A common issue for taxpayers and their CPA return preparers is whether an activity for which the taxpayer received compensation during the tax year constitutes self-employment for purposes of self-employment tax. The answer can make a big difference in tax liability, since self-employment tax amounts to 15.3% of net self-employment earnings (13.3% for 2011).
SE tax replaces the Social Security and Medicare taxes paid by employees and is subject to the same $106,800 ceiling on the Social Security portion. Moreover, taxpayers with SE income may not have had taxes withheld or paid estimated SE or income tax on the amount. An estimated tax underpayment penalty may further increase the taxpayer’s bottom-line shock. No doubt every tax preparer has, in such circumstances, heard the question, “How could I owe that much?”
The answer is hard to explain to taxpayers, who might not have thought of that temporary job, honorarium or intern stipend as self-employment. SE tax applies only to net profit (unless it’s under $400) in a tax year, derived from a trade or business carried on by an individual as a sole proprietor or partner of a partnership (IRC § 1402(a), Treas. Reg. § 1.1401-1(c)). Determining whether a taxpayer is engaged in a trade or business depends on all the facts and circumstances in a particular case, and the objective facts speak louder than the taxpayer’s statement (Walter L. Medlin, TC Memo 2003-224, citing Engdahl v. Commissioner, 72 TC 659).
Nonetheless, certain types of activities have been determined not to be a trade or business for purposes of SE tax, such as looking after one’s investments, engaging in hobbies or performing a public office. Activities performed as an employee are not self-employment. And while partners and sole proprietors generally must pay SE tax on the net profits of their trade or business, S corporation shareholders do not pay SE tax on distributions from the corporation.
Carrying on a trade or business involves ongoing efforts, and the activity may be so sporadic as to perhaps escape SE tax. For example, in Revenue Ruling 58-112, an officer of a company was paid a commission by another corporation to negotiate the sale of his company to the corporation. Even though the officer was paid in four equal installments during the year for his services, the IRS ruled the payments were not self-employment income, since the officer had never previously engaged in such a transaction and did not maintain an office or otherwise hold himself out to the public as available for such negotiations. Similarly, as has been noted in an article in The Tax Adviser, “Tax Aspects of an Author’s First Book” (Oct. 2008, page 694), someone who as a sideline writes only a single book and is not obligated to revise it in the future or write more books is probably not engaged in the trade or business of being an author and is therefore not self-employed (including several U.S. presidents and first ladies who nonetheless paid SE tax on income from sales of their first books).
In other instances, however, activities that might seem sporadic, in the sense that they are engaged in according to no particular schedule, have been held to be self-employment, based primarily on the number of times they recurred during a tax year. In Revenue Ruling 77-356, a member of Congress received payment for giving speeches, for which there was no pattern to the number of speeches given, the amount of time they required or remuneration received. During the year in question, the taxpayer made 10 speeches, for which $1,500 was received. Their frequency indicated “a degree of recurrence, continuity, and availability for speech making,” and thus were considered self-employment. On the other hand, a taxpayer who was paid for an “occasional” speech and did not seek such engagements or indicate availability for them was not self-employed (Revenue Ruling 55-431).
Frustratingly perhaps for practitioners, there is no bright line for determining when an activity is sporadic for SE tax purposes. But the more regular, frequent and continual the activities are, the more likely that the taxpayer will be considered to be carrying on a trade or business and subject to SE tax.
By Paul Bonner, senior editor–tax. To comment on this article or to suggest an idea for another article, contact him at firstname.lastname@example.org or 919-402-4434.
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