Case — Self-Employment Income

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TL Case Summ

THE QUESTION

Are commissions received by a retired insurance agent self-employment income subject to self-employment tax?

THE DISPUTE

Taxpayer Says: Due to retirement, no trade or business was carried on and self-employment tax is not owed on commissions received.

Internal Revenue Service Says: Commissions are deferred compensation from past income- producing activities and are subject to self-employment tax.

THE LAW

From Internal Revenue Code Section Sec. 1402(b):  Self-employment income means the net earnings from self-employment derived by an individual.

From Federal Tax Regulation 1.1402(a)-2(b): The trade or business must be carried on by the individual, either personally or through agents or employees.

From Newberry v. Commissioner, 76 T.C. 441, 444 (1981): The term “derive” requires “a nexus between the income received and a trade or business that is, or was, actually carried on.” Income must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer before it becomes subject to self-employment tax.

THE CAUSE OF THE DISPUTE

When you run your own business, you’re required to pay social security and Medicare tax on the income from that business (after deducting related expenses).

In this case, the taxpayer retired and turned day-to-day business operations of his sole proprietorship insurance agency over to an office manager. Though taxpayer maintained an insurance license, he did not actively sell insurance, and neither did anyone else in the office. The commissions received were primarily renewals of policies sold in prior years.

The taxpayer believes he is no longer working in the business, and is not self-employed.

The IRS says that previous business activity satisfies the “carried on” requirement of the statute, and self-employment tax is due.

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, 12KB)

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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. For purposes of income being included in net earnings from self-employment, a trade or business can be carried on by an individual either personally or through agents or employees. The renewal commissions are tied to the quantity and quality of prior labor and are subject to self-employment tax.
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