Case — Common Law Employees and SEP Plans

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TL Case Summ

THE QUESTION

Can a common law employee contribute to a SEP plan?

THE DISPUTE

Taxpayer Says: He can deduct contributions to a SEP plan because he is self-employed. A common law employee who has self-employment earnings is treated as an owner-employee and can make retirement plan contributions and deduct those contributions on the basis of the self-employment income.

Internal Revenue Service Says: The taxpayer is a common law employee, and is not eligible to make retirement plan contributions for income earned as a common law employee.

THE LAW

From Internal Revenue Code Section 401(c)(3): Defines an owner-employee, in pertinent part, as an employee who owns the entire interest in an unincorporated trade or business.

From Internal Revenue Code Section 404(a)(8): Permits an employer to deduct certain contributions to an employee’s Simplified Employee Pension (SEP) plan.

From Internal Revenue Code Section 408(k): A SEP plan is a qualified plan pursuant to which an employer makes direct contributions to its employees’ individual retirement accounts or individual retirement annuities as defined under section 408(a) and (b).

From Internal Revenue Code Section 3121(b)(11). For the purposes of Chapter 21 Federal Insurance Contribution Act taxes, excludes from the definition of “employment” any service performed in the employ of a foreign government.

From Federal Tax Regulation 1.401-10(b)(2): Self-employed individuals and sole proprietors are treated as their own employers and employees for purposes of SEP plan deductions.

From Federal Tax Regulation 1.401-10(b)(3)(i): Provides that an individual who is a common law employee is not a self-employed individual with respect to income attributable to such employment, even though such income constitutes net earnings from self-employment as defined in Section 1402(a).

THE CAUSE OF THE DISPUTE

When you own a business you can choose to establish a retirement plan, and make deductible contributions to that plan. The amount you can contribute and deduct is generally limited to a percentage of your self-employment income from the business, and/or a statutory ceiling.

In this case, the dispute arose over whether income from work performed for a foreign government as a common law employee is considered self-employment income that can be used to compute contributions to a retirement plan. [Editorial note: The case also covers other issues, including whether the taxpayer was a common law employee. The court decided he was, based on an eight factor test.]

The taxpayer, who owned his own consulting business, worked for a foreign government under a letter of appointment during 2003. In the letter of appointment, the foreign government categorized the taxpayer as self-employed “for tax purposes.” The foreign government did not withhold taxes from his salary, and he was responsible for all federal, State, and local taxes and for self-employment taxes. [Note: Because the IRS is unable to levy the employer portion of FICA taxes on a foreign government, US citizens employed by foreign governments are treated as self-employed when it comes to computing these taxes. That means they must pay social security tax on the income. This is not in dispute in this case.]

The taxpayer reported the income from the foreign government, along with other income from his consulting business, on Schedule C, Profit or Loss from Business (Sole Proprietorship). He calculated the contribution for his Simplified Employee Pension (SEP) plan based on the total amount of Schedule C income, and took a corresponding deduction.

Though the tax court decided he was a common law employee of the foreign government, he believed he was entitled to make the retirement plan contribution and take the deduction. His reasoning: Income from his consulting business meant he satisfied the definition of “employer” under Internal Revenue code section 401(c).

The IRS says a US citizen working as a common law employee of a foreign government is not considered self-employed for purposes of contributing to a retirement plan. Therefore, the taxpayer’s SEP contribution could be based only on his income from his other consulting work, not including income from the foreign government.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 40KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The taxpayer owned the entire interest in and maintained a qualified SEP plan for his consultant business, and may deduct contributions made to that SEP plan only with respect to the earned income from that business. [See sec. 401(d).] With respect to his work for the foreign government, the taxpayer does not satisfy the definition of employer under section 401(c) because he does not own the entire interest in the foreign government entity he worked for (the consulate). As a common law employee of the foreign government, he does not satisfy the definition of “employer” for purposes of section 401(c)(4); he is not his own employer for purposes of those earnings. Therefore, he is not entitled to a deduction with respect to the contributions attributable to those earnings.
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