The vast majority of real estate brokers and agents are self-employed sole proprietors. They are often married to spouses who are self-employed as well.
Marital togetherness is great, but when spouses each have their own separately run business, they need to keep their business income (or losses) separate for self-employment tax purposes.
One spouse’s business losses cannot be used to reduce the other spouse’s net self-employment income and thereby reduce the Social Security and Medicare tax due on that income. This is so even if spouses live in a community property state like California.
The U.S. Tax Court recently taught this lesson to Brenda Fitch, a California-licensed real estate agent, and her husband, Donald, a CPA.
Self-employment taxes are based on net earnings from self-employment — that is, on the profit earned from the business after subtracting deductible expenses.
They consist of a 12.4 percent Social Security tax up to an annual income ceiling ($117,000 for 2014) and a 2.9 percent Medicare tax on all net self-employment income. For many self-employed people with modest incomes, self-employment taxes make up most or even all of the federal taxes they pay each year on their annual tax returns.
During 2005 through 2007, Brenda Fitch worked full time as an independent contractor real estate agent for a Re/Max-affiliated brokerage. She had net self-employment income from her realty business of $12, 498, $2,366 and $20,659.
During the same years, Donald Fitch operated his own CPA practice, which incurred losses of $69,366, $59,132 and $64,652, respectively.
In computing their net self-employment on Schedule SE, the couple subtracted Donald’s losses from Brenda’s profits — leaving no net self-employment income subject to tax.
The IRS audited the Fitches and recomputed the self-employment tax separately for Brenda and Donald. The result was that Brenda owed self-employment tax on her realty business income of $1,766 for 2005, $334 for 2006, and $2,919 for 2007.
Donald owed no tax because he had net losses from his accounting business.
Brenda and Donald argued to the U.S. Tax Court that the IRS had erred because Donald managed and controlled the realty business, so all the income it earned was his alone. Alternatively, they claimed that they each co-managed the realty business, so the income it earned should be split between them.
The tax court didn’t buy either argument, concluding that the realty business was solely controlled and managed by Brenda.
She was a licensed real estate agent and a member of three professional real estate organizations. Every morning she reviewed business emails, new real estate listings, and buyer criteria for clients. She showed properties to clients and went on caravans to view new properties that were listed with Re/Max.
And although Donald Fitch was a CPA, Brend kept and maintained the realty business’ accounting records. Donald Fitch even testified that when he and Brenda dined together, they would talk about “her business.” (Fitch v. Comm’r, T.C. Memo. 2013-244.)
When spouses like the Fitches each have their own sole proprietor business and file a joint return, they should each file their own Schedule SE listing the net income they each earned from their own business.
This means that if one spouse has business losses, and the other has net income, the losses cannot be used to reduce the self-employment tax the spouse with income must pay.
Stephen Fishman is a tax expert, attorney and author who has published 20 books, including “The Real Estate Agent’s Tax Deduction Guide,” “Working for Yourself,” “Deduct It!” and “Working with Independent Contractors.” His website can be found at fishmanlawandtaxfiles.com.
