Ninth Circuit disallows Keogh deduction based on S income.
Keogh plans are retirement plans for self-employed individuals. Sec. 404 (a) (3) (A) and (a) (8) (D) allow self-employed taxpayers to deduct up to a maximum of 15% of earned income for contributions to a qualified retirement plan. A complex series of statutory sections define the meaning of "self-employed" and "earned income." Sec. 401 (c) (1) (B) defines "self-employed individual" as "an individual who has earned income." Sec. 401 (c) (2) (A) defines "earned income" as "net earnings from self-employment (as defined in section 1402 (a))." However, Sec. 401 (c) (2) (A) limits the net earnings for the Keogh plan deduction to net earnings from a trade or business "in which personal services of the taxpayer are a material income-producing factor." Sec. 1402 (a) defines "net earnings from self-employment" as the "gross income from any trade or business carried on by such individual...plus his distributive share...of income or loss...from any trade or business carried on by a partnership of which he is a member." There is no mention of S income in Sec. 1402 (a).
In Durando, Antonio and Naomiann Durando were sole proprietors, and were also shareholders in several S corporations in 1985 and 1987. They claimed Keogh retirement plan deductions of over $9,000 in each of those years, which was 15% of their combined Schedule C income plus their pro rata share of the S corporations' income. The Durandos did not report their share of the S corporations' income as net earnings for self-employment tax purposes. Although Antonio spent a substantial amount of time providing services to one of the S corporations, he received no compensation as an employee. Therefore, the only income he reported from the S corporations was as a shareholder.
The IRS disallowed the portion of the Keogh plan deductions based on the Durandos' share of income from the S corporations. The Durandos paid the deficiency and sued for a refund in Federal district court, where they lost.
The Court of Appeals ruled that passthrough income of an S corporation cannot be treated by the shareholders as self-employment income for Keogh plan deduction purposes. The court based its ruling on the failure of the relevant statutes to allow S shareholders to deduct contributions to qualified retirement plans. Also, the court explained that income is taxed to the owners of sole proprietorships or partnerships because they helped create the income, but S income is passed through to its shareholders only because they are shareholders, and they elected to become so.
The Durandos had argued that Sec. 1366 (b) and (c) provide support for treating passthrough income as self-employment income. These sections state that a shareholder's gross income includes his pro rata share of the S income and the character of any item included in the pro rata share will be determined as if the item were realized directly by the shareholder from the source from which it was realized by the corporation. The word "character" in Sec. 1366 indicates how each item on the S corporation's tax return affects each shareholder's tax liability. For example, tax-exempt income, capital losses, charitable contributions, etc., retain their tax status when they are passed through to the shareholders. In finding Sec. 1366 (b) and (c) inapplicable to the self-employment income issue, the court cited Rev. Rul. 59-221, which held that S corporation passthrough income did not constitute net earnings for self-employment tax purposes.
The court also cited the legislative history of Keogh plans, in which Congress stated that the plans cover "self-employed individuals (sole proprietors and partners)." Concluding that the law reflects the difference between carrying on a trade or business as a sole proprietor or partner as opposed to being an S shareholder, the court pointed out that S corporations can establish retirement plans for their employees, including those who are shareholders.
An important point not sufficiently emphasized by the court in Durando is that the statutory scheme covering Keogh plans links self-employment income for Keogh plan purposes to net earnings for self-employment tax purposes. Sec. 1401 (a) and (b) impose the self-employment tax on this self-employment income. S income is not income for self-employment tax purposes; therefore, it cannot be treated as income for Keogh plan deduction purposes. However, if the S shareholder is also an employee, he can obtain retirement plan coverage, assuming compensation is received for the services performed. Of course, employee compensation is subject to FICA tax under Secs. 3101 and 3111. Moreover, Rev. Rul. 74-44 allowed the IRS to assess FICA taxes when S shareholders perform services for and receive distributions from an S corporation, but receive no salary or compensation for the services. Presumably, such action by the Service would permit the shareholder-employee to be covered by a retirement plan to the extent of the services performed.
Of the three forms of passthrough entities (S corporations, partnerships and limited liability companies (LLCs)), only S corporations are affected by Durando. Since LLCs are taxed as partnerships, Keogh plan deductions can be based on passthrough income of LLC members. However, personal services of the members would presumably have to be a material income-producing factor, as required by Sec. 401 (c) (2) (A).
Although Durando is binding only in the Ninth Circuit (i.e., California, Arizona, Nevada, Idaho, Montana, Washington and Oregon), it is likely that the other circuits will follow this ruling.
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|Author:||Sager, Clayton R.|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 1996|
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