Buying your Building.
Below is an excerpt from Thompson PPPC that exemplifies one of CFS’ basic strategies: encourage business owners to purchase the building they operate out of. Please review for your benefit.
Use of rentals exception can cut self-employment tax
Taxpayers who own closely held businesses can maximize their tax savings by taking advantage of the self-employment tax “rentals exception” under which rentals from real estate and from personal property leased with the real estate (and the corresponding deductions) are excluded in determining net earnings from self-employment. The tax savings can be significant.
Background. The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax). For self-employed workers, the FICA tax normally is 15.3%—12.4% for OASDI and 2.9% for the Medicare tax. But for 2012, the self-employment tax rate is 13.3%—10.4% for OASDI, reflecting a two percentage point drop in the OASDI rate for employees, plus 2.9% for the Medicare tax.
There is generally a maximum amount of compensation subject to the OASDI tax, but no maximum for the Medicare tax. The Social Security Administration’s (SSA’s) Office of the Chief Actuary (OCA) has projected that the Social Security wage base for OASDI will increase from $110,100 for 2012 to $113,700 in 2013.
For tax years beginning after 2012, an additional 0.9% Medicare tax is imposed on taxpayers (other than corporations, estates, or trusts) receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately). (Code Sec. 3101(b)(2)) The tax only applies to the employee portion of Medicare tax. An additional 0.9% tax also applies to net earnings from self-employment. This tax was added by the 2010 Patient Protection and Affordable Care Act (PPACA, P.L. 111-148), which was largely upheld by the Supreme Court. For a Practice Alert on planning for the additional .9% tax, see Weekly Alert ¶ 38 05/03/2012.
In addition, for tax years beginning after Dec. 31, 2012, an unearned income Medicare contribution tax is imposed on individuals, estates, and trusts. For an individual, the tax is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount. (Code Sec. 1411(a)(1)) MAGI includes wages, salaries, tips, and other compensation; dividend and interest income; business and farm income; realized capital gains; income from a variety of other passive activities; and certain foreign earned income. (Code Sec. 1411(d)) The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others. (Code Sec. 1411(b)) The tax generally doesn’t apply to an active (i.e., nonpassive) trade or businesse conducted by a sole proprietor, partnership, or S corporation. (Committee Report) This tax was added by the Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-52). For a Practice Alert on planning for the additional 3.8% tax, see Weekly Alert ¶ 29 05/13/2010.
Self-employment tax. The self-employment tax is imposed on self-employment income, which is generally defined by Code Sec. 1402(b) as the net earnings from self-employment derived by an individual. In general, Code 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 the individual, less the deductions allowed by the Code which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member.
Rentals exception. Certain items are specifically excluded in determining net earnings from self-employment. One of these exclusions is rentals from real estate and from personal property leased with the real estate (together with the deductions attributable to them). This “rentals exception” doesn’t apply to:
- Rentals received in the course of a trade or business as a real estate dealer;
- Rentals from real estate paid in crop shares if certain conditions are met; and
- Payments made for rooms or other space where services (e.g., maid service) are also rendered to and primarily for the occupant’s convenience. (Code Sec. 1402(a)(1), Reg. § 1.1402(a)-4(c)(2))
The “rentals exception” doesn’t apply to rentals received by an individual in the course of a trade or business as a real estate dealer. In general, an individual who is in the business of selling real estate to customers with a view to the gains and profits that may be derived from those sales is a real estate dealer, and the rents from the property are includible in net earnings from self-employment. Thus, a real estate dealer who receives rentals from real estate and from personal property leased with the real estate must include those rentals in self-employment income. (Code Sec. 1402(a)(1), Reg. § 1.1402(a)-4(a))
IRS has ruled that an individual who merely holds real estate for investment or speculation and receives rentals from the property isn’t considered a real estate dealer. Thus, an office building owner who provided normal building services and who was an investor, not a dealer, wasn’t subject to self-employment tax on the rentals. (Rev Rul 55-559, 1955-2 CB 315) Similarly, the Tax Court has held that a taxpayer who acquired 10 parcels of real estate for the purpose of producing rental income wasn’t a real estate dealer. He didn’t offer or advertise any of the parcels for sale and, although he lost the properties to foreclosure, the lenders who foreclosed weren’t his customers. (Blythe, (1999) TC Memo 1999-11)
Tax planning strategy. Taxpayers can withdraw money from their closely held business while dramatically cutting their self-employment income by simply leasing property they own to their closely held business. Under Code Sec. 1402(a)(1) and the regs, rentals from real estate and personal property leased with it, and the corresponding deductions, are excluded in computing net earnings from self-employment, unless received by a real estate dealer in the course of his trade or business.
Whether payments for the use of land or occupancy of rooms is rental income depends upon the nature and amount of services rendered the occupant by the landlord or owner. Reg. § 1.1402(a)-4(c)(2) provides that payments aren’t rental income if services are rendered primarily for the convenience of the occupant and are other than those usually rendered in connection with the rental of rooms or other space for occupancy only. For example, the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash aren’t services that turn rental income into self-employment income.
But, Reg. § 1.1402(a)-4(c)(2) provides that rents from living quarters aren’t exempt if the landlord provides services primarily for the occupant’s convenience, for example, maid service. Similarly, payments for the use or occupancy of rooms or other space aren’t rentals from real estate where services are also rendered to the occupant. For example, payment for the use or occupancy of rooms in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or space in parking lots, warehouses, or storage garages aren’t rent excluded from self-employment income. Such payments are included in determining net earnings from self-employment.
In Chief Counsel Advice 200816030, IRS concluded that a qualified joint venture election under Code Sec. 761(f) wouldn’t cause self-employment tax to be imposed on income from a rental real estate business that would otherwise be excluded. Each spouse had a share of the qualified joint venture income, and each spouse could exclude his or her respective share of the qualified joint venture income from net earnings from self-employment under the Code Sec. 1402(a)(1) exclusion.
References: For the self-employment rentals exception, see FTC 2d/FIN ¶ A-6105 ; United States Tax Reporter ¶ 14,024.04 ; TaxDesk ¶ 576,018 ; TG ¶ 1785