In General: Certain income items are excluded from the calculation of net earnings from self-employment, items excluded are:
[a] Rentals from real estate: Rentals from real estate and from personal property leased with the real estate are generally excluded from net earnings from self-employment, unless the rentals are received in the course of a trade or business as a real estate dealer (Code Section 1402(a)(1); Regulation Section 1.1402(a)-4(a)).
Generally, an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits he or she may derive from such sales is a real-estate dealer. An individual who merely holds real estate for investment or speculation and receives rentals from the property is not considered a real-estate dealer. If a real-estate dealer holds real estate for investment or speculation in addition to real estate held for sale to customers in the ordinary course of his trade or business as a real-estate dealer, only the rentals from the real estate held for sale to customers in the ordinary course of his or her trade or business as a real-estate dealer, and the deductions attributable thereto, are included in determining net earnings from self-employment; the rentals from the real estate held for investment or speculation, and the deductions attributable thereto, are excluded (Regulation Section 1.1402(a)-4(a)).
Payments for the use or occupancy of entire private residences or living quarters in duplex or multiple-housing units, in which no services are rendered for the occupants, are generally rentals from real estate. Thus, except in the case of real-estate dealers, these payments are excluded in determining the recipient’s net earnings from self-employment (Regulation Section 1.1402(a)-4(c)(1)).
In contrast, payments for the use or occupancy of rooms or other space where services are also provided to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate. Thus, such payments are included in determining net earnings from self-employment. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant (Regulation Section 1.1402(a)-4(c)(2); Bobo v. Commissioner, 70 Tax Court 706 (1978); Revenue Ruling 83-139). When determining whether service is for the maintenance of property, the courts have emphasized that the rental exclusion must be read narrowly and that any service not clearly required to maintain the property in condition for occupancy is considered work performed for the tenant (Delno v. Celebrezze; Johnson v. Commissioner, 60 Tax Court 829 (1973)).
Once the services that are considered to be for the convenience of the tenants have been determined, it is necessary to determine whether the compensation for these services constitutes a material portion of the payments made by the tenants. If it does, the services are substantial and the income received by the property owner will not be considered rentals from real estate, but rather net earnings from self-employment (Revenue Ruling 83-139). In Revenue Ruling 57-108, the IRS addressed the self-employment tax issue with respect to short-term rentals of beach houses. The IRS ruled that income derived by an individual, who is not a real estate dealer, from the rental of furnished beach dwellings where, in addition to rendering the usual necessary services with respect to the property, the individual also performs many personal services for the comfort and convenience of guests in connection with their recreational activities, does not constitute rentals from real estate and is includible in computing such individual’s net earnings from self-employment.
Tax Tip & Observation: Practitioners have debated whether or not a taxpayer renting property as an AirBnB is subject to self-employment tax. It appears to hinge on whether or not the taxpayer is providing “substantial” services.
Example 1:
A trailer park owner and operator provides trailer lots, services, and facilities to trailer owners for a monthly fee. The park owner allots a parcel of land to each trailer and maintains a laundry facility, city sewerage and electrical connections and a roadway into the trailer park. The owner cleans and maintains the premises daily and furnishes hot water for the laundry facility. The trailer owners maintain shower, toilet, and water heating facilities inside their trailers and pay for their own water and electricity. Most of the services rendered by the owner are required to maintain the space in condition for occupancy, and the services rendered by the owner for the convenience of the tenants are not substantial. Therefore, the income received by the trailer park owner constitutes rentals from real estate and is not includible in computing net earnings from self-employment.
Example 2:
The facts are the same as in the preceding example, except that the trailer park owner provides additional services. The park contains a recreation hall, consisting of a card area, pool room, kitchen, auditorium, stage, and library. Employees of the owner supervise and maintain these areas. The owner also provides numerous recreational events, distributes a monthly newsletter to the tenants, and helps the tenants buy or sell their trailers. Employees of the owner also will connect and disconnect water, sewerage, and electrical lines for the trailer owners. In this case, the owner provides many services beyond those required for occupancy. These services are of such substantial nature that compensation for them can clearly be said to constitute a material part of the payments made by the tenants of the trailer park. Therefore, the income received by the trailer park owner is includible in computing net earnings from self-employment.
Under the Conservation Reserve Program (CRP), if the taxpayer owns or operates highly erodible or other specified cropland, the taxpayer may enter into a long-term contract with the USDA, agreeing to convert to a less intensive use of that cropland. The CRP is the current version of a long line of federal soil conservation programs, and is so substantially similar to its predecessor, the Soil Bank Act, that it has been referred to as the “Son of Soil Bank.” In Revenue Ruling 60-32, the IRS concluded that soil bank payments made to persons who did not operate or materially participate in a farming operation (nonfarmers) were not included in determining net earnings from self-employment. Soil bank payments to farmers, however, were to be treated as self-employment income derived from their farming business. Although Revenue Ruling 60-32 did not explain why the IRS differentiated between farmers and nonfarmers, the IRS subsequently issued Revenue Ruling 65-149 in which it indicated that it viewed soil bank payments to nonfarmers as rental income.
In Wuebker v Commissioner, 110 Tax Court 431 (1998), the taxpayers were active farmers who claimed their CRP payments constituted rentals from real estate. The Tax Court agreed with the taxpayers’ position that CRP payments constituted rentals from real estate that were excludable from self-employment income. However, the Sixth Circuit reversed the Tax Court, holding that CRP payments to farmers do not fall within the “ordinary or natural” meaning of the phrase “rentals from real estate,” and that therefore CRP payments to farmers are not excludable from self-employment tax as rentals from real estate (Wuebker v Commissioner, 205 F.3d 897 (6th Cir. 2000)).
Subsequently, the IRS issued a proposed revenue ruling to address whether CRP payments received by a recipient who is retired and not otherwise actively engaged in farming are subject to self-employment tax. In that proposed ruling, the IRS tentatively concluded that CRP rental payments (including incentive payments) from USDA to a (1) farmer actively engaged in the trade or business of farming who enrolls land in CRP and fulfills the CRP contractual obligations personally, and to (2) an individual not otherwise actively engaged in the trade or business of farming who enrolls land in CRP and fulfills the CRP contractual obligations by arranging for a third party to perform the required activities are both includible in net income from self-employment for purposes of the self-employment tax and are not excludible from net income from self-employment as rentals from real estate (Notice 2006-108).
In Morehouse v. Commissioner, 140 Tax Court No. 16 (2013), the Tax Court concluded that CRP payments received by a taxpayer who was not a farmer were subject to self-employment tax. In reaching this decision, the Tax Court held that the taxpayer was engaged in a trade or business by virtue of participating in the CRP with the primary intent of making a profit. The Tax Court also rejected the taxpayer’s assertion that CRP payments were rentals from real estate under Code Section 1402(a)(1) and should thus be excluded from net earnings from self-employment. According to the Tax Court, the CRP payments were proceeds from the taxpayer’s own use of his land and thus did not constitute rent. However, in Morehouse v. Commissioner, 2014 PTC 534 (8th Cir. 2014), the Eighth Circuit reversed the Tax Court and held that CRP payments made to nonfarmers constitute rentals from real estate for purposes of Code Section 1402(a)(1) and are excluded from the self-employment tax. The Eighth Circuit noted this was the same conclusion reached by the IRS in Revenue Ruling 65-149 with respect to soil bank payments.
Caution: In AOD 2015-02, the IRS recommended nonacquiescence to the decision in Morehouse. The IRS’ position is that it will follow Morehouse within the Eighth Circuit but only with respect to cases in which the CRP payments at issue were both (1) paid to an individual who was not engaged in farming before or during the period of enrollment of his or her land in the CRP, and (2) paid before January 1, 2008. For cases without those facts, the IRS will continue to litigate its position in the Eighth Circuit. It will also continue to litigate its position in all cases in all other circuits.
[b] Dividends and interest: Dividends on any share of stock, and interest on any bond, debenture, note, or certificate, or other evidence of indebtedness, issued with interest coupons or in registered form by any corporation (including one issued by a government or political subdivision thereof), are generally excluded from an individual’s net earnings from self-employment unless the individual receives the dividends and interest in the course of a trade or business as a dealer in stocks or securities (Code Section 1402(a)(2); Regulation Section 1.1402(a)-5).
Caution: Only interest on bonds, debentures, notes, or certificates, or other evidence of indebtedness, issued with interest coupons or in registered form by a corporation, is excluded under this rule; other interest received in the course of any trade or business – such as interest a pawnbroker receives on his or her loans, or interest a merchant receives on his accounts or notes receivable – is not excluded.
For this purpose, a dealer in stocks or securities is a merchant of stocks or securities with an established place of business, regularly engaged in the business of buying stocks or securities and reselling them to customers. Individuals who buy and sell or hold stocks or securities for investment or speculation, whether or not that buying or selling constitutes the carrying on of a trade or business, are not dealers in stocks or securities (Regulation Section 1.1402(a)-5(d)).
Even a dealer can exclude otherwise excludable dividends and interest on stocks or securities he or she holds for speculation or investment (Regulation Section 1.1402(a)-5(c)).
[c] Gains and losses: Generally, net earnings from self-employment do not include any gain or loss:
(1) that is considered gain or loss from the sale or exchange of a capital asset;
(2) from the cutting of timber, or the disposal of timber, coal, or iron ore, if Code Section 631 applies to the gain or loss; or
(3) from the sale, exchange, involuntary conversion, or other disposition of property if the property is neither (a) stock in trade or other property of a kind that would properly be includible in inventory if on hand at the close of the tax year, nor (b) property held primarily for sale to customers in the ordinary course of the trade or business (Code Section 1402(a)(3); Regulation Section 1.1402(a)-6).
Example:
During the year, Ann, who owns a shoe store, realized a net profit of $10,500 from the sale of shoes and a gain of $550 from the sale of a display case. During the same year, she sustained a loss of $3,000 as a result of damage by fire to the store building. In computing taxable income, Ann takes all these items are taken into account. In determining net earnings from self-employment, however, she includes only the $10,500 of profit she derived from the sale of shoes. The $550 gain and the $3,000 loss are excluded.
An exception to this exclusion rule applies in determining the net earnings from self-employment of an options dealer or commodities dealer. For those taxpayers, there is no exclusion for any gain or loss (in the normal course of the taxpayer’s activity of dealing in or trading Code Section 1256 contracts) from Code Section 1256 contracts or property related to such contracts (Code Section 1402(i)(1); Rudman v. Commissioner, 118 Tax Court 354 (2002)). For this purpose, an options dealer is generally any person registered with an appropriate national securities exchange as a market maker or specialist in listed options (Code Section 1402(i)(2)(A)). A commodities dealer is a person who is actively engaged in trading Code Section 1256 contracts and is registered with a domestic board of trade that is designated as a contract market by the Commodities Futures Trading Commission (Code Section 1402(i)(2)(B)).
[d] NOL deduction: The deduction for net operating losses is excluded from the calculation of an individual’s net earnings from self-employment (Code Section 1402(a)(4); Regulation Section 1.1402(a)-7; DeCrescenzo v. Commissioner, 2014 PTC 210 (2014)).
[e] Personal exemption deduction: The deduction for personal exemptions (which has been suspended by Code Section 151(d)(5) for tax years beginning after December 31, 2017 and before January 1, 2026) is excluded from the calculation of an individual’s net earnings from self-employment (Code Section 1402(a)(7)).
[f] Domestic production activities deduction: The deduction relating to income attributable to domestic production activities under Code Section 199 (which has been repealed for tax years beginning after December 31, 2017) is excluded from the calculation of an individual’s net earnings from self-employment (Code Section 1402(a)(16)).
[g] Possession-source income: The exclusion from gross income provided under Code Section 931, relating to bona fide residents of certain possessions of the United States (Guam, American Samoa, and the Northern Mariana Islands), does not apply in calculating an individual’s net earnings from self-employment. Thus, an individual’s net earnings from self-employment are subject to self-employment tax even if they are excluded from his or her gross income under Code Section 931.
[h] Certain termination payments for former insurance salesmen: An individual’s net earnings from self-employment do not include any amount the individual receives during the tax year from an insurance company on account of services the individual performed as an insurance salesperson for that company if:
(1) the individual receives the payment after the termination of his or her agreement to perform those services for the company;
(2) the individual performs no services for the company after the termination date and before the close of the tax year;
(3) the individual enters into a covenant not to compete against the company that runs for a period of at least one year, beginning on the date of the termination;
(4) the amount of the payment depends primarily on policies sold by or credited to the individual’s account during the final year of the agreement, or the extent to which those policies remain in force for some period after the termination, or both; and
(5) the amount of the payment does not depend to any extent on the individual’s length of service or overall earnings from services he or she performed for the company (Code Section 1402(k)).
The individual’s eligibility for the payment (unlike the amount of the payment) may depend on his or her length of service with the company (Code Section 1402(k)(4)(B)).
Where the payments received by the individual are tied to the quantity and quality of his or her prior services, they are subject to self-employment tax (Schelble v. Commissioner, Tax Court Memo. 1996-269, aff’d, 130 F.3d 1388 (10th Cir. 1997); Parker v. Commissioner, Tax Court Memo. 2002-305; Farnsworth v. Commissioner, Tax Court Memo. 2002-29).
[i] Section 199A deduction: The deduction allowed under Code Section 199A does not reduce net earnings from self-employment (Regulation Section 1.199A-1(e)(3)).
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
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(Updated 03/07/2021 06:48)