Self-employment tax treatment of Keogh and SEP contributions and unreimbursed business expenses.

A recurring issue self-employed persons face is whether amounts expended for self-employed retirement plan (Keogh) and simplified employee pension (SEP) contributions, as well as certain unreimbursed trade or business expenses paid by a partner, are subject to taxation under the Self-Employment Contributions Act (SECA).

Self-employed individuals are subject to Social Security taxes under Sec. 1401(a) and (b). For the retirement/disability (OASDI) portion of SECA, Sec. 1402(b) caps self-employment income at the Social Security taxable wage base (e.g., $61,200 for 1995). For the Medicare portion of SECA, however, there is no wage cap. Thus, the 2.9% Medicare rate applies to all self-employment income, while the 12.4% OASDI rate applies only to self-employment income up to the taxable wage base.

Unreimbursed business expenses

Sec. 1402(b) defines "self-employment income" as net earnings from self-employment. In relevant part, Sec. 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 Subtitle A of the Code attributable to such trade or business. Sec. 162(a) provides a deduction for the ordinary and necessary expenses paid or incurred in carrying on any trade or business. in relevant part, Sec. 62(a)(1) provides that adjusted gross income means gross income less the deductions allowed by chapter 1 of Subtitle A (which includes Sec. 162(a)) attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.

In general, a partner may not deduct partnership expenses on his own income tax return, even if the expenses were incurred by the partner in furtherance of partnership business. However, if under the partnership agreement or practice the partner is required to pay certain partnership expenses out of his own funds, the partner is entitled to a Sec. 162 deduction on Schedule E of Form 1040 for the amount of such expenses; see, e.g., Klein, 25 TC 1045 (1956), Rev. Rul. 70-253 and Letter Ruling 9330001.

Based on the above authorities, business expenses, including a partner's unreimbursed business expenses, are subtracted from gross income in arriving at net earnings from self-employment. Therefore, such expenses can reduce SECA tax payable by that individual and should be taken into account when completing Schedule SE of Form 1040.

Keogh/SEP contributions

Unlike unreimbursed business expenses, it is not clear from Sec. 1402(a) whether amounts expended for Keogh and SEP contributions on behalf of a self-employed individual qualify as deductible business expenses such that they reduce net earnings from self-employment (and therefore reduce SECA payable by that individual). Sec. 401(c)(2)(A), the definition of earned income used for the Sec. 401(a) qualified plan rules, defines "earned income" as net earnings from self-employment as defined under Sec. 1402(a), but determined with regard to deductions allowed by Sec. 404 (i.e., the deduction for the Keogh or SEP contributions). In other words, the Keogh or SEP contributions on behalf of a self-employed individual must be subtracted from that individual' Sec. 1402(a) net earnings from-self employment in arriving at earned income under Sec. 401(c)(2)(A). From this wording, one can only infer that the amount contributed to a Keogh or SEP is not a business expense deductible from gross income in arriving at Sec. 1402(a) net earnings from self-employment. Therefore, it is arguable that such contributions do not reduce the SECA tax payable by a self-employed individual.

From Alan A. Nadel, CPA, New York, N.Y.