Wouldn’t it be nice if post-retirement payments from former employers were tax-free?
Unfortunately, this is not the case. A recent letter ruling from the Internal Revenue Service brings
clarity to a complex issue that many retirees, such as partners in a law firm, experience when
receiving multiple sources of post-retirement income.
The IRS has always viewed that compensation paid to a partner in a partnership acting as an
employee of the partnership should be reported as a guaranteed payment to the individual on a form
K-1 (rather than paid as salary and reported on a W-2). In their most recent ruling on the subject,
the IRS determined that payments made by a former employer to a retiree were subject to self-
employment tax because
1. the payments were in result of the retiree’s 34 years of service to the company and
2. the payments were not being treated as wages subject to payroll taxes.
Simply put, self-employment tax is applicable when a connection is made between the income
received and the trade or business that is (or was) carried on.
This principle even applies to post-retirement payments. The IRS’ ruling on another case stated that
a long-serving sales director’s post-retirement payments was subject to self-employment tax because
the payments resulted from an association with the business. While there is an exception for certain
payments, it rarely applies. For instance, payments made to former insurance company salesmen can
be exempt from self-employment tax, but only if they meet specific requirements.
An increase in cases involving self-employment tax prove that the issue is multifaceted. For instance,
the Tax Court recently determined whether a plastic surgeon’s income from their surgery center was
subject to self-employment tax. The court concluded that since the income received by the taxpayer
was from their 12.5 percent share in the center, the income was not subject to self-employment tax,
rather it was considered income as an investor. The income was not linked to their medical practice,
because the fees paid to surgeon and the surgical center were kept separate.
In yet another situation, partners practicing out of a limited liability partnership law firm were
receiving revenue from the legal fees and were not reporting this revenue on the firm’s tax return as
net earnings from self-employment tax. The Tax Court ruled that the partners were subject to self-
employment tax because the revenue they collected was a direct result of the legal services they
performed in their role as partners.
While Tax Court rulings aim to bring clarity to self-employment tax issues, there are still areas that
are uncertain, especially as it relates to post-retirement income. If you are struggling to determine
which of your post-retirement income sources are subject to self-employment tax, call us today.