s) to subrogate to the landowner’s interest in return for a lease on his or her land.

Alternatively, he or she may require a letter of credit (which guarantees payment of the rent) from the tenant’s banker or other primary lender when the above alternatives are not practical or do not provide sufficient assurances. Of course, a landowner may require an advance payment of the entire cash rent.

Landlord’s Lien

When a landowner in Indiana expects the rent may be in jeopardy, he or she may obtain a “landlord’s lien” under an Indiana statute [See IC 32-7-1-18]. This statute requires a courthouse filing at least 30 days before the crop matures but during the year the crop is growing. This lien will have priority over liens filed later, including subsequent UCC liens. It will be inferior to prior UCC liens and will be avoided in bankruptcy.

Obtaining a landlord’s lien is a good idea for an insecure landowner who cannot get a tenant to grant a security interest which is required for a UCC lien. The landlord’s lien does not require the consent or knowledge of the tenant.

Clearly, the landlord’s lien is bet-ter than no lien at all and may be adequate protection if the tenant does not go into bankruptcy. When the tenant (or landowner) anticipates or incurs financial stress, both the landowner and the tenant may need legal counsel.

 

Tax Implications: Leases and Material Participation

Generally, the tenant will report farm income and expenses to the Internal Revenue Service on Schedule F. A sole proprietor/tenant will pay self-employment (SE) tax on net farm income.

Material participation (MP) was originally placed into the tax law as a criteria by which to establish whether the landowner was liable for or allowed to pay self-employment tax on the annual, net returns from a farm lease or rental activity. (See the Farmer’s Tax Guide, IRS Publ. #225 for the alternative material participation tests).

For example, the landowner may satisfy one of the MP tests with a share lease with which the land-owner reserves certain authority over the decisions to be made throughout the lease (such as what to plant and whether to treat for a crop insect infestation). When materially participating, the landowner has veto power over key production decisions. In addition, the landowner must also inspect and observe pro-duction activities periodically. An agent (e.g., a farm manager) cannot perform these MP tasks for the landowner. However, the professional manager may assist the landowner. Landowners who materially participate in a farming business, will report income and expenses on Schedule F and pay the Self-Employment (SE) tax.

It should be stressed that a crop-share lease need not involve material participation by a landowner. If it does not, the landowner with a crop-share lease reports the farm income and expenses on the Form 4835, and there is neither a requirement nor an entitlement to pay the SE tax.

Earned Income in Social Security Retirement

One of the widely circulated myths about Social Security (SS) retirement is that it is necessary for the retiring landowner to rent land for cash. Clearly, a crop-share will be okay as long as it is clear that the retiree does not materially participate. MP income is active income for SS retirement purposes while non-MP crop share income is not — just as cash rent income generally is not MP income.

A landowner’s MP income counts toward the maximum amount of income that may be earned before Social Security retirement benefits will be reduced under the “annual earnings test.” This test applies until the SS retiree reaches age 70. [There is a “monthly test” for the first year of a Social Security retirement. A prior year’s crop sold from inventory does not count as income for the monthly test though the sales may be subject to the SE tax.] After the individual on Social Security reaches age 70, earned (active) income does not cause an offset against annual, SS retirement benefits. However, the requirement to pay SE tax on earned income never ends.

In contrast, the cash rent lease arrangement generally is not a materially participating arrangement. The income to the cash rent land-owner is unearned income and is reported on a Schedule E for federal income tax purposes. Just as for a non-materially participating land-owner with a crop-share lease, SE tax is not required, nor payable on cash rent income.***

When non-material participation status is desired, a crop-share lease should clearly indicate that the land-owner does not have farm operating or other decision-making powers throughout the production period. However, not materially participating does not prevent the landowner from dictating in the terms of a rental agreement or crop-share lease much of what will happen on his land during the course of the crop year.

The following list contains other publications that may be useful in arriving at farm lease arrangements including Harrison’s complete “Legal Aspects of Farmland Leases” paper. For copies contact Gerald Harrison at (765)494-4216; Email: harrison@agecon.purdue.edu or call your county Purdue Cooperative Extension Office for assistance.

 

**Items d. and e. are not essential to have in a valid (lease) contract—once it is signed by the parties to the lease. In fact, if the lease could be interpreted as a term lease by setting-out the specific dates for its term, no notice may be required for the lease to automatically expire at the end of the term.

*** It is possible for a landowner to have a cash rental payment yet still satisfy an alternative material participation test. This may be done by providing sufficient (100 hours or more over at least five weeks in activities connected with the production of crops) labor and/or management on the rental land. However, this is not a com-mon situation in Midwestern farming arrangements though in some cases this may be a satisfactory arrangement for a “retired” farmer who wishes to stay involved in farming activity.

Atkinson, J.H., “Indiana Cash Farm Lease,”EC-257, 10 pp.

Atkinson, J.H., “Indiana Crop Share Lease Form,” 5 pp. 1995.

Doster, D.H., et al. “Annual Purdue Crop Guide,” ID-166, 2 pp. Jan. 1997.

Doster, D.H., “Indiana Custom Rates for Power Operated Farm Machines,” a periodic sur-vey, 2 pp., EC-130.

Doster, D.H., “What’s the Right Rent?,” EC-708. Doster, D.H., et al., “Tillage Economics, One Planter Farms: A Comparison of Expected Revenues and Costs, Six Tillage Systems, Two Crop Rotations, Three Representative Indiana Soils,” 15 pp., ID-191

Harrison, G., “Legal Aspects of Indiana Farmland Leases.” Unpublished paper, 11pp., Dec. 1996.

Harrison, G., “Cropland Leases: Is Minimum Tillage Changing Share Lease Terms?” 30 pp., 9/94.

“Indiana Livestock Share Lease,” EC-207, 22 pp., 1/72, with an updated lease form.

Pershing, Don & J.H. Atkinson, “Figuring Rent for Existing Farm Buildings,” EC-451, 7 pp., Rev. June 1989.