Even for the most basic W-2-and-standard-deduction taxpayers, complying with the many complexities of the Internal Revenue Code is no picnic. For those who are self-employed, well…things get exponentially more convoluted. This is due to the fact that the income tax –which is imposed on “taxable income” by Chapter 1 of Subtitle A of the Code — is separate and distinct from the self-employment tax, which is imposed on “net self-employment income” by Chapter 2 of Subtitle A.
Each subtitle is replete with its own rules governing the treatment of items of income and loss, with disparate treatment often resulting regarding the effect of a particular item on a taxpayer’s taxable income tax versus their net self-employment income.
The Tax Court recently illustrated one of these differences in LaFlamme v. Commissioner, T.C. Memo 2012-36 (2012).
During 2006, Lisa LaFlamme (LaFlamme) was a self-employed real estate agent. That year she contributed $34,408 to the aptly-named Lisa K. LaFlamme Defined Benefit Pension Plan. LaFlamme claimed a deduction for the pension contribution on line 19 of her Schedule C rather than on line 28 (page 1) of her Form 1040.
By deducting the pension contribution on Schedule C rather than page 1 of Form 1040, LaFlamme reduced not only her income tax liability, but also her self-employment tax liability, as any expense on Schedule C reduces a taxpayer’s net earnings from self employment.
The IRS permitted the deduction from taxable income, but disallowed the pension contribution deduction for purposes of computing LaFlamme’s self-employment tax liability.
The Tax Court sided with the IRS after separately evaluating the rules governing the deduction for pension plan contributions under each subtitle:
I.R.C. § 404 governs the deductibility of an employer’s contribution to an employee pension plan under Subtitle A. In general, only an employer is permitted to deduct a contribution to a pension plan, and only if the contribution satisfies I.R.C. § 162 (relating to trade or business expenses) or I.R.C. § 212 (relating to expenses for production of income).
I.R.C. § 404(a)(8), however, provides special rules for self-employed taxpayers. A self-employed individual is considered to be her own employer and her own employee, and contributions made by a self-employed taxpayer to her pension plan “shall be considered to satisfy the conditions of section 162 or section 212.” [i]
Conclusion: Based on I.R.C. § 404(a)(8), LaFlamme was entitled to deduct the pension contribution in computing her taxable income.
I.R.C. § 1402(a) defines “net earnings from self-employment” 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 [i.e., subtitle A ] which are attributable to such trade or business”.
Thus, in order for LaFlamme to deduct her pension contribution from her self-employment income, the pension contribution must meet a two-prong test; (1) it must be allowed as a deduction for income tax purposes, and (2) it must be attributable to her trade or business.
With the first requirement having already been established as previously discussed, the court turned its attention to the second requirement, seeking to determine if a self-employed person’s pension contribution is attributable to her trade or business.
The Tax Court held that it was not, highlighting the differences between the two subtitles:
Except for the special rule in section 404(a)(8) [which provides for a deduction for a pension contribution of a self-employed individual in computing taxable income], a self-employed taxpayer’s contribution is not an expense attributable to the taxpayer’s trade or business. Petitioner points us to no authority, and we have discovered none, that provides that the special rule in section 404 (a)(8) applies outside the context of that section. Petitioner’s pension contribution is not attributable to her trade or business.
Conclusion: Because a self-employed taxpayer’s pension contribution is only attributable to her trade or business for purposes of computing her taxable income pursuant to I.R.C. § 404(a)(8), LaFlamme was not permitted to deduct her pension contribution for purposes of computing her net earnings from self-employment.
The lesson? The tax code is exceedingly complicated, and common sense does not always rule the day. When dealing with self-employed clients, keep in mind that just because an expense is allowable in computing taxable income it does not guarantee that the expense is also available to reduce the client’s self-employment tax obligation.
[i] This deduction was also added to the statute in the form of I.R.C. § 62(a)(6).