Qualified joint venture’s rental real estate income isn’t subject to self-employment tax – Chief Counsel Advice 200816030
Mike Habib, EA
myIRSTaxRelief.com In Chief Counsel Advice (CCA), IRS has concluded that the qualified joint venture election under Code Sec. 761(f) doesn’t cause self-employment tax to be imposed on income from a rental real estate business that would otherwise be excluded. Dividends and capital gains are similarly excluded. The qualified joint venture election, which was recently added by the Small Business and Work Opportunity Act of 2007 (Small Business Act), allows eligible married co-owners to avoid filing partnership returns and both spouses to receive credit for social security and Medicare coverage purposes.
Background on qualified joint ventures. The Small Business Act provision generally allows a qualified joint venture whose only members are a husband and wife filing a joint return not to be treated as a partnership for Federal tax purposes. (Code Sec. 761(f)) A qualified joint venture is a joint venture involving the conduct of a trade or business, if:
(1) the only members of the joint venture are a husband and wife,
(2) both spouses materially participate in the trade or business, and
(3) both spouses elect to have the provision apply. (Code Sec. 761(f)(2))
The meaning of material participation is the same as under the passive activity loss rules in Code Sec. 469(h) and its regs.
Where the election is made, all items of income, gain, loss, deduction, and credit are divided between the spouses according to their respective interests in the venture, and each spouse takes into account his or her respective share of these items as if they were attributable to a trade or business conducted by the spouse as a sole proprietor.
Background on self-employment tax. A tax is generally imposed on an individual’s self-employment income (i.e., on his net earnings from self-employment) with certain adjustments. (Code Sec. 1401, Code Sec. 1402(b)) Net earnings from self-employment generally includes an individual’s gross income from a trade or business, plus his distributive share of income or loss from a partnership in which he is a member. An exception provides that rental income from real estate is excluded from net earnings from self-employment, unless the rental income is received in the course of a trade or business as a real estate dealer. (Code Sec. 1402(a)(1)) Similarly, dividend income and gain or loss from sale or exchange of a capital asset are excluded from net earnings from self-employment. (Code Sec. 1402(a)(2), Code Sec. 1402(a)(3))
Code Sec. 1402(a)(17), added by the Small Business Act, provides that “notwithstanding the preceding provisions of this subsection,”each spouse’s share of income or loss from a qualified joint venture is taken into account under the Code Sec. 761(f) qualified joint venture rules in determining the spouse’s net earnings from self-employment. IRS has indicated that an electing husband and wife must each file with their joint income tax return a separate Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship) or Schedule F (Form 1040), Profit of Loss From Farming, and a separate Schedule SE (Form 1040), Self- Employment Tax, as applicable (see Newsstand e-mail 3/21/08 or Federal Taxes Weekly Alert 03/27/2008). While the general instructions for the 2007 Form 1040 don’t address the issue, the instructions for the 2007 Schedule E informs electing spouses that for a rental real estate business each spouse must report his or her share of this income on their respective Schedules C and not on Schedules E.
IRS examiners have questioned whether the spouses’ qualified joint venture election for a rental real estate business doesn’t convert income derived from business, which would otherwise be excluded, into net earnings from self-employment.
Effect of spousal joint venture election on self-employment tax. The CCA concludes that in the case of a husband and wife who make the qualified joint venture election for a rental real estate business, each spouse has a share of the qualified joint venture income, and each spouse may exclude his or her respective share of the qualified joint venture income from net earnings from self-employment under the Code Sec. 1402(a)(1) exclusion.
Generally, an individual who has income from a rental real estate business won’t be subject to self-employment tax on the income because it’s excluded from net earnings from self-employment under Code Sec. 1402(a)(1). He’ll report the income on a Schedule E (Form 1040) and carry over the amounts to his individual return (e.g., Form 1040), but not include the amounts on Schedule SE (Form 1040) in calculating self-employment tax.
The CCA reasons that the legislative history of Code Sec. 761(f) suggests that any income earned by a qualified joint venture is reported for all federal tax purposes using the same forms as if each spouse were a sole proprietor who earns that income. The phrase “not withstanding the preceding provisions of this subsection,” in Code Sec. 1402(a)(17) taken together with the rest of Code Sec. 1402 and Code Sec. 761(f) ‘s legislative history directs that none of the preceding subsections in Code Sec. 1402 are to alter that allocation between spouses. To read this phrase as nullifying the application of all the exclusions from net earnings from self-employment would trigger dramatic changes in the application of the self-employment tax to spouses electing qualified joint venture treatment. This was clearly not intended. The purpose of Code Sec. 761(f) wasn’t to convert income that would otherwise be excluded from net earnings from self-employment altogether into income that is subject to self-employment tax.
Dividends and capital gain aren’t subject to self-employment tax. The CCA similarly concludes that its reasoning applies to dividends and capital gains earned by a qualified joint venture. This income, otherwise excluded from net earnings from self-employment, is also excluded from self-employment tax for a qualified joint venture.