Academic journal article Journal of Accountancy

Impact of Self-Employment Loss on Earned Income

Academic journal article Journal of Accountancy

Impact of Self-Employment Loss on Earned Income

Article excerpt

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 tax payer 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:

Wages              $4,275
Taxable interest    7,922
Business loss      (3,703)
Capital losses     (2,858)
Total income       $5,636

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. …

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