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Consultant Not an "Employer" With Respect to Work for Foreign Government SEP Contributions Disallowed. (Parker's Federal Tax Bulletin: August 14, 2013)

While the term employer is straightforward in most situations, the line may be blurred where a taxpayer is self-employed. Whether a taxpayer is considered his or her own employer has ramifications such as whether or not the individual can contribute to a simplified employee pension (SEP) plan and take a deduction for the contribution. If the individual does so contribute but should not have, additional taxes, as well as excise tax penalties apply. That was the situation in Rosenfeld v. Comm'r, 2013 PTC 234 (9th Cir. 8/8/13), where a freelance writer accepted an assignment to work for a foreign government, whose contract with the writer specified that he was self-employed and that the foreign government would not withhold taxes. The taxpayer then contributed money to his SEP and deducted the contributions.

The IRS challenged the deductions, and the Tax Court held that the taxpayer was an employee under common law factors, and that the portion of his SEP contribution relating to his work for the foreign government was disallowed.

OBSERVATION: In the lower court decision, the Tax Court recognized the difficulty of the interplay between Code Sec. 3121 and Code Sec. 401(c) and thus did not uphold the IRS's penalty assessment against the taxpayer.

On appeal, the taxpayer argued that the Tax Court was wrong in finding he was an employee and that, because he worked for a foreign government, he was considered his own employer. Unfortunately, the Ninth Circuit agreed with the Tax Court and upheld the tax deficiency and excise tax penalties against the taxpayer.


Michael Rosenfeld graduated from the University of Southern California with a master's degree in journalism and has worked as a corporate marketing executive, financial writer, and journalist for over 20 years. In 1985, he started his own consulting business, representing clients in a variety of professional services. In 1994, he left his consulting business to work in corporate communications and marketing. In 1999, he reestablished his business and currently works as a consultant for his business.

In July or August 2003, in an effort to expand into the British investment community, Michael met with the deputy consul general, Brian Conley, of the British Consulate General (BCG) in the United States. During the meeting Mr. Conley indicated that the BCG might be interested in using Michael's services to promote British companies seeking to invest in the United States and to assist U.S. companies interested in investing in the United Kingdom.

After several meetings discussing Michael's qualifications, the BCG formally offered Michael a full-time appointment for a three-year defined term. Michael signed a letter of appointment dated September 22, 2003, and was appointed at the level of "Trade Officer Grade US 8." The letter provided for annual increases to his salary depending on satisfactory services, as determined by the BCG. The BCG, as a foreign employer of a U.S. citizen, categorized Michael as self-employed for tax purposes. The BCG did not withhold taxes from Michael's salary, and Michael was responsible for all federal, state, and local taxes and for self-employment taxes.

IRS Deficiency Assessment

On Schedule C of his 2003 Form 1040, Michael reported total gross receipts of almost $110,000 and total expenses of $37,280, and a deduction for the business use of his home. As a self-employed individual, Michael contributed to an SEP plan on the basis of his consultant earnings. Michael reported gross receipts from the BCG on Schedule C and also contributed to an SEP plan on the basis of those earnings. In 2003 he contributed $12,242 to his SEP plan.

In a notice of deficiency, the IRS determined, in part, that Michael was: (1) a common law employee of the BCG and consequently was not entitled to report gross receipts and expenses associated with his work for the BCG on Schedule C for 2003; (2) subject to an excise tax under Code Sec. 4973 for excess contributions to an SEP plan; and (3) liable for the accuracy-related penalty under Code Sec. 6662(a).

Simplified Employee Pension Plans

A SEP plan is a plan under which an employer makes direct contributions to its employees' individual retirement accounts or individual retirement annuities (IRAs).

Under Code Sec. 404(a)(8), an employer can deduct certain contributions to an employee's SEP plan. For purposes of Code Sec. 404(a)(8), the term "employee" includes an individual who is an employee within the meaning of Code Sec. 401(c)(1), and the employer of such an individual is the person treated as his employer under Code Sec. 401(c)(4).

Under Code Secs. 401(c), 404(h), 408(k)(7), and Reg. Sec. 1.401-10(b)(2), self-employed individuals and sole proprietors are treated as their own employers and employees for purposes of SEP plan deductions. For purposes of applying Code Sec. 401 through Code Sec. 404, if a self-employed individual is engaged in more than one trade or business, each business is considered a separate employer. A self-employed individual is treated as his own employer if he satisfies the definition of employer under Code Sec. 401(c)(4). Additionally, under Code Sec. 408(k)(7), a self-employed individual must also be his own employee and is treated as such if he satisfies the definition of employee under Code Sec. 401(c)(1).

The Parties Arguments

Michael argued that he satisfied the requirements of Code Sec. 401(c) and was qualified to make and deduct contributions to his SEP plan derived from both his consultant business and BCG earnings. The IRS did not contest that Michael was entitled to deduct contributions to his SEP plan from the earnings derived from his consultant business. The IRS did contest, however, Michael's deductions to his SEP plan with respect to his BCG earnings.

Michael said that as an employee of a foreign government, he is self-employed pursuant to Code Sec. 3121(b)(11) and is treated as his own employee under Code Sec. 401(c)(1) and (2). Code Sec. 3121(b)(11) provides that service performed in the employ of a foreign government (including service as a consular or other officer or employee or a nondiplomatic representative) is not considered employment for purposes of social security and Medicare taxes, and is thus exempt from such taxes.

Michael argued that even if the court concluded that he was a common law employee of the BCG, he was still his own employer under Code Sec. 401(c)(4) with respect to his BCG earnings. Consequently, he is entitled to deduct the contributions to his SEP plan that are attributable to his BCG earnings. Code Sec. 401(c)(4) provides that an individual who owns the entire interest in an unincorporated trade or business is treated as his own employer.

Michael also cited the legislative history of Code Sec. 401(c) in support of his argument that he was his own employer with respect to his BCG earnings. He cited a House report, which defines an employee for purposes of retirement plan contributions, as a self-employed individual. Michael argued that, on the basis of the legislative history, a common law employee who has self-employment earnings is treated as an owner-employee and is entitled to make retirement plan contributions and deduct those contributions on the basis of the self-employment income.

Tax Court Holding

The Tax Court sided with the IRS. The court noted that the term employee is not defined in the Code. An individual's status as an employee is a factual question that depends on the application of common law concepts. Among the relevant factors in determining the substance of an employment relationship are: (1) the degree of control exercised by the principal over the details of the individual's work; (2) the taxpayer's investment in facilities; (3) the taxpayer's opportunity for profit or loss; (4) the permanency of the relationship between the parties; (5) the principal's right of discharge; (6) whether the work performed is an integral part of the principal's business; (7) what relationship the parties believe they are creating; and (8) the provision of employee benefits.

The Tax Court addressed each factor and found that the factors either favored the IRS's position or were neutral. For example, the court found that the BCG had the right to exercise control over Michael's work, which favored the IRS's position. With respect to employee benefits and Michael's testimony that he did not receive sick pay, overtime pay, retirement benefits, or life insurance and received only minimal remuneration for health and dental insurance, the court noted that, in 2003, Michael accrued annual and sick leave and had the opportunity to participate in the BCG's health insurance and pension plans but declined to do so. Considering all the facts and circumstances, the court concluded that Michael was a common law employee of the BCG.

The court found that, as a common law employee of the BCG, Michael was not an employer under Code Sec. 401(c)(4) with respect to his BCG earnings, which barred him from contributing to an SEP and deducting contributions based on those earnings.

The court also rejected Michael's reliance on Levine v. Comm'r, T.C. Memo. 2005-86, a case in which the taxpayer entered into a personal services contract with the U.S. State Department to manage and implement the Department's worldwide industrial hygienist field technical services program. The taxpayer in that case, the court noted, provided significant explanatory evidence of her position with the Department, including her employment contract. The employment contract described, in detail, her employment duties, how she performed her duties, and how she interacted with employees and supervisors. In contrast, the court observed, Michael provided mere generalities as to his tasks, his employment position, and the control the BCG exercised over his position.

The phrase self employed for tax purposes in the letter of appointment did not reflect the BCG's understanding of Michael's employment status. Rather, the court said, it reflected the tax consequences for a U.S. citizen employed by a foreign government. The letter of appointment was unambiguous regarding Michael's employment relationship. The BCG offered him a full-time appointment as a Trade Officer US8 with a fixed monthly salary. The court noted that the record did not reflect that the BCG intended to hire Michael as an independent contractor. The fact that the BCG did not withhold taxes from Michael's pay did not establish either his or the BCG's intent regarding his relationship with the BCG, the court said.

Ninth Circuit's Analysis

The Ninth Circuit affirmed the Tax Court's decision. With respect to whether Michael, as a common law employee of the BCG, still could have contributed to a SEP based on his BCG earnings, the Ninth Circuit agreed with the Tax Court's interpretation of the Code Sec. 401(c)(4). Because Michael did not own any interest in the BCG, the court found that he was not an employer under Code Sec. 401(c)(4) with respect to his BCG earnings, thus leaving him ineligible to contribute to an SEP and deduct contributions based on those earnings.

Parker Tax Publishing Staff Writers


Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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