Ding v. Commissioner

T.C. Memo. 1997-435

UNITED STATES TAX COURT

PAUL B. AND JANE C. DING, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15935-95. Filed September 24, 1997.

Paul B. and Jane C. Ding, pro sese.

Robert J. Burbank, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

CARLUZZO, Special Trial Judge: This case was heard pursuant

to the provisions of section 7443A(b)(3) and Rules 180, 181, and

182. Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the years at issue. Rule

references are to the Tax Court Rules of Practice and Procedure.
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Respondent determined deficiencies in petitioners' 1991 and 1992

Federal income taxes in the amounts of $3,562 and $6,159,

respectively.

The deficiencies are attributable primarily to respondent's

determinations that petitioners understated Paul B. Ding's self-

employment tax liabilities for the years in issue. The issues

for decision are: (1) Whether pass-through items from certain S

corporations are taken into account in computing Paul B. Ding's

self-employment income for each year; and (2) whether a carryover

loss from 1991 can be taken into account in computing Paul B.

Ding's self-employment income for 1992.

FINDINGS OF FACT

Some of the facts have been stipulated, and they are so

found. Petitioners filed joint Federal income tax returns for

the years 1991 and 1992. At the time the petition was filed in

this case petitioners resided in St. Louis, Missouri. References

to petitioner are to Paul B. Ding.

During the years in issue, petitioners were shareholders in,

and petitioner was president of, three corporations (the S

corporations), each of which had an election under section

1362(a) in effect for one or both years. Each corporation was

organized to take advantage of the limited liability

characteristic of that form of business. Petitioners owned 100

percent of the stock of one of the S corporations and at least 50
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percent of the stock of each of the others. Two of the S

corporations owned and operated restaurants. The third owned and

operated a 30-room motel. Through a sole proprietorship, Ding

Trading, petitioner, or petitioners, provided various services to

the S corporations.

Petitioners devoted substantial time to the business

activities of the S corporations during the years in issue. They

were actively involved in the conduct of those businesses on a

daily basis, as summarized by petitioner, "[doing] everything"

that needed to be done. Petitioners considered themselves to be

independent contractors who provided services to the S

corporations on a contractual basis through Ding Trading. The S

corporations paid consulting fees to Ding Trading and, along with

other income, these fees were reported on Schedules C included

with petitioners' 1991 and 1992 Federal income tax returns.

In computing petitioner's self-employment tax liabilities

for the years in issue, petitioners took into account net profits

and losses from petitioner's sole proprietorships (including Ding

Trading), a partnership loss, and pass-through items from the S

corporations. For 1991, because of the amount of the losses from

two of the S corporations, petitioners reported that petitioner

had negative net earnings from self-employment and no self-

employment tax liability. For 1992, petitioners treated the

excess of 1991 losses over 1991 income as some form of carryover
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loss. They included the carryover loss in the computation of

petitioner's 1992 self-employment tax. Once again they reported

that petitioner had negative net earnings from self-employment

and no self-employment tax liability.

In the notice of deficiency respondent determined that

petitioner's self-employment tax liability for each year must be

computed by taking into account only: (1) The net profits and

losses attributable to petitioner's sole proprietorships; and (2)

the partnership loss. Implicit in respondent's determination is

the disallowance of the pass-through items from the S

corporations and the carryover loss from 1991 to 1992. Other

adjustments in petitioners' favor were also made in the notice of

deficiency and are either not in dispute or will be resolved in

accordance with the determination of petitioner's self-employment

tax liability for each year.

OPINION

In addition to other taxes, an individual's self-employment

income is subject to a self-employment tax. Sec. 1401. Subject

to irrelevant exclusions, self-employment income means net

earnings from self-employment. Sec. 1402(b). Net earnings from

self-employment generally include gross income derived from any

trade or business carried on by the individual, less allowable

deductions attributable to such a trade or business, plus the

individual's distributive share, if any and whether or not
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distributed, of income or loss (as described in section

702(a)(8)) from any trade or business carried on by a partnership

in which the individual is a partner. Sec. 1402(a). The statute

makes a distinction between general and limited partners. Other

than certain guaranteed payments (described in section 707(c))

made to a limited partner by a partnership, a limited partner's

distributive share of the partnership's items of income or loss

is excluded from the definition of net earnings from self-

employment. Sec. 1402(a)(13). Briefly stated, income derived by

an individual from carrying on a trade or business through a sole

proprietorship or as a partner (other than a limited partner) in

a partnership generally constitutes net earnings from self-

employment. Sec. 1.1402(c)-1, Income Tax Regs.

The parties agree that the items attributable to

petitioner's sole proprietorships and the partnership were

properly included in the computation of petitioner's net earnings

from self-employment for each year. They disagree over the

treatment of the pass-through items from the S corporations and,

although petitioners presented no argument on the point,

apparently disagree over the treatment of the carryover loss with

respect to 1992.

S Corporation Pass-Through Items

Neither section 1402, which provides the definition of net

earnings from self-employment, nor the regulations promulgated
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thereunder contain any reference to S corporation pass-through

items.

Petitioners point out that the self-employment tax

provisions were enacted prior to the S corporation provisions.1

They suggest that the absence of any reference to S corporations

in section 1402 is due to the timing of the enactments of the

relevant statutes and should not be considered indicative of how

Congress intended pass-through items from S corporations to be

treated for self-employment tax purposes. According to

petitioners, in situations such as theirs, where a shareholder

actively participates in the business of an S corporation, the

pass-through items should be considered net earnings from self-

employment because, in reality, such items are derived from the

shareholder's trade or business. According to respondent, the

absence of any reference to such items renders them outside the

definition. Respondent goes on to argue that such items are not

attributable to the shareholder's trade or business, or to the

trade or business of a partnership in which the shareholder is a

partner, and therefore such items are not considered net earnings

from self-employment within the meaning of section 1402 and are

not taken into account in the computation of an individual's

1
Subch. S was added to the Internal Revenue Code by the
Technical Amendments Act of 1958, Pub. L. 85-866, 72 Stat. 1606,
subsequent to the enactment of the self-employment tax.
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self-employment tax liability. For the following reasons we

agree with respondent.

We find the absence of any reference to S corporation pass-

through items in section 1402 to be significant, and not merely a

consequence of timing. The statute has been amended 34 times

since the enactment of the S corporation provisions. None of the

amendments address pass-through items from S corporations. We

note that respondent's position on the issue here under

consideration was published 38 years ago in Rev. Rul. 59-221,

1959-1 C.B. 225, which states, in part:

it is apparent that income not resulting from
the conduct of a trade or business by an
individual or by a partnership of which he is
a member is not includible in computing the
individual's net earning from self-
employment. Amounts which must be taken into
account in computing a shareholder's income
tax by reason of the provisions of * * * [a
predecessor of section 1366] of the Code, are
not derived from a trade or business carried
on by such shareholder. Neither the election
by a corporation as to the manner in which it
will be taxed for Federal income tax purpose
nor the consent thereto by the persons who
are shareholders results in the consenting
shareholder's being engaged in carrying on
the corporation's trade or business.
Accordingly, amounts which a shareholder is
required to include in his gross income by
reason of the provisions of * * * [a
predecessor of section 1366] of the Code
should not be included in computing his net
earnings from self-employment * * *.

The revenue ruling concludes that S corporation pass-through

items do not constitute net earnings from self-employment to the
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corporation's shareholder because such items are not derived from

a trade or business carried on by the shareholder. We understand

that we are not bound by the revenue ruling, Stark v.

Commissioner, 86 T.C. 243, 250-251 (1986); however, the fact that

the revenue ruling has remained in effect, unmodified, for 38

years provides a strong commentary on the validity of

respondent's position. During the period the revenue ruling has

been in effect, Congress has amended section 1402 approximately

30 times. If Congress had intended pass-through items from S

corporations to be included in the definition of net earnings

from self-employment, which would obviously be contrary to the

conclusion of the revenue ruling, we expect that one of the many

amendments made to the statute since its enactment would have so

indicated. See generally Helvering v. R.J. Reynolds Tobacco Co.,

306 U.S. 110 (1939).

Furthermore, respondent's position that the pass-through

items were not derived from a trade or business carried on by

petitioner is supported by two firmly established principles of

Federal income taxation, namely: (1) A corporation formed for

legitimate business purposes and its shareholders are separate

entities, Moline Properties, Inc. v. Commissioner, 319 U.S. 436

(1943); and (2) the business of a corporation is separate and

distinct from the business of its shareholders, id.; Deputy v. du

Pont, 308 U.S. 488, 494 (1940); Crook v. Commissioner, 80 T.C.
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27, 33 (1983), affd. without published opinion 747 F.2d 1463 (5th

Cir. 1984).

In a situation such as theirs, where a shareholder actively

participates in the trade or business of an S corporation,

petitioners contend that the distinction between the business of

the S corporation and its shareholder is an "absolute fallacy".

No doubt, due to the extent of their participation in the

businesses of the S corporations, petitioners sincerely

considered the businesses of the S corporations to be one and the

same as petitioner's. They argue that the use of the word "by"

as opposed to "as" in the first sentence of section 1402(a)

suggests that if an individual actively participates in the

conduct of a business and derives income therefrom, the form of

the business is "irrelevant" in determining whether such income

constitutes net earnings from self-employment. Petitioners

suggest that for purposes of sections 1401 and 1402 a shareholder

who is a passive investor in an S corporation should be treated

like a limited partner whose distributive share of partnership

income and losses are not considered net earnings from self-

employment. Conversely, they argue that a shareholder who

actively participates in the conduct of an S corporation's

business should be treated like a sole proprietor or a general

partner whose distributive share of the partnership income and

losses is considered net earnings from self-employment.
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In essence, petitioners request that we ignore the existence

of the S corporations, which we are unwilling to do. The

principles of Moline Properties, Inc. v. Commissioner, supra,

Deputy v. du Pont, supra, and Crook v. Commissioner, supra, are

not limited to passive shareholder investors. In order to limit

their liability, petitioners chose the corporate form through

which the restaurant and motel businesses of the S corporations

were conducted, and they are bound by the Federal income tax

consequences of their choice. Moline Properties, Inc. v.

Commissioner, supra.

Respondent's position is further supported, and petitioners'

position severely undermined, by the literal language of section

1366, which provides that a shareholder's pro rata share of an S

corporation's pass-through items are only taken into account in

determining the tax imposed under chapter 1 of the Internal

Revenue Code. The section 1401 self-employment tax is not a tax

under chapter 1, but rather chapter 2.

Lastly, we note that on the rare occasions that courts have

directly or indirectly focused upon issues similar to the one

here under consideration, the Commissioner's position, as

reflected in the Rev. Rul. 59-221, 1959-1 C.B. 225, has been

upheld. See Durando v. United States, 70 F.3d 548 (9th Cir.

1995); Hansen v. Commissioner, T.C. Memo. 1994-388.
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To summarize, respondent's position on this issue is

consistent with the literal language of sections 1402 and 1366.

Furthermore, it is supported by the principles expressed in

Moline Properties, Inc. v. Commissioner, supra, and Deputy v. du

Pont, supra, as well as the holdings in Durando v. United States,

supra, and Hansen v. Commissioner, supra. Accordingly, we hold

that petitioner must compute his net earnings from self-

employment, and correspondingly his section 1401 self-employment

tax liabilities for the years in issue, without taking into

account pass-through items from the S corporations.

1992 Carryover Loss

As previously indicated, petitioners have presented neither

authority nor argument in support of their position that the

carryover loss should be included in the computation of

petitioner's 1992 net earnings from self-employment. Respondent

has characterized the item as a net operating loss and argues

that section 1402(a)(4) prohibits petitioners from taking it into

account in computing petitioner's 1992 net earnings from self-

employment. To the extent that the carryover loss, or any

portion of it, constitutes a net operating loss, respondent is

correct. In any event, as we view the matter, our holding with

respect to the treatment of the pass-through items effectively

resolves the dispute between the parties on this issue.

Eliminating the pass-through items from the 1991 computation of
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petitioner's net earnings from self-employment eliminates the

carryover loss. Accordingly, we hold that petitioner's 1992 net

earnings from self-employment must be computed without taking

into account any carryover loss from 1991.

On brief respondent concedes that certain of the fees paid

by the S corporations and reflected on the Schedules C for Ding

Trading for the years in issue constitute wages and not earnings

from self-employment. Consequently, respondent no longer claims

any section 1401 tax attributable to those amounts.

To reflect the foregoing,

Decision will be

entered under Rule 155.