The IRS and personal property rental income.
In 1991, the Internal Revenue Service quietly added a new wrinkle to its instructions for the Form 1040 Schedules C and E. Without highlighting the move in its "Changes You Should Note" section, the Service stated that taxpayers should, "Use Schedule C to report income and expenses from the rental of personal property, such as equipment or vehicles."
The problem with this instruction is its failure to account for individuals who do not operate a trade or business renting personal property but who are involved with what could be termed passive personal property rental activities. Because of this overly broad inclusion, many individuals found that income not properly attributable to a trade or business wound up subject to self-employment tax.
Although slipped quietly into the instructions, this item caused a lot of concern among NSPA members, as it affected a broad range of clients including farmers, S corporation shareholders and senior citizens. NSPA's Federal Taxation Committee identified this change in instructions as a high priority at their January meeting, where they questioned then-Acting Commissioner of Internal Revenue Michael Dolan about the issue. Dolan thought the change in the instructions was meant to clarify the treatment of income under existing law and therefore it did not qualify as a "Change You Should Note" in the instructions. He promised to examine the issue further and respond in more detail when he had obtained more information.
From Instructions to Form
The change in the form worked its way first into the instructions and then onto the Schedule E itself. In 1990, personal property rentals were not specifically mentioned either in the instructions or on the face of Schedule C or E. In 1991, the IRS noted in its instructions to Schedule E that Schedule C should be used to report income and expenses from the rental of personal property. The Service did not mention personal property rentals in its 1991 Schedule C instructions, but for the first time it noted in the "Other Schedules and Forms You May Have to File" section that a Schedule E would be required for "rental and royalty income or (loss) that is not subject to self-employment tax."
By 1992, IRS has added an instruction on the face of the Schedule E to "Report income and expenses from the rental of personal property on Schedule C or C-EZ." These instructions appeared overly broad because they did not make an exception for personal property rental income received outside of a trade or business.
Change Affects a Wide Variety of Clients
As a result of this change, many individuals and small businesses found themselves subject to an unexpected self-employment tax burden. Two groups that exemplify the effect of this hidden tax are S corporation shareholders and retiring farmers. Members of these groups often participate in personal property leasing arrangements that do not constitute a separate trade or business but are taxed on Schedule C.
S corporations often do not qualify for credit, particularly in the early stages of their existence. To finance capital expenditures, many shareholders take out loans in their own names to purchase equipment. Upon purchasing the equipment, they immediately lease it to the corporation for the value of the loan payments. Under the current IRS instructions, these lease payments are now subject to self-employment taxes, adding an extra burden to the individual struggling to start a small business.
Farmers planning retirement have developed a plan to provide a steady stream of income through their senior years by leasing the equipment they have purchased over the years. Individuals who have run their family farms for a number of years often own substantially all of their equipment by the time they retire. In order to supplement their retirement income, these farmers often enter into lease agreements with younger farmers to allow the newcomers to use the lessors' equipment for a set price. This provides a predictable source of cash for the retirees and relieves the younger farmers from the burden of buying new equipment.
Unfortunately, the Service would now subject this income to self-employment taxes. In addition, those who plan retirement incomes that include personal property rentals risk a reduction in their social security benefits between the ages of 65 and 70, as the Service's current treatment classifies this rental as earned income.
Administrative Steps Taken
The initial step on the part of NSPA's Federal Taxation Committee was to query the IRS as to what motivated this change to the instructions in the first place. According to the Service, "When the instructions to Schedule E were changed...it was not a policy change, but an attempt to clarify the point that individuals receiving income from their business of renting personal property are subject to self-employment taxes and must use Schedule C or C-EZ."
While the Service has yet to identify what prompted the change in the instructions, several publications have pointed toward a tax court memorandum decision, Stevenson v. Commissioner, 57 TCM 1032 (1989), as the possible motivation behind the change. In Stevenson, the taxpayer sold and rented portable advertising signs in what was clearly an ongoing trade or business operation. The decision does not specifically address the treatment of personal property rentals not arising from a trade or business nor does it define at what point a personal property rental activity becomes a trade or business. Clearly a gap exists between the cut-and-dried Schedule C treatment warranted in the Stevenson example and the S corp shareholder who receives rental income solely to pay off the loans necessary to start a business.
IRS Responds to NSPA
Jerry Holmes, the Chief of Branch 2 in the Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations), addressed the Society's concerns by stating, "We now realize that the instruction was too broad. We are in the process of revising the instruction to clarify that the income must be from a trade or business and the instructions will also include an explanation of what constitutes a trade or business." The letter goes on to admonish that, "|T~he recent changes to the instructions for Schedule E and the revisions we are presently making do not reflect a change in policy or the law. A farmer who receives income from the business of renting personal property should report such income on Schedule C or C-EZ." It appears the Service is concerned with compliance in this area and will continue to monitor the issue. Fires Being Kindled.
With this letter from the IRS, many of the legislative contacts that NSPA has made on this issue will not have to be called upon. The Service's intention to narrow the scope of the instruction should go far toward alleviating the problem. Nevertheless, several members of the Federal Trade Commission have written letters to their Senators and Representatives to lay the groundwork for legislative change, should it become necessary. More recently, numerous NSPA members who visited members of Congress as part of the National Issues Conference in May raised this issue in face-to-face meetings. None of the elected representatives had previously been aware of the problem, but many who were enlightened by NSPA members expressed concern that the IRS's then-current instruction appeared far too broad.
The Next Step
NSPA commends the steps taken by the IRS to alleviate this problem that has eaten into the after-tax income of so many of our members' clients. As we go to press, our next step is to offer assistance to those who are working on defining "trade or business" in order to provide insight from the practitioner community into the new instructions.