Impact of Self-Employment Loss on Earned Income

Inconsistencies in the law often prove troublesome for taxpayers and the IRS. Various tax code sections define “earned income” differently, some reference it differently and still others refer to it but don’t define it.

IRC section 63 is a case in point. Generally, section 63 says taxpayers are entitled to the standard deduction if they do not itemize deductions in calculating their taxable income. Section 63(c)(5) limits the basic standard deduction allowable to someone another taxpayer claims as a dependent for the taxable year to the greater of (a) $500 (adjusted to $700 for 1999) or (b) the sum of $250 and the individual’s earned income. The deduction a taxpayer claims under (b) cannot exceed the basic standard deduction for the tax year in question. While section 63(c)(5) refers to earned income, it does not define it.

Statutory definitions of earned income can be found in IRC sections 32 and 911. Section 32 (c)(2)(A) defines it for purposes of the earned income credit as any wages, salaries, tips and other employee compensation that are includible in gross income for the taxable year, plus the amount of the taxpayer’s net earnings from self-employment for the taxable year (within the meaning of IRC section 1402(a)). These net earnings are determined with regard to the deduction allowed to the taxpayer by IRC section 164(f), which is the allowable deduction for self-employment tax.

Earned income also can be defined by its statutory reference in section 911(d)(2) for purposes of the foreign tax credit, which says, in part,

In general. The term earned income means wages, salaries or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation the taxpayer derived for personal services he or she rendered to a corporation that represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services.

Taxpayer engaged in trade or business. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Treasury Secretary, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30% of his or her share of the net profits of such trade or business, shall be considered earned income.

It’s apparent that sections 32 and 911 define earned income very differently with respect to the treatment of the self-employment income of a taxpayer engaged in a trade or business. Section 911 does not refer to “net earnings from self-employment” and thus excludes a loss from self-employment in determining earned income.

Allyson Briggs timely filed her 1999 federal income tax return on which she reported the following:

The business loss resulted from cleaning and lawn-mowing services Allyson provided. Her filing status was single. She did not claim a personal exemption; her parents claimed that deduction on their tax return. However, she did claim the full basic standard deduction for the year of $4,300. Allyson argued section 63 did not define earned income and that “earned income is only the positive amount,” which she contrasted to “net earnings from self-employment,” which could be—and was for her—a loss.

The IRS did not dispute the correctness of any item shown on the tax return except the standard deduction. It argued Allyson must subtract her net business loss from her wages in determining her earned income under the section 63(c)(5)(B) limitation on the basic standard deduction for certain dependents.

The IRS issued a deficiency notice limiting Allyson’s standard deduction to $822, rather than the $4,300 shown on her return. The allowable amount included the statutory minimum of $250 plus earned income (wages of $4,275 plus the schedule C loss of $3,703). The IRS embraced the statutory definition of earned income in section 32(c)(2)(A) and urged the court to use that approach. The IRS computation can be found on the form 1040 standard deduction worksheet which refers to earned income as compensation for personal services, including any scholarship includable in income. The worksheet says, “Generally, your earned income is the total of the amounts reported on form 1040, lines 7 (wages), 12 (business income or loss), and 18 (farm income or loss) minus the amount, if any, on line 27 (self-employment tax deduction).”

In Allyson Christina Briggs v. Commissioner, TC summary opinion 2004-22, the issue for the court was whether the taxpayer’s loss from trade or business must be subtracted from other earned income in determining her standard deduction.

The court reviewed the legislative history of the standard deduction limitation. From its origin through its 1977 revision, until the Tax Reform Act of 1986, the earned income limitation on the standard deduction was statutorily defined by reference to section 911. In the 1986 act Congress departed from the previous section 911 definition, but neither adopted the section 32 definition nor the approach of using both section 911 and net earnings. Congress could have, but did not, incorporate the section 32 language, reference it or use other language to achieve the same definition. The legislative history does not show an intent to define earned income in section 63(c)(5)(B) by reference to net earnings from self-employment.

Citing Robinson v. Commissioner, 199 TC 44, 61-62 (202), and other cases, the court said it had found nothing in the legislative history to conclude a change in statutory language did not show a change in meaning had occurred. The court concluded earned income in section 63(c)(5)(B) means something different from “earned income as defined in section 911(b).” It also concluded it wasn’t required to interpret the term earned income as though Congress had not intended to change the law when it changed the statutory language or Congress had intended to change the law to the section 32 model even though it did not use its language or even show in the legislative history that section 32 was to be the model for section 63.

The court ruled Allyson’s self-employment loss did not reduce her earned income for section 63 purposes. The standard deduction worksheet does not explain “generally” and does not specifically require a taxpayer to include business losses in computing earned income. Consequently, her allowable standard deduction was $4,300.

Observation. Congress’s election not to incorporate section 32 language in section 63 continues the exclusion of a self-employment loss from the calculation of earned income in determining the basic standard deduction allowable to taxpayers claimed as dependents by other taxpayers. College-age children claimed as dependents on their parents’ returns who have part-time earnings, summer jobs or similar side-line business losses should exclude such losses in determining the basic standard deduction.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.