The Limits of Self-Employment Taxation

The IRS needed to be reminded that’s more to being subject to the self-employment tax than merely an individual receiving payment for providing services outside of an employment arrangement, and that reminder came in a Tax Court Summary case of Steele v. Commissioner, TC Summary 2009-45.

The Steeles received $16,974 from the state of Illinois to care for their young granddaughter during 2005 and received a 1099 from the state for that amount. They were paid under the Child Care Assistance Program (CCAP) of the state of Illinois, a program that gave assistance to low income individuals, allowing an individual to have the state make payments to a child care provider chosen by the individual so that the individual can continue working or participate in eligible education. The child’s parent chose the grandparents to provide such care and receive the payments.

The IRS, upon receipt of the 1099, concluded it was income (which it was) and also that it was subject to self-employment tax. That latter point is the problem—the Court reminded us that to be subject to self-employment tax under §1401 the activity must from a trade or business carried on by the taxpayer (there is a second test used for passthrough income from a partnership, but that isn’t relevant to this case).

The Court noted, referencing the Supreme Court’s 1987 decision in the Groetzinger case, that to be a trade or business, “the primary purpose for engaging in the activity must be for income or profit.”

The Court found that, in fact, the Steele’s were engaged in this activity not because they were actively running a child care operation, but rather were motivated by their desire to provide the care that their daughter could not provide. The Court noted that the Steeles did not attempt to claim deductions against this income, nor was it their main source of income.

The fact that they did not attempt to claim expenses is significant since, as the court notes, the definition of a trade or business is the same one as used under §162, the provision that would be used to justify deductions a taxpayer might attempt to claim above the line—a matter we discussed earlier in when we reviewed the Hastings case.

The case is a good reminder that the mere receipt of a 1099MISC with an entry in the “nonemployee compensation” box does not establish conclusively that the payment will be subject to self-employment taxes. Rather, you must determine whether the taxpayer is actually involved in the conduct of a trade or business.

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