Steel yourself for a bit of truth: The internal revenue code occasionally uses phrases that are not defined anywhere in the code itself. For example, under the Self-Employment Contributions Act of 1954 (SECA), as the owner of an unincorporated business, you’re required to pay social security and Medicare taxes. These taxes are assessed on your “net earnings from self-employment.” That phrase is defined in code section 1402 as “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business…”
If you’re now wondering about the definition of “trade or business,” that term, according to the tax court, is used in at least 800 subsections of the internal revenue code, but is never defined.
In T.C. Memo. 2016-56 (Ryther), the court turned to an eight-part test to help make the determination of whether a taxpayer’s income was a trade or business for purposes of assessing self-employment tax.
The taxpayer was the owner of a steel fabrication business that was liquidated in bankruptcy in 2004. From 1997 to 2004, the business had generated a quantity of scrap steel left over from the fabrication of steel beams. The scrap pieces, some of which were 40 feet long and weighed hundreds of pounds, were abandoned by the bankruptcy trustee and taken over by the taxpayer.
From 2004 through 2010, the taxpayer sold scrap steel once or twice a month, to at least five different scrap wholesalers, in sales that totaled over $317,000. In 2012, the taxpayer filed tax returns for those seven years and reported the sales as miscellaneous income.
In 2013, the IRS determined that the sales were attributable to a trade or business and subject to self-employment taxes.
The taxpayer disagreed.
Here are the eight factors the court considered in reaching a decision.
1. Frequency and regularity of sales.
The taxpayer didn’t do anything to create the scrap. His efforts were limited solely to liquidating it. Despite relative ease in finding customers and the little to no effort required to make the scrap salable, his sales were sporadic. He sold scrap at most on 24 days a year, and only once per day.
2. Substantiality of sales.
His sales totaled over $300,000 over seven years. This amount was substantial to the taxpayer and comprised 100% of his net income.
3. Length of time the property was held.
The taxpayer sold the scrap over the course of seven years. The scrap required no maintenance and next to no marketing: Scrap has a published market price, and the taxpayer easily sold it, and could have sold it the day he got it.
4.Segregation of property from business property.
The taxpayer had a single big pile of scrap, not collections of business scrap and personal scrap that he commingled.
5. Purpose of acquisition.
The parties stipulated that the taxpayer’s company abandoned the scrap, that the taxpayer researched scrap wholesalers, and that he starting selling the scrap in 2004. Perhaps he decided to take possession of the scrap only after he learned there was a market for it, which would indicate that he acquired it for resale. Or perhaps he immediately took possession of it, and figured that maybe someday it could be useful, which would indicate that he intended to hold on to it. There aren’t enough facts to determine when and why the taxpayer acquired the scrap.
6. Sales and advertising effort.
The taxpayer spent nothing to sell the scrap, and didn’t advertise the metal or do anything else to make it more salable. The market for scrap has established prices, and one can sell by simply picking up the phone and arranging delivery. No other advertising would be ordinary.
7. Time and effort spent on sales.
The taxpayer was active in selling the scrap. He researched scrap wholesalers and contacted them to arrange sales. The amount of time he spent on these activities is unclear. It doesn’t appear that buyers came to the taxpayer in the way customers come to a store to browse.
8. How the proceeds of the sales were used.
The taxpayer didn’t use the proceeds to buy more scrap. He slowly liquidated the large pile of scrap to pay everyday expenses.
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For the Taxpayer.
1. Frequency and regularity of sales. We find this factor favors the taxpayer. That he decided to sell the scrap slowly over time instead of in one lump doesn’t make the sales a business.
2. Substantiality of sales. Because the taxpayer’s sales were “sporadic” and generated large profits with little effort, we find that although the sales were substantial, this factor doesn’t favor the IRS. It’s neutral.
3. Length of time the property was held. In this market, one would expect a short holding period if the taxpayer was holding it primarily for sale to customers in the ordinary course of business. On the facts of this case, a holding period of seven years persuades us that the taxpayer wasn’t holding his scrap for sale in the ordinary course of business.
4.Segregation of property from business property. This factor is neutral.
5. Purpose of acquisition. This factor is neutral. There simply aren’t enough facts to determine when and why the taxpayer acquired the scrap.
6. Sales and advertising effort. We find that this factor also neither favors nor disfavors the taxpayer.
7. Time and effort spent on sales. We find this factor to be neutral.
8. How the proceeds of the sales were used. This factor greatly favors the taxpayer.
Decision: We find that the scrap wasn’t property primarily held for sale to customers in the ordinary course of a trade or business because the sales weren’t part of a trade or business. We therefore also find that the income the taxpayer realized from selling the scrap isn’t net earnings from self-employment under section 1402(a)(3)(C). As this is the only income in question, we conclude the taxpayer isn’t liable for self-employment tax.