“To earn or not to earn, that is the question.”
(adaptation of Shakespeare)
Earned income is a key concept for setting up a retirement plan for a self-employed individual. While a comprehensive discussion of earned income is beyond the scope of this article, there has been recent information provided by the IRS with respect to the treatment of post-retirement payments. Information Letter 2016-0081 discussed whether post-retirement payments are subject to self-employment tax. This article will discuss the Information Letter and the court cases referred to in it.
For a self-employed individual, the treatment of payments as earnings from self-employment is not always welcome. On the one hand, the earned income is compensation for purposes of those sections of the Internal Revenue Code (Code) pertaining to qualified plans (e.g., Code Sections 401(c) and 415). On the other hand, the earned income is subject to self-employment tax.
Accordingly, it should not be a surprise if there is a desire to treat payments as not includible in earned income. Such was the case with certain post-retirement payments and Information Letter 2016-0081 (which will be referred to as “the Information Letter” in this article).
The Information Letter was in response to an inquiry from Sen. Bill Nelson (D-FL) on behalf of an individual (the name of the individual was deleted from the copy made public, which normally occurs with the release of such letters), and concerned whether certain post-retirement payments were subject to self-employment tax. Without describing the particulars of the post-retirement payments, the IRS stated: “the post-retirement payments you receive from [deleted material] are subject to self-employment tax because the payments resulted from your 34 years of services on behalf of the company.”1 (emphasis added) The Information Letter went on to cite two court decisions; one by the Tax Court and one by the 11th U.S. Circuit Court of Appeals.
The Tax Court decision is Newberry v. Commissioner, 76 T.C. 441 (1981), “Newberry” for the remainder of this article. The 11th Circuit decision is Peterson v. Commissioner, 827 F. 3d 968 (11th Cir. 2016), “Peterson” for the remainder of this article.2 Peterson also had a related Tax Court decision that is of interest as well. While both cases will be reviewed below, Peterson is particularly interesting for two reasons. First, there were qualified plans involved. Second, the Information Letter stated that, “A Federal Court of Appeals considered the application of this general principle to payments such as yours just this past May.”3 (emphasis added)
Newberry Case
In Newberry, Max G. Newberry owned and operated a grocery store.4 The store was destroyed by fire in November 1974, and he did not operate the store until June 1975. From Jan. 1, 1975, until mid-June 1975, Mr. Newberry received $11,000 from two insurance companies through a loss of earnings endorsement. On their 1975 tax return, the Newberrys5 reported the $11,000 as income but designated the amount as business interruption insurance. They did not report self-employment tax due on that amount.
The IRS asserted that the $11,000 was subject to self-employment tax and issued a notice of deficiency. The case went to court. The IRS noted there was no dispute that the grocery business was a trade or business whose profits were subject to self-employment tax. Thus, the IRS insisted that the insurance proceeds were merely a substitute for the loss of profits and were similarly subject to tax. The Newberrys argued (they were represented by an attorney) that because there was business interruption the insurance proceeds “were not derived from any trade or business carried on.” (emphasis in original)
Resolution of the dispute depended on the interpretation of the statutory wording of Code Section 1402(a), which defines self-employment earnings as “gross income derived by a trade or business carried on by such individual.” Apparently, the IRS argued that the words “carried on” mean carried on at some point: past, present or future. Thus, in the court’s view, there would be no requirement that the income in question result from the operation of the taxpayer’s trade or business. The court rejected that view.
Instead, the Tax Court agreed with the position taken by the Newberrys that “there must be a nexus between the income received and a trade or business that is, or was, actually carried on.” The court quoted from the Senate report in stating that there must be some trade or business activity by the taxpayer which gives rise to the income. The proceeds were compared to supplemental unemployment benefits that the IRS held (in Revenue Ruling 56-110) to not be wages for FUTA or FICA purposes. Accordingly, after reviewing and rejecting other case law the IRS cited, the court held that the business interruption proceeds were not earnings from self-employment.
Newberry reached a sensible result and that principle has apparently been applied in other cases. That case was referred to by one of the judges in the 11th Circuit in Peterson.
Peterson Case
In Peterson, Christine C. Peterson was an independent beauty consultant for Mary Kay, Inc. who worked her way up to become a national sales director (on July 1, 1991), which is apparently Mary Kay’s highest sales position.6 Mrs. Peterson sold Mary Kay products7 and recruited other individuals to join the company. As a national sales director (NSD), Mrs. Peterson continued to earn commissions on wholesale purchases of Mary Kay products by her network and was considered an independent contractor by Mary Kay, which was stated in the NSD agreement.
On Nov. 12, 1992, and July 1, 2005, Mrs. Peterson and Mary Kay entered into a Family Security Program (Family Program) agreement and the Great Futures Program (Futures Program) agreement, respectively. (Collectively, they are referred to in this article as the “Programs.”) The Programs provided that Mary Kay would make distributions to Peterson after she stopped being an NSD. (There were other conditions such as having 15 years as an NSD and having attained age 65.)8 Effective Dec. 31, 2008, Mary Kay amended the Programs to expressly provide that each program wan “intended to be a non-qualified deferred compensation arrangement” and was “intended to meet the requirements of Section 409A of the Code and shall be construed and interpreted with such intent.” (Quotations are from court opinions.)
On April 1, 2000, the Petersons entered into the Christine Peterson Defined Benefit Plan and Trust (CP Plan) and designated Christine Peterson as the employer. In December 2002, the Petersons formed NSD Interests, L.P. (NSD Interests) a Georgia limited partnership. The Petersons were limited partners and their wholly owned entity was the general partner (apparently called NSD Management with the Petersons as officers). Mrs. Peterson apparently tried to assign her Mary Kay commissions to NSD Interests prior to her retirement in 2009, but Mary Kay would not consent to such an assignment. On Dec. 29, 2003, NSD Interests entered into an adoption agreement relating to the NSD Interests, L.P. Defined Benefit Plan and Trust (NSD Plan). The adoption agreement provided it amended and restated the CP Plan. The NSD Plan designated NSD Interests as the employer and the Petersons as trustees. In formulating the entities and adopting the plans, the Petersons were acting on the advice of a financial advisor and his company, First Tax, which prepared the tax returns for 2006-2009.
Mrs. Peterson received nonemployee compensation from Mary Kay and NSD Interest claimed deductions for contributions to the NSD Plan for 2006-2008 as shown in the following table.
Nonemployee Compensation Deduction for Contribution
Year From Mary Kay To NSD Plan
2006 $750,127 $275,365
2007 $799,191 $312,266
2008 $892,543 $173,500
Mrs. Peterson retired from (stopped working for) Mary Kay in 2009. For 2009, she received nonemployee compensation from the Programs of $489,707. For each of the years 2006-2009, the amounts received from Mary Kay were reported on Schedule C, Profit or Loss From Business, as “Other Expenses.” NSD Interests filed its Federal income tax return for 2006-2009 and reported the Mary Kay amounts as gross receipts and claimed the deductions shown in the table. The amounts received from Mary Kay were not treated as self-employment income subject to self-employment tax.
Tax Court Decision
As you might expect, the IRS took a dim view of the tax treatment upon audit. The IRS sent notices of deficiency on April 7, 2011 (relating to the 2006 and 2007 years) and Oct. 18, 2011 (relating to the 2008 and 2009 years) (collectively, “the notices”). In the notices, the IRS determined that the Petersons were subject to self-employment tax relating to their distributive shares of net partnership income reported by NSD Interests and were subject to accuracy related penalties. After the Petersons filed petitions with the Tax Court, the IRS (in its amended answers to the petitions) took the position that:
- NSD Interests was not engaged in a trade or business during the years at issue, 2006-2009;
- deductions claimed by NSD Interests were not ordinary or necessary business expenses;
- NSD Interests was a disregarded as a partnership for federal income tax purposes;
- all items of income reported by NSD Interests were properly allocable to Mrs. Peterson;
- NSD Interests did not qualify as an employer pursuant to Section 401(c)(4); and
- Mrs. Peterson’s nonemployee Mary Kay compensation was subject to self-employment tax.
After (unspecified) concessions, the Tax Court was left to decide whether retirement plan contributions that NSD Interests made for the 2006-2008 years are deductible pursuant to Code Section 404(a), and whether distributions received in 2009 from the Programs are subject to self-employment tax.9 The Tax Court dealt first with the retirement plan deductions.
Apparently, from page 6 of the Tax Court opinion, the Petersons10 conceded that NSD Interests was not engaged in a trade or business in 2008. Also, presumably in testimony, Mrs. Peterson “readily acknowledged” that NSD Interests was merely a structure to hold her Mary Kay earnings and that it was created for tax savings. Furthermore, the Petersons conceded that during 2006-2008 NSD Interests had no income and that the income reported on its returns should have been reported on their returns. The Tax Court therefore stated (after reciting the above) “In sum, NSD Interests was not engaged in a trade or business during 2006, 2007, and 2008.”11 Accordingly, the court held that NSD Interests is not entitled to deduct retirement plan contributions relating to those years.
The Tax Court then turned its attention to whether Mrs. Peterson was an employer (and stated the IRS contended she was not an employer), and therefore not entitled to take deductions for the retirement contributions to the NSD Plan. There is some confusion here. In the amended answer, the IRS reportedly claimed that NSD Interests was not an employer under Code Section 401(c)(4); however, the court then stated that the IRS was contending that Mrs. Peterson was not an employer. It is likely that the IRS realized that if NSD Interests was disregarded then the commissions flowed directly to Mrs. Peterson, and, if an employer, she could deduct the contributions to a plan. In any case, as described in the next paragraph, the IRS was not successful in its argument.
The Tax Court stated that the IRS conceded that the NSD Plan was valid. Mrs. Peterson was engaged in carrying on a Mary Kay business during the 2006-2008 years, and expenses that were originally reported on the Form 1065 for NSD Interests were allowable as deductions and reportable on Schedules C of the Petersons’ Forms 1040 (this may be part of the unspecified concessions). She had formed the CP Plan and was designated as the employer pursuant to it. The NSD Plan (which, as noted above, was an amendment and restatement of the CP Plan) defined an “Employer” as “an entity specified in the Adoption Agreement, any successor which shall maintain this Plan and any predecessor who maintained this Plan.” (emphasis added) Mrs. Peterson, a predecessor who maintained the plan, was an “Employer” pursuant to the NSD Plan, and the retirement contributions were expenses which would be deductible under Code Section 162 (with a quotation from the regulations under Section 404(a)). Accordingly, the Tax Court held that Mrs. Peterson was entitled to deduct the retirement contributions for 2006-2008 pursuant to Section 404(a).12
It is worth considering the reasoning here. If the facts were slightly different, Mrs. Peterson may have had a different result. The key facts appear to be that Mrs. Peterson was an employer pursuant to the plan terms, and that the plan was originally created by her as an employer. Without these facts, the Petersons might not have been able to successfully argue that Mrs. Peterson was an employer under the terms of the plan. Of course, one can easily see that the entire structure was not necessary to deduct retirement plan contributions and possibly jeopardized the deductions, but that was not the main reason for the tax structure.
With respect to the 2009 payments from the Programs, the Tax Court held that they were subject to self-employment tax. The reasoning was that the payments were based upon the quantity and quality of Mrs. Peterson’s prior labor with Mary Kay. The Family Program payments were based upon her average commissions over the five years prior to her “retirement.” The Futures Program payments were based upon on the postretirement wholesale volume of her network. Both programs also based the distributions upon her age and minimum years of service. The court also took into account that the agreements expressly provided that the payments were deferred compensation. The court cited to a number of cases dealing with payments from prior labor without extensive explanation. Accordingly, the Tax Court held the 2009 distributions are subject to self-employment tax.
The prior case law cited by the Tax Court did not include Newberry. The Petersons were not pleased with the decision with respect to 2009 and appealed.13
11th Circuit Decision
The 11th Circuit agreed with the Tax Court that the 2009 distributions were subject to self-employment tax. However, the decision is long and was not unanimous among the three judges.14 We briefly discuss the opinion below.
First, the 11th Circuit provided a somewhat extensive description of the Mary Kay sales structure and commission compensation. This description included more details with respect to the Family Program and the Futures Program. It included testimony from the Mary Kay Director of Consultant Marketing in the Tax Court trial. The quoted testimony was “I don’t know another direct selling company that offers anything like [these programs]” and that the Programs are “unique.” Accepting that testimony at face value, and understanding (from footnote 41) that one or more amicus briefs were filed by approximately 250 former Mary Kay NSDs (who were currently receiving payments from the Programs) in support of the position taken by the Petersons, we refer back to the information letter. The statement that a Federal court of appeals had considered “payments such as yours” suggests that the payments addressed in the letter were likely Mary Kay payments under the Programs.
Second, the two-judge majority took a view similar to that of the Tax Court and placed significant weight on the fact that the Programs were classified by Mary Kay as deferred compensation. In doing so, the panel rejected the Petersons’ argument that they were consideration for her ending her business and agreeing not to compete. The case law cited by the majority was pretty much the same as the case law cited by the Tax Court, but the 11th Circuit opinion also distinguished the payments from payments made to insurance salesmen after termination of employment. We will not delve into the details of the case law relied upon and readers are welcome to read the opinion and follow up with the cases.
Third, one judge dissented with respect to the reasoning and result. The dissenting judge did not place the same weight on the statements in Mary Kay’s documents concerning the plans being deferred compensation arrangements. The dissent disagreed with the legal approach, and the dissenting judge would apply Newberry to the factual situation. The result in the view of the dissenting judge would be that the Family Program payments are linked to Mrs. Peterson’s work prior to retirement and were thus subject to self-employment tax. The Futures Program payments are linked to the future work of Mrs. Peterson’s network and thus should not be subject to self-employment tax.
Summary and Final Thoughts
The payments from the Mary Kay Programs are subject to self-employment tax. However, as payments from a nonqualified deferred compensation plan, they may or may not be considered as compensation for purposes of Section 415, an consideration that was not addressed in the cases.15 More generally, post-retirement payments that are not from a qualified plan need to be carefully considered to see whether they constitute earned income and are therefore subject to self-employment tax. Generally, the proper treatment of the payments is considered an issue for the accountants; however, actuaries may be asked for their views. When approached about setting up a plan, consideration of the source for the contributions may be in order depending on the situation.
Complicated tax structures are likely to be regarded with suspicion by the IRS. As Peterson shows, the complicated structure is not needed to get a deduction for retirement plan contributions, and the other supposed tax advantages may not stand up to scrutiny. Caution is indicated in such situations.
Footnotes
1. See the second paragraph of the information letter.
2. Looking at the decision, you can see that the case is Christine C. Peterson, Roger V. Peterson v. Commissioner of IRS. From the opinions (Tax Court and 11th Circuit), they are married.
3. See the fifth paragraph in the information letter.
4. All facts recited for these cases are taken from the opinions issued by the courts.
5. Tina F. Newberry was one of the petitioners and, I surmise, is the spouse of Max.
6. Facts are from Tax Court opinion and/or 11th Circuit opinion.
7. Cosmetics, toiletries, skin care and related products.
8. One can read the Tax Court and 11th Circuit opinions and understand that they do not describe the programs in the same level of detail. What is common and important is that the Programs provided for post-retirement payments where retirement (in context) means not working in the NSD role.
9. Most of the details surrounding the pension plan (such as actuarial assumptions and benefit formula) were not stated in the opinion, nor was the resolution of the self-employment tax issues for 2006-2008. Also, we can surmise that the Petersons conceded that the commissions for 2006-2008 were subject to self-employment tax because no issue for those years was decided in the court.
10. Who were represented by attorneys.
11. See page 7 of the Tax Court Opinion.
12. See pages 7 and 8 of the Tax Court Opinion.
13. The 11th Circuit opinion discusses the confusion concerning what was appealed but concluded that it only needed to address the self-employment tax question for 2009.
14. Generally, there is a three-judge panel that hears and rules upon cases appealed to the federal Circuit Courts of Appeals.
15. See § 1.415(c)-2(c)(1) of the Income Tax Regulations.
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