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Used Car Seller’s Bonus Payments Do Not Constitute A Separate Trade or Business

Posted on Apr. 18, 2023

Many Americans work in multiple settings, earning wages from an employer and also payments from third parties that do not treat those payees as employees. Does the receipt of a 1099 for non employee compensation always relate to a separate trade or business? Schmerling v Comm’r, an S case from earlier this month, highlights how earning income apart from W-2 wages may not amount to a separate trade or business and may just relate to the recipient’s employee status.

Interpreting and applying our tax system to everyday individual taxpayers can be challenging. For example last week in Neo-TikTok-Tology Megan Brackney and Melina Watson raise questions about how ordinary taxpayers come to learn, or think they are learning, about tax law. As social media’s influence continues to grow and become the go to source for all kinds of information, will the IRS or courts consider social media posts as a possible defense to the imposition of penalties?

And last week the Wall Street Journal in Cotton Candy and $864 in Sex Toys: Influencers Go Big on Tax Write-Offs, ($), reporter Sarah Needleman explores the blurry line of what precisely is an ordinary and necessary business expense for those who create content on social media. From sex toys to dog costumes, and tickets for mixed martial arts fights, the article explores how some influencers push the line and search for return preparers who might bless aggressive deductions.

Well while we might see some of these issues in Tax Court someday, Schmerling v Comm’r raises similar practical concerns.

The case involves a taxpayer who was a successful used car sales manager at McKenna, a BMW dealership. The taxpayer, Schmerling, earned over $200,000 in wages as an employee at that dealership. In addition to selling cars for the dealer, Schmerling also traveled to auctions to purchase cars that the dealer would resell. Schmerling also received about $37,000 in bonus payments from BMW USA for exceeding certain performance goals. On top of that bonus, he earned about $2,500 in payments from Devex, an insurance company, for selling warranties on the cars.

Schmerling was not treated as an employee of either BMW USA or Devex, and the bonus and warranty payments were reported to him on Forms 1099. He treated those 1099 payments as a separate business as reflected on a Schedule C that he filed with his return.

Much of the Schmerling case turns on substantiation and whether Schmerling demonstrated a sufficient business connection between travel and other expenses that supposedly related to his used car sales.

Those issues are not as interesting as the broader issue as to whether the 1099 activities are a separate trade or business, as well as the implications flowing from the conclusion that the 1099-income producing activity is not a separate trade or business.

The opinion rejects Schmerling’s attempt to treat the bonus and warranty income as associated with a separate trade or business:

Whether an activity is a trade or business is a question of fact that takes into account a taxpayer’s intent and all other relevant facts and circumstances surrounding the activity. See Commissioner v. Groetzinger, 480 U.S. 23, 35–36 (1987). Petitioner does not claim that he earned any income from either BMW or Devex independently from his employment with McKenna. The income that petitioner earned from BMW and Devex is inextricably intertwined with and connected to his status as an employee of McKenna. Using common sense as a guide, as Groetzinger suggests, we are not persuaded that petitioner’s relationships to BMW and Devex provided him with the opportunity to earn a living separate and apart from his status as an employee of McKenna. Petitioner “earned his living” during 2014 as a result of his “trade or business” of being an employee of McKenna, not as the proprietor of a separate trade or business independent from his employment with McKenna.

In effect, the opinion treats the bonus and insurance income as potentially generating deductions relating to investment or other income generating activity that does not rise to the level of a trade or business. Deductions from an income generating activity that is not a trade or business are authorized under Section 212; ordinary and necessary business expenses are deducted under Section 162.

A little background is helpful. Caselaw establishes that one can be in the trade or business of being an employee. Unlike most Section 162 trade or business expenses, which can be deducted above the line, most Section 162 employee expenses, like unreimbursed employee expenses, are below the line and treated as miscellaneous itemized deductions.

The case involves the tax year 2014, prior to the TCJA and its effective suspension of the deductibility of unreimbursed business expenses and most 212 expenses due to Section 67(g). Section 67(g) suspends deductions for miscellaneous itemized deductions from 2018-25. In pre TCJA years, MIDs (including unreimbursed employee expenses) were deductible to the extent they exceeded 2% of a taxpayers AGI.

I suspect that during the years that the TCJA suspends the deduction of MIDs, people like Schmerling, who have W-2 income and 1099 income may try to allocate expenses that are arguably related to both to the W-2 income and the 1099 income toward the 1099 income. And those taxpayers will argue that the 1099 income would constitute income from a trade or business separate from their employee status. When the 1099 income does not relate to an activity that amounts to a trade or business (as in Schmerling), any expenses that might arguably be related to the 1099 income should be treated as Section 212 expenses associated with the production of income. Thus, to the extent so allocated, the 212 expenses would generally* be MIDs, below the line, and for the years 2018-25 disallowed as per Section 67(g). *Section 212 expenses associated with rental or royalty income is the exception and are deducted above the line).

Even if the 1099 income producing activity were a separate trade or business, there are lurking allocation issues. How should expenses that arguably relate to both one’s status as an employee or one’s role as effective sole proprietor be allocated across those activities?

With more individuals holding down side hustles (see Side Hustlers on the Rise, and Nearly 70% Say They’re More Reliant on the Extra Income Due to Inflation), and the stakes potentially high with the disallowance of any unreimbursed expense deductions associated with employment, it is tempting to treat all expenses as connected to the trade or business that generates the 1099.

While most of this post involves substantive tax issues rather than procedural ones, there are still procedural questions lurking as the Code incentivizes the worker to have certain activities labeled as non-employee compensation in order to obtain deductions for what might otherwise be non-deductible employee expenses. Prior to the change in the law the general rule pitted the individual who almost always wanted to be an employee against the hiring entity which almost always wanted the compensation to be treated as paid to an independent contractor. Add to that mix the deduction for qualified business income under Section 199A, which does not apply to wages but can apply to 1099 income. Now that the payor and payee share some of the same goals, the natural tension that helped to govern these relationships (and create reclassification questions using Form SS-8) may be lessening. That could create less tax controversy as the interests of the two parties may align against the IRS rather than each one seeking a different outcome leading to controversy with the IRS as arbiter. Though, as this post shows, the IRS can still challenge that classification, and the receipt of 1099 income itself that is related to services performed does not always connect to a separate trade or business.

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