Are you self-employed? Do you ever wonder how much of your earnings is subject to self-employment tax? (SET) If you are self-employed you should be paying the correct amount of social security but not be overpaying. Employees are subject to payroll withholding and W2 year-end reporting as per the W2 withholding laws enacted in 1943. But if you a small business owner who pays social security or an SBOSS you are governed by IRS Section 1402(a). Based on 1402(a) the IRS would have you believe all your income is subject to SET. But the fact is that the kind of work you do each day will create facts and evidence that the Courts use to determine whether you pay more or less social security. So if you are an SBOSS, stay with us here on TaxView with Chris Moss CPA to learn how to save taxes by not overpaying your SET, but by paying the correct and fair amount of SET each year on your small business earnings.
So how does an SBOSS know how much SET to pay? For answers let’s start with a simple US Tax Court farming case, Bot v IRS U S Tax Court (2002) and appealed to the 8th Circuit in Bot v IRS 353 F.3d (2003). Bot was a farmer who reported much of their income earned from a cooperative association as farm rental income for 1994 and 1995 on IRS Form 4835, and Schedule D and paid no SET. The IRS audited and invoiced the Bot’s for social security reclassifying much of their income on to Schedule C Profit and Loss. Bot appealed to US Tax Court in Bot v IRS US Tax Court (2002).
The Court noted that all gross income derived by and SBOSS is subject to SET under Section 1402(a).The business must be transacted either personally or through agents or employees as per IRS regulation 1.1402(a) and 1.1402(b).Judge Marvel compares the IRS argument that Bot was in a trade and business to Bot’s claim that his earnings was from investment income. Judge Marvel attempts to differentiate a trade or business from passive investment income and reasons that only from a review of all the facts can a decision be reached. The Court concludes after reviewing all the evidence presented from both the Government and Bot that the facts show that Bot was engaged during 1994 and 1995 in regular efforts to reap a profit from the sale of corn products and those “efforts” constituted a trade or business. IRS wins Bot loses.
Bot appealed to the 8th Circuit in Bot v IRS 353 F.3d (8th Circuit 2003). The problem with the Bot appeal is that in US Tax Court he claimed much of the income from the Government conservation reserve program was Schedule D capital gains. However on appeal Bot changed his legal argument claiming the income he earned was passive investment income similar to dividends. Bot had not recorded this income on Schedule B of his original tax return. Was this a smart legal move by Bot to change his legal theory from Schedule D to Schedule B on appeal? Perhaps not. Circuit Judge Hansen voting with the majority finds for the Government. IRS wins Bot loses, again.
For our next case, Morehouse v IRS US Tax Court (2013), we have somewhat similar facts as Bot, but with a very different outcome. Morehouse received payments from the US Department of Agriculture Conservation Reserve Program. Was Morehouse an SBOSS? Let’s look at the facts. Morehouse lived in Texas but owned farmland in South Dakota. Between 1997 and 2007 Morehouse visited the farm various times and personally purchased materials need to implement conservation plans. Morehouse hired Mr. Redlin to help comply with the US Government’s conservation reserve program and sought and received from the United States Department of Agriculture cost-sharing payments for the seeding and weeding activities on the property. Morehouse filed a 2006 and 2007 income tax return with a Schedule E reporting rental income but paid no SET. The IRS audited and classified Morehouse as an SBOSS owing SET reclassifying his income to Schedule C. Morehouse appealed to US Tax Court in Morehouse v IRS US Tax Court (2013). What do you think? Was Morehouse subject to SIT?
Judge Marvel in Morehouse as he did in Bot clearly supported the IRS position and found for the Government even though Morehouse testified credibly that his actual work was “De Minimis” and did not constitute farming. The Court nevertheless concluded that Morehouse was an active participant in the farming program citing Bot v IRS US Tax Court (2002) and Bot v IRS 353 F.3d 595 (8th Circuit 2003). IRS Wins Bot Loses.
Morehouse appealed this decision to the United States Court of Appeals for the 8th Circuit. Wait for the surprise Court ruling.. Oral arguments were held on June 11, of 2014 and the case was decided just two months ago in Morehouse vs IRS 8th Circuit Court of Appeals (2014). In an amazing total reversal of the US Tax Court and the 8th Circuit decision in Bot, Circuit Judge Beam concludes that land conservation payments made to non-farmers constitute rentals from real estate and are excluded from SET because private landowners who participate in government funded land conservation are not self-employed, nor does their participation change the fact that “the government is using their land for its own purposes”, citing 16 USC §3831, even though contrary toIRS Notice 2006-108. Beam and Judge Loken in a 2-1 vote remanded to the US Tax Court with instructions to enter judgment in favor of Morehouse. IRS loses, Morehouse wins.
Circuit Judge Gruender in his dissenting opinion disagreed with 8th Circuit majority. Judge Gruender felt that the 8th Circuit should follow the 6th Circuit interpretation of the law citing Wuebker v IRS 205 F.3d 897 (6th Circuit 2000) and IRS Notice 2006-108, Application of 2006-108, and IRS Bulletin 2006-2 and finally citing, you guessed it, Bot v IRS 353 F. 3d 595 (8th Cir) 2003. Judge Gruender would have us believe that payments to Morehouse were for work performed by Morehouse or his agent Redlin with continuity and regularity. Note that Wuebker who initially won in US Tax Court in Wuebker v IRS US Tax court (1998), and was reversed on appeal in Wuebker v IRS 205 F.3d 897 (6th Circuit 2000), hinged on Circuit Judge Gilman’s ruling that the Wuebkers’ maintenance obligations to the US Government were somehow continuous and regular. Were the Morehouse facts any different that Wuebker? Read the NGFA commentary (National Grain and Feed lobby group). Also read the Iowa State University Center for Agricultural Law and Taxation October 2014 update. What do you think? By the way, if you search the IRS website the Government still claims USDA Conservation Reserve Payments are subject to SET. Also see IRS Chief Counsel Memorandum (2003). Perhaps this issue is headed to the US Supreme Court?
What does all this mean if you are an SBOSS out there paying SIT? First, sit down with your tax attorney at the end of each year and record the facts and evidence to support whether or not you your employees or agents actively participated in a business on a regular basis. Are you receiving income from this business? Chances are you are an SBOSS subject to SIT. However, you may still be able to “carve out” some non-SIT income with this second step: Examine closely all the income you earn as an SBOSS. Do you receive some rent in addition to professional fees? Do you sublease some space to other businesses? Or perhaps you invest in the stock market and earn capital gains and dividends during office hours and you report that income as an SBOSS. Various other income streams may be exempt from SIT as well, depending on how you are structured and the facts as they occurred each year as an SBOSS. Finally get your tax professionals to go over with you each year what types of your unique taxable income may be exempt from SIT. Have your tax attorney memorialize in writing what she said to you and include that document in the tax return you are filing. If there is ever an IRS audit years later you would be glad you did.
Thank you for joining us on TaxView with Chris Moss CPA. See you next time on TaxView.
Chris Moss CPA