Case — Self-Employment Tax

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TL Case Summ

THE QUESTION

Is a police officer’s off-duty work subject to self-employment tax?

THE DISPUTE

Taxpayer Says: He remained an employee of the police department while working off duty and he is not liable for self-employment tax.

Internal Revenue Service Says: The taxpayer was not an employee of the police department while working off duty, and he is liable for self-employment tax.

THE LAW

From Internal Revenue Code Section 1401: Imposes a tax upon a taxpayer’s self-employment income.

From Internal Revenue Code Section 1402(a): Self-employment income consists of gross income derived by an individual from any trade or business carried on by such an individual.

From Internal Revenue Code Section 1402(c)(2): The self-employment tax does not apply to compensation paid to an employee.

From Internal Revenue Code Section 3121(d)(2): Defines an employee as “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee”. That definition is made applicable for self-employment tax purposes by section 1402(d).

From Federal Tax Regulation 31.3401(c)-1(b), (d): Whether an individual is an employee or an independent contractor is a question of fact determined by application of common law principles.

THE CAUSE OF THE DISPUTE

The determination of whether you’re self-employed or an employee is based on the relationship between you and the person or entity you perform work for. Generally, you’re considered an employee when you’re subject to the will and control of your employer as to what work you do and how you do it. It’s not necessary for your employer to actually direct or control the way you do your work. It’s enough that your employer has the right to do so.

Facts and circumstances based on the level of financial and behavioral control the person or entity you work for has over you, as well as your relationship with that person or entity, also play a role, which is why disputes in this area arise so often. The factors used to make the determination are open to interpretation, leading to a natural tension between taxpayers, who have an incentive to classify themselves as employees and escape the self-employment tax, and the IRS.

In this case, the taxpayer, a deputy sheriff, worked for businesses and others while off-duty from his law enforcement job. Each business or entity paid him directly, and issued Forms 1099, which he reported as income. While working off-duty, he was required to comply with departmental policies concerning the off-duty service, including wearing his uniform. In addition, the department determined the off-duty minimum pay rate, limited the hours he could work, and reserved the right to suspend his work if he did not meet policy requirements. The department acted as liaison between the taxpayer and the entity requesting the off-duty service and required the entity to pay an administrative fee for each hour of off-duty service. Because of the department’s level of control over his off-duty work, the taxpayer believes he performed that work as an employee of the department, and that no self-employment tax is due.

The IRS says the taxpayer was not an employee of the department while working off-duty, because the department merely acted as a referral service. Such broad control is not the same as direct control over an employee. While working off-duty, he was not an employee of the entities he performed the off-duty work for, nor the department, and he is liable for self-employment tax on the amounts received.

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, 15KB)

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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 incidental control held by the department relates solely to the on-duty employment relationship, rather than to the details of the off-duty relationship. The department is looking after its own interests. When taken as a whole, the facts establish the taxpayer was self-employed with respect to the off-duty services he provided to third-party entities. The earnings in dispute are earnings from self-employment, subject to the tax imposed by section 1401.
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