Karen is self employed and her partner is an employee, whose salary exceeds the social security maximum for social security taxes. Karen earns $140,000 from her business. It is all community income. According to IRS Publication 555, Karen will pay income taxes on only $70,000 of her income. Of course she will also pay taxes on half of her partner’s W-2 income. The partner will get full credit for social security benefits ($106,800), but, according to Pub 555, Karen will be limited to $70,000 for social security benefits purposes. Can this be right?
I challenged the language in Pub 555 when it first came out and was told by the person in Forms and Pubs at the IRS that the language had been approved by the Office of Chief Counsel. That is the office that gives legal advice to the IRS. So, I pushed a little further and talked to the person in Chief Counsel who had approved the language. The problem, she says, is DOMA. Our conversation went something like this:
PC: Under Section 1402 of the Internal Revenue Code, it looks like there is a general rule that says the self-employment tax should be paid by the person who manages the business. That would be Karen in my hypo.
IRS: Yes, but there is a special rule in 1402(a)(5) that applies to community property spouses. It allocates the self-employment tax to the person who manages the business. And since same-sex couples can’t be spouses, this special rule can’t apply to them.
PC: Isn’t that just a restatement of the general rule – allocating the earnings to the spouse who earns them? Why can’t we have the general rule apply to same-sex couples subject to community property.
IRS: Because the community property rule says the income must be split 50/50.
PC: Yes, that’s what Poe v. Seaborn said in 1930 about income tax liability. There was no social security tax then. So why split the income for self-employment taxes?
IRS: Because community income is always split 50/50 except when there’s a code provision that says otherwise. All the other code provisions say things like “community property rules should not be applied under this section.” They don’t use the word “spouse.” Unfortunately 1402(a)(5) does.
PC: OK, then let’s consider why that special provision does include the word “spouse.” Remember that the original provision, enacted in 1950 did provide a special rule for community property spouses that was different from the general rule. The 1950 provision said that in community property states the husband would be presumed to be the manager of the business. As a result, rather than allocating self-employment earnings to the person who managed the business, such earnings were allocated to the husband.
IRS: True. But that was struck down as unconstitutional in the 1980s and in 2004, as part of some changes to the social security statutes, the new provision was enacted.
PC: Right. So the new rule was intended to reverse the special rule and thus make community property spouses subject to the general rule – all self-employment earnings are allocated to the earner for self-employment tax purposes.
IRS: No, it created a special rule that reversed the 50/50 presumption of community income. And unfortunately, that special rule can’t apply to same-sex couples because of DOMA.
PC: Even though the purpose of the self-employment tax was to create social security benefits for the earner?
IRS: The statute uses the word “spouse.”
Clearly, this conversation was going nowhere. But let me point out a couple of important things in support of my argument that the general rule should apply to community property RDPs and allocate the self-employment earnings to the earner for SE tax purposes:
1. The IRS has not yet published anything that counts as authority on this question. Pub 555 is an IRS publication, but it is not “authority.” As a result, you can ignore it with impunity – so long as the position you take is based on a sound construction of the statute, which I think it is.
2. What we have is two competing constructions of the same Code provision – the IRS construction and my construction. Both are reasonable (although, given statutory purpose, I think mine is more reasonable).
3. If DOMA is unconstitutional, then it should not be used to require the construction that the IRS supports. As a matter of statutory construction, wouldn’t it make more sense to avoid applying a possibly unconstitutional law like DOMA? We could do that by saying that everyone who is a manger of a business falls under the general rule unless there is a specific exception. The only authority for splitting income is Poe v Seaborn and it did not address the question of who should be treated as the earner for social security tax purposes – the earner or the owner? That is a different question. Wages, for example, are allocated to the earner for social security tax purposes even though they are split for income tax purposes. Alternatively we could argue that use of the word “spouse” in 1402(a)(5) is merely descriptive, not normative. The provision was meant to describe those persons with community property income who had been subject to the prior “husband presumption” rule and it wasn’t intended to create a special rule that only applied to spouses.
4. During the 1980s, after the “husband presumption” was struck down as gender discrimination, what allocation rule was applied by the federal government to community income? In every reported case I have read on this issue, the Secretary allocated self employment earnings to the manager of the business despite the fact that the earnings were community property. Why isn’t that the default rule for community property RDPs? See Edwards v Heckler, 789 F.2d 659 (9th Cir. 1986)(recognizing that the federal district court had ordered the Secretary to allocate earnings on the “basis of the amount of labor each spouse contributed”).
Conclusion: I think the right allocation of income for self-employment tax purposes is to the person who did the labor, the manager of the business. If you are concerned about losing social security credits by reporting in accord with the IRS construction of the statute, you should consider taking a different position. Of course, if you like the IRS position because it allows you to create social security benefits for your perhaps unemployed spouse, then you should report in accord with the IRS view of the matter.
Maybe they’ve given us the best of both worlds here. We now have two reasonable constructions of the statute. In the absence of authority, you should be free to choose the one you like. That’s a crazy way to administer the tax law in my view, but that’s the world we live in right now.
