U.S. Tax Court holds retiring allowance from foreign consulate subject to self-employment tax

2 Jul

The Tax Court’s recent decision in the Weaver case examines the nature of retiring allowances, and whether they are subject to self-employment tax. The payment in issue was received by the taxpayer from a foreign consulate upon her retirement. As a memorandum decision, the opinion does not qualify as precedent, but still is a useful example of how the Court will likely rule on these issues.

The taxpayer began working as a business-development officer for a consulate in San Francisco in late 1991. In 2002, she became unable to work due to disability, and took a leave of absence from the consulate. The consulate was required to keep her position open until she returned to work or relinquished her position.

Taxpayer eventually relinquished her position in 2006. The consulate made a payment to her of approximately $65,000 in 2007. The consulate characterized the payment as a “severance payment” and calculated it, based on taxpayer’s length of service, annual salary and age.

Taxpayer reported the payment as “other income” on her return. She did not pay self-employment tax for 2007, although she previously had paid self-employment tax on her income from the consulate. The Internal Revenue Service issued taxpayer a deficiency notice, determining that the retirement payment constituted self-employment income.

Self-employment tax is imposed on an individual’s self-employment income. The tax rate for self-employment income earned in 2011 is 13.3% (10.4% for Social Security and 2.9% for Medicare). Self employment income is defined as “net earnings from self-employment,” which is income derived from a business, less allowable deductions.

In general, compensation from the performance of services as an employee is not self-employment income. There is an exception for compensation earned by a U.S. citizen in the United States, in the employ of a foreign government.

Taxpayer argued that the Consulate made the payment to her on account of disability, and therefore the payment was not “wages” subject to self-employment tax. Certain payments on account of disability are not considered wages for purposes of employment tax. The Internal Revenue Service argued that the payment was a severance payment subject to self-employment tax. The Tax Court agreed. Taxpayer bore the burden of overcoming a deficiency notice’s presumption of correctness, and the taxpayer had failed to do so here.

Severance pay is a form of compensation for services, paid for termination of the employer-employee relationship. Severance is a
replacement or substitute for wages for Federal tax purposes, even when the employee claims to have left employment due to physical illness. Severance is typically calculated by reference to an employee’s salary and length of tenure.

The consulate was required to hold taxpayer’s job until she returned to or relinquished her position, and made the payment to her only after she agreed to retire. The consulate characterized the payment as a severance payment in a confirmation letter, and calculated the payment based on Mrs. Weaver’s length of service and salary.

There was nothing in the record designating the payment as made on
account of taxpayer’s medical disability, or to settle any claim she may have had against the consulate for injuries.

Accordingly, the payment was self-employment income, subject to self-
employment tax.

The accuracy-related penalty under IRC section 6662(a) is imposed on
any part of an underpayment attributable to, among other things, a substantial understatement of income tax. There is a substantial
understatement of income tax, if the amount of the understatement exceeds the greater of either 10% of the tax required to be shown on the return, or $5,000. The taxpayer in this case met this threshold.

A taxpayer is not liable for an accuracy-related penalty, however, if the
taxpayer acted with reasonable cause and in good faith with respect to any portion of the underpayment. This determination depends on the pertinent facts and circumstances, including the taxpayer’s efforts to assess her proper tax liability, her knowledge and experience, and her reliance on the advice of a professional.

Taxpayer in this case asked the Court not to sustain the accuracy-related penalty, because they had a tax professional prepare the return for 2007. The Tax Court has found that reliance on a tax professional demonstrates reasonable cause, when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and,
consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations. All facts and circumstances are considered, including the taxpayer’s education, sophistication and business experience.

In this case, the Court, alas, found that taxpayer had not established that her reliance on the return preparer was reasonable and in good faith. Taxpayer failed to demonstrate that she provided all the necessary and accurate information to the return preparer. Taxpayer also failed to otherwise show that her failure to report the payment as self-employment income was due to reasonable cause and was in good faith. Accordingly, the Court sustained the Service’s penalty determination.

T.C. Summary Opinion 2012-52, Weaver v. Commissioner of Internal Revenue, Docket No. 8055-11S; filed June 7, 2012

 

James Cantillon Ross
Attorney at law
(LL.M. Taxation)
Bars of California, New York and Quebec
mail: 230 Cook Street # 23019 RPO, Victoria V8V 4Z8
(not admitted in British Columbia)
tel/fax 206 338 4456 cantilon@cruzers.com

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