Payments received by an employee from a former employer were subject to self-employment tax because the payments resulted from 34 years of service to the company, according to a recent letter ruling from the Internal Revenue Service.

In the ruling (CONEX-132030-16), the IRS analyzed the issue under Code Section 1402(b), which states that payments are subject to self-employment tax if they are “net earnings from self-employment derived by an individual … during any taxable year.” The net earnings this definition refers to are “the gross income derived by an individual from any trade or business carried on by such individual.”

The ruling cited a Tax Court case, Newberry v. Commissioner, 76 T.C. 441 (1981) for the proposition that self-employment tax applies when there is “a nexus between the income received and a trade or business that is, or was, actually carried on.” In Newberry, the Tax Court indicated that the income “must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer before such income becomes subject to … self-employment taxes.”

The IRS also cited a more recent case that applied this general principle to the issue of whether Mary Kay retirement payments are subject to self-employment tax (Peterson v. Commissioner, 827 F.3d 968 (11th Cir.2016)). The taxpayer in this case was a long-serving Mary Kay national sales director who retired from Mary Kay and began receiving post-retirement payments. According to the IRS, the court concluded that these payments were subject to self-employment tax because they resulted from her association with Mary Kay.

Although Section 1402(k) provides an exception for certain payments, it does not apply here, the IRS stated. It applies only to certain payments made to former insurance company salesmen, and even then, only if they meet a number of specific requirements.

“These issues keep coming up,” said Barbara Weltman, author of J.K. Lasser’s Small Business Taxes for 2017. “You would think they would be well-settled by now, but they aren’t.”

“There have been several recent Tax Court decisions on self-employment tax issues,” Weltman observed. “In Hardy, [T.C. Memo 2017-16, filed Jan. 17, 2017] the issue was whether a plastic surgeon’s income from a surgery center was subject to self-employment tax.”

In Hardy, the Tax Court found that the income the taxpayer received from his 12.5 percent share in the surgery center was not linked to his medical practice. Patients separately paid Dr. Hardy his fees as a surgeon, and they separately paid the surgical center for use of the facility in the same manner as with a hospital. Consequently, the court held, Dr. Hardy’s distributive shares are not subject to self-employment tax because he received the income in his capacity as an investor.

The court distinguished this situation from a 2011 case, Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), in which the partners were lawyers operating out of a law firm, which was formed as a limited liability partnership. The law firm received revenue from the partners’ legal fees, but the firm did not report those revenues on the firm’s tax return as net earnings from self-employment. The Tax Court in that case agreed with the IRS that the partners’ distributive shares of the law firm’s net business income were subject to self-employment tax. Because the revenue was derived from legal services performed by the partners in their capacity as partners, they were not acting as investors in the firm, and were thus liable for self-employment tax.

Roger Russell

Roger Russell is senior editor for tax with Accounting Today, and a tax attorney and a legal and accounting journalist.