SE Tax and Sporadic Activity

Article excerpt

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 [section] 1402(a), Treas. Reg. [section] 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. …