Do you owe the dreaded 15.3% self-employment (SE) tax on random non-employee income that you only collect occasionally or in a one-off circumstance? Good question. This column explains why you probably don’t owe SE tax, after first covering some necessary background information. Here goes.
The dreaded self-employment tax
The SE tax is the way the Feds collect Social Security and Medicare taxes on non-salary income from work-related activities. For 2019, the SE tax rate is 15.3% on the first $132,900 of net SE income. That 15.3% rate is comprised of:
* 12.4% for the Social Security tax component of the SE tax plus
* 2.9% for the Medicare tax component.
Above the $132,900 threshold, the Social Security tax component goes away, but the 2.9% Medicare tax continues. And the Medicare tax rises to 3.8% at higher income levels. That 3.8% rate then continues up to net SE income of infinity.
If you’re regularly self-employed, you know all this, and you plan for it. You must include the SE tax hit with your quarterly estimated federal income tax payments to avoid an interest charge penalty. Cost of doing business.
The question
But what if you are not regularly self-employed, and you earn some income from some random work or one-off circumstance that would be subject to SE tax if you were regularly self-employed in the activity? Do you owe SE tax or not?
The answer: you must engage in trade or business to owe SE tax
You don’t owe SE tax unless the income in question is from a trade or business. According to a 1987 Supreme Court decision, that means an activity that you conduct with continuity and regularity and with a profit motive. Source: Robert P. Groetzinger, 59 AFTR 2d 87-532 (Supreme Court 1987).
So income earned from an isolated or sporadic activity is generally not subject to SE tax, because the random activity does not rise to the level of a trade or business. I dreamed up some examples to show how this standard might apply in real-life situations.
Example 1: Your sideline job is similar to your day job (Part 1)
You’re a self-employed construction supervisor who works regularly for just a few selected construction outfits that you know and love. You agree to supervise the construction of your neighbor’s new home in your “spare time” and collect $25,000 for your efforts. Even though such sideline work is not something you do with any regularity (in fact, you’ve never done it before at all), the sideline work is so closely related to your regular self-employed work that you probably owe SE tax on the $25,000. You can be pretty sure the IRS will make that claim if you get audited.
Example 2: Your sideline job is similar to your day job (Part 2)
You’re employed by a construction company as a construction supervisor. You agree to supervise the construction of your neighbor’s new home in your “spare time” and collect $25,000 for your efforts. Even though such sideline work is not something you do with any regularity (in fact, you’ve never done it before), the sideline work is so closely related to your regular job as an employee of the construction company that the IRS would probably claim that you owe SE tax on the $25,000. Why? Because you’re in the business of being a construction contractor — as an employee or otherwise. However since you’ve never before done such work on a self-employed basis, you might beat the IRS if you get audited on the issue and are willing to fight. It’s up to you to decide if taking the position that you don’t owe SE tax on the $25,000 is worth the risk.
Example 3: A one-time realtor gets lucky (Part 1)
You’re a former active realtor. For the last few years, however, you’ve been a full-time house-husband taking care of your young kids. But you’ve maintained your realtor license “just in case.” This year you get lucky and earn a $25,000 fee for referring an acquaintance to another realtor who sells the acquaintance’s home for big bucks. Do you owe 15.3% SE tax on the $25,000 referral fee? I think the answer is “No” because you are not currently in the realtor business. If you get audited, the IRS might disagree based on your past history as an active realtor. But if you fight, I bet you’ll win.
Example 4: A one-time realtor gets lucky (Part 2)
A few years ago, you dabbled as a part-time realtor, but lost interest after never making any real money at it. Nevertheless, you’ve maintained your realtor license “just in case.” This year you get lucky and earn a $25,000 fee for referring an acquaintance to another realtor who sells the acquaintance’s home for big bucks. Do you owe 15.3% SE tax on the $25,000? I think the answer this time is “No” beyond any shadow of a doubt.
What if you get lucky again next year and earn another $15,000 referral fee. Do you owe 15.3% SE tax on the $15,000? Once again, I think the answer is “No” beyond any shadow of a doubt.
Even if you get lucky year after year, I still don’t think you owe SE tax on random referral fees that you collect just by answering the phone once in a while and making a call to another realtor. This sporadic-at-best activity is not a trade or business, because you don’t do it with continuity and regularity. So IMHO you don’t owe SE tax on the referral fees. In this scenario of getting lucky over and over again, the IRS might disagree. But if you fight, I bet you’ll win.
Reality check: You do owe income tax on random income
Just because your random income is righteously exempt from SE tax — because it’s not from a trade or business — doesn’t mean it is also federal-income-tax-free. It is not. You must report random income on line 21 of Form 1040, Schedule 1 (Other Income and Adjustments to Income). You may owe state income tax too.
Finally, if you take the position that random income is SE-tax-exempt because it’s not from a trade or business, you give up the right to claim deductions for any related expenses. So our imaginary inactive but money-making realtors in Examples 3 and 4 cannot write off their annual license fees and continuing education expenses paid to keep their licenses in force. Sorry.
The bottom line
You now understand that random income is usually SE-tax-exempt. Of course, there are categories of non-random income that are also SE-tax-exempt, such as billboard rental income where your only real “work” is cashing checks. Consult your tax pro if you are unsure about your SE tax exposure, but clarify that you want to be firmly convinced that you really owe the tax before coughing it up. It’s OK to be a reluctant taxpayer, as long as you abide by the rules.