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The Amazing Tax Loophole That Might Let Self-Employed Gays Not Pay Taxes On 50% Of Their Income

Ask your accountant before you attempt this scheme, but it sounds like there might be a loophole for self-employed partnered gays to get out of paying a whopping 50 percent of their income. We’ve already seen one trick for gays living in community poperty states like California, New Mexico, and Texas to get out of paying some taxes: hire your partner as a nanny. But for gays in domestic partnerships who work for themselves, here’s a novel way to exploit the tax code.

Class 5 Tax explains (with the obvious disclaimer that you should consult a tax professional first) that in community property states, where one spouse’s income is assigned to both partners, the one area where same-sex partners and married heterosexuals who don’t file joint returns are not thrown for a loop is in the arena of self-employment income.

This is stated clearly in Publication 555 [which cover community property], 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 how does this apply, in real world terms, to self-employed gays?

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.

Keep in mind, of course, that the IRS — whose goal is to get taxpayers to fork over every penny they legally owe — may not see things this way, and pulling this stunt could earn you one of America’s most fun headaches: an audit. But if the above information is accurate (sorry, verifying tax code is above this blogger’s pay grade), the loophole does seem to exist, and makes a case for why the U.S. tax code is in desperate need of reform … for all the reasons above, and the additional asterisks it creates. As Class 5 Tax also points out, “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 mind boggles.

By:           Max Simon
On:           Mar 26, 2011
Tagged: ,
  • 4 Comments
    • Ian
      Ian

      Now I know why I pay someone to do my taxes. I read this article and still completely didn’t understand a damn word of it.

      Mar 26, 2011 at 11:13 pm · @ReplyReply to this comment ·
    • DeGuyz in Mississippi
      DeGuyz in Mississippi

      You can bet the wealthiest of Americans utilize every loophole known to man. While paying our fair share of taxes makes the country stronger, business is business.

      Mar 27, 2011 at 12:17 pm · @ReplyReply to this comment ·
    • TiredOldQueen@Queerty
      TiredOldQueen@Queerty

      This article is highly misleading. To be clear, the IRS has a standing policy with respect to vague interpretations of (especially) its recent rulings. The community property ruling from May of 2010, affecting DP’s in states with state income tax provisions for DP’s, is a blessing and a curse.

      On the curse side it requires that you file manually, use a very good CPA and expect a much more intrusive review of your filing.

      As for vague wording that might seem to allow for a large avoidance of a tax liability, the IRS historically bides its time, allows the suckers to file, then jumps on them after the fact with a vengeance. And then it issues another “clarifying ruling” just to let everyone know its not stupid.

      Try this loophole and I assure you that the IRS will respond as stated above.

      The odds are 100%.

      Mar 27, 2011 at 1:56 pm · @ReplyReply to this comment ·
    • Samantha
      Samantha

      The reality is this: I’m self employed, my partner is not… I had to claim half of her income, she had to claim half of my self employment tax… it has been a nightmare, with multiple letters and many IRS employees who were more confused than we were. It’s now halfway thru June, and I still have not received my full refund. To top if off, because my partner paid half of my SE tax, she also gets half of my SS benefits. I do not get any of hers. So if she dies before I do, I’m screwed. I’ll not only not get hers, but I won’t get half of mine either.

      IMHO the IRS should not have been allowed to make this major rule change without 1) researching all the ramifications and also because 2) DOMA is still in effect (which it won’t be for long)… but community property is a STATE issue, not a federal one…

      This has been a nightmare of a tax season, and every single return my CPA has done for domestic partnerships has come back, been delayed, had questions, had IRS agents who did not know how to handle the rule change, etc… if we find any group taking legal action, we plan on joining in!

      Jun 17, 2011 at 3:39 pm · @ReplyReply to this comment ·

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