Did the IRS intend to give same-sex couples a 50% Self-Employment Tax break?

With any luck, this will be my last post for awhile on the strange tax consequences of being a Registered Domestic Partner or same-sex spouse in a community property state. I think the multiple posts to this point cover the topic pretty exhaustively, at least for what you can really learn about a topic from blogs. (See here for the main overview, and here, here, and finally here.) More guidance is available in IRS Publication 555, but as we’re about to see, even that is lacking guidance in crucial areas, one in particular.

Also, the Class 5 Resources page has an updated worksheet to help RDPs/same-sex spouses in community property states (CA, NV, and WA) to correctly allocate their income and deductions for federal tax filing.

So in general, community property rules state that when a spouse earns income, that income belongs equally to both spouses in the relationship. (Historical footnote: this dates back to property law in Catholic Spain, which is why most of the community property states are in territory that used to belong to Mexico when it was a colony of Spain. The community property states are LA, TX, NM, AZ, CA, NV, WA, ID, and (sort of) WI. Don’t ask about the “sort of”… )

For same-sex partners, and other married couples who don’t file joint federal returns, this means numerous adjustments must be made to income and deductions. One area that doesn’t get adjusted, however, is Self-Employment income. This is stated clearly in Publication 555, which says that for Self-Employment Tax purposes, no income is allocated to the spouse. The spouse that actually works for the income pays the Self-Employment Tax on the entire amount.

This is simply a clear statement of Internal Revenue Code (IRC) Section 1402(a)(5). But here’s the catch. IRC 1402(a)(5) refers to a “spouse”. And because of DOMA, same-sex partners are not considered spouses under any federal law, regardless of their relationship status under state law.

So IRS Publication 555 states “RDPs and same-sex spouses in California report community income for self-employment tax purposes the same way they do for income tax purposes.” OK, so clearly this means that the spouse who works for the income allocates half of that income to the spouse, and therefore pays self-employment tax on only half the amount. No problem there. But what about the spouse who didn’t earn the income? The spouse must report half of the income for income tax purposes and for self-employment tax purposes. But does that mean that the spouse who did nothing to earn the income pays tax as though they did?

That might seem unfair, but frankly, fairness doesn’t really matter in this discussion. We’re talking about the tax code. And, in fact, the tax code does not seem to support the notion that a person can pay self-employment tax on income in this situation.

IRC Section 1401 states that self-employment tax is imposed on the “self-employment income” of every individual. IRC section 1402(b) defines “self-employment income” as the “net earnings from self-employment” by an individual meeting certain criteria. And 1402(a) defines “net earnings from self-employment” as the “gross income derived by an individual from any trade or business carried on by such individual (…).”

So following that series of definitions leads to the logical conclusion that an individual can only be subject to self-employment tax if “such individual” actually carried on a trade or business. For a same-sex spouse who receives business income merely from an act of property law, it is difficult to see any reasonable way the spouse could be considered to be “carrying on” the trade or business. The inactive spouse may do nothing to participate in the business. Absent such participation, the only other way an individual can be subject to self-employment tax is to be a “general partner” in a partnership. A “partnership” is not explicitly defined in the tax code, but the consensus legal definition seems to require a relationship entered into with a profit motive. This clearly isn’t the case for Registered Domestic Partners. So there seems to be no rational basis for considering a same-sex spouse to be “carrying on” a business when he or she derives income from the spouse’s business by mere act of property law.

So this seems to leave us with the very surprising result that a same-sex couple with self-employment income may only pay half the Self-Employment Tax as  a heterosexual married couple with one spouse earning the self-employment income. For example, an individual with $100,000 of self-employment income would normally pay just over $15,000 in self-employment tax, but in the case of a Registered Domestic Partner would pay only about $7,500. The other Partner would pay no self-employment tax on their half of the earnings. The RDPs get a $7,500 tax break compared to a heterosexual couple in an otherwise identical situation.

This is not legal advice. I am not advising anybody to take this position on the basis of something you read on a blog. Even if this interpretation is legally correct, you may very well have to go to Court with the IRS to prove it. (Or maybe not…it’s hard to say at this point what the IRS’ intention is.) But it’s certainly something interesting to consider and discuss with your tax advisor.

Of course, taking the other interpretation, that a Registered Domestic Partner IS subject to self-employment tax based on their partner’s income, also produces a rather surprising result. Self-employment taxes are how an individual earns credit in the Social Security system. This credit determines how much SS you will receive up on retirement, and how much you would receive in the event of disability. So if a Registered Domestic Partner does pay self-employment taxes on the partner’s income, you would have the result where same-sex spouses are earning Social Security Benefits based on their partner’s earnings. This does NOT actually violate DOMA (I checked), but it certainly goes against the an underlying principle of DOMA: namely, the belief that same-sex spouses should not receive federal benefits on the basis of their relationship.

And it gets crazier. If an individual can have “earnings” based on their same-sex spouse’s earnings, what does this do in the case of disability claims? Could an individual be denied disability because of the “earned” income they derive from their Partner? Or, conversely, could a disabled individual earn credits, and keep increasing their disability benefit after they become disabled, based on the earnings of their Partner?

The idea that same-sex partners would get a 50% tax break on self-employment tax seems bizarre. But in my mind it’s not nearly as bizarre as the results that would come from a same-sex spouse being able to earn Social Security credits on their partner’s earning record.

This is turning out to be quite the Pandora’s box that has been opened up by the Federal government’s refusal to recognize unions formed at the state level. Sure will be nice when we can put this DOMA thing behind us and end all these crazy games.

6 Responses to Did the IRS intend to give same-sex couples a 50% Self-Employment Tax break?

  1. Steve says:

    I found this article immensely helpful. I’m currently wrestling with this very subject.

    Is there a typo in this sentence in the sixth paragraph?: “…so clearly this means that the spouse who works for the income does not allocate half of that income to the spouse, and therefore pays self-employment tax on only half the amount.”

    Shouldn’t it read “…so clearly this means that the spouse who works for the income DOES allocate half of that income to the spouse…”?

    • class5tax says:

      It’s not quite a typo, but I agree what I said is ambiguous. My intent was to say that half of the amount is not treated as income subject to SE tax for the person who earned it–but of course the other half of the amount IS income subject to SE tax. I’m going to make a quick edit to hopefully clear it up…then back to preparing returns! Thanks for pointing that out and I apologize for any other ambiguities/misstatements.

      • Steve says:

        Thank you for the quick clarification. We’re Oakland residents and we’ve always done our own taxes with TurboTax, but this year is a big headache. In fact, I just contacted your firm to inquire about your rates for reviewing the returns we’ve prepared.

        The self-employment tax question is a real conundrum. I’m not involved in my husband’s self-employment in any way, so it makes no sense that I should pay half of his self-employment tax and receive the resulting Medicare and Social Security credit. But I think that’s what we should do because it seems like the safest option. But how would we do that? It’s his “business” under his social security number. Can I submit my half of his self-employment income on a schedule C with my federal return? Or would that effectively create a second business under my SSN?

        You probably can’t answer that :)

      • class5tax says:

        Hi Steve,
        I think you’ve been in contact w/ my office manager. Yes, as you’ve guessed this is an area where there’s not a simple black & white answer that can go in a blog post. Hopefully we’ll be in touch and can review the options, as well as pros/cons to each approach.

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