Self-Employment Tax Developments

With the growth in sole proprietorship and partnership returns, self-employment tax continues to be a significant tax for individuals and their return preparers. The sharing economy has not only created more freelancers (contractors), but also more owners of short-term rentals who might be subject to self-employment tax. This article addresses developments of the past 18 months involving self-employment tax and reviews the rules as relevant in today’s sharing economy.  

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Recent cases have generally centered around whether an individual’s activity constituted a trade or business subject to self-employment tax. Some cases focused on the nature of the receipts and application of the definition at IRC Section 1402 on “net earnings from self-employment tax.” In addition, the IRS issued regulations in May 2016 involving certain partnership arrangements. Summaries of this guidance follows.

Is it Self-Employment Income?

Blogger’s Ad Revenue Subject to Self-Employment Tax: In 2012, Mr. Clark was a full-time video blogger. He had an agreement with Google to allow ads on his blog website. For 2012, ad revenue was just over $20,000 and Google issued Clark a 1099-MISC for this amount. Clark reported this as other income on his Form 1040. After an examination, the IRS imposed self-employment tax on Clark.

The Tax Court found that Clark was engaged in a trade or business as his intent was to make a profit. In addition, he worked six to eight hours per day seven days a week, making this a regular and continuous activity.

Clark’s argument that the revenue constituted royalty payments not subject to self-employment tax failed. The court noted that per Section 1402, “royalty payments received from a trade or business are subject to self-employment tax.”

Tax Shelter Activity Can Be Subject to Self-Employment Tax: Mr. Chai, an architect, became involved in tax shelter activity through a Harvard College classmate who married his cousin. Millions of dollars flowed through some of the more than 100 entities set up by the classmate. At issue was a $2 million payment to Chai in 2003. At one point, Chai was told the payment was a non-taxable return of capital (although he had not invested in the entity) but it was eventually reported on Form 1099 for consulting services. Chai did not report the income, arguing it was a return of capital from his investments.

Chai argued that he did not provide “any meaningful services” to the partnership. But the IRS argued that even if he delegated duties to others, the “risky nature and large receipts of the tax shelters provide ample justification for the high compensation relative to the low amount of personal effort involved.” Chai also indicated he signed a lot of documents. The IRS noted that whether Chai understood the transactions “does not eliminate the significance of the services he provided to Delta and the other tax shelters by signing the formation and organizational documents.” Also, Chai received large payments in the past (over $1 million) and had properly reported then as nonemployee income. The court also noted that the payment was not a gift because the payor expected work from Mr. Chai.

The court agreed with the IRS that the $2 million payment was income and subject to self-employment tax, finding that Chai’s “activities were continuous and regular.”

The court also upheld penalties against Chai. Chai’s argument that he relied on advice from his tax return preparer failed because he had not given all of the details of the transactions to his preparer.

Self-Employment Tax Owed on Working Interests: Mr. Methvin owned two percent to three percent interests in various working interests in oil and gas ventures. Per agreement, another party managed the interests. An election to be excluded from Subchapter K was filed, and Methvin received Form 1099-MISC reporting his share of revenues. Methvin reported the revenue less his share of expenses as “other income” on his Form 1040. No self-employment tax was paid, but the IRS assessed this tax ($690).

Methvin argued that the working interests were investments rather than business operations. He also noted that he was not actively involved in the wells and lacked knowledge as to their operation. However, as noted by the court:

“a taxpayer who is not personally active in the management or operation of a trade or business may be liable for self-employment tax if the trade or business is carried out on his behalf through his agents or employees or constitutes his distributive share of income from a partnership in which he was a member. Sec. 1402(a); Cokes v. Commissioner, 91 T.C. 222 (1988).”

Methvin argued that his situation varied from Cokes because he owned a much smaller share in the working interests (Cokes owned 42 percent) and that Cokes had greater rights and involvement in the operation of the wells.

The Tax Court argued though that despite electing out of Subchapter K, the venture was still a partnership regardless of the low level of ownership. Also, per the court: “We have held that making this election “‘does not operate to change the nature of the entity. A partnership remains a partnership; the exclusion simply prevents the application of subchapter K.” Methvin’s interest created a pool or joint venture constituting a partnership under Section 7701(a)(2) with the owner subject to self-employment tax on the net income from the working interests.

In June 2016, the Tenth Circuit Court upheld the Tax Court decision, finding that Methvin was involved in a partnership and did indeed owe $690 of self-employment tax for 2011 as assessed by the IRS. Per the circuit court, whether a partnership exists is a factual matter and not finding any error by the Tax Court, its decision holds.

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