TN 17 (09-06)
RS 01802.400 SEI in Community Property States
Section 211(a) (5) (A) of the Social Security Act previously provided that community income subject to community property laws and derived from a trade or business (other than a trade or business carried on by a partnership) was to be treated as the income of the husband unless the wife exercises substantially all the management and control of the trade or business. Several Federal courts found this section of the Act to be unconstitutional as it discriminated against women in violation of the equal protection provision of the Due Process Clause of the Fifth Amendment to the Constitution. Cases so holding are: Carrasco V. Secretary, HHS (1 Cir. 1980); Hester v. Harris (5th Cir. 1980); and Becker v. Harris (E.D., California; 1980). SSA acquiesced in the Becker decision (see SSR 81-17c) and in October 1980 the Attorney General notified Congress that he would not appeal the decision that the statute was unconstitutional.
Therefore, effective with taxable years that include October 1980, the unconstitutionality of section 211(a) (5) (A) applied and SSA no longer applied the statutory presumption that self-employment income (SEI) would be considered earned by the husband under the statutory presumption that the husband is the operator of the business. The following States have community property laws: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Wisconsin, Texas, and Washington. The court decisions affected Federal Social Security coverage. The State laws themselves were not declared unconstitutional.
However, Section 425 of the Social Security Protection Act of 2004 amended section 211(a)(5)(A) of the Social Security Act and section 1402(a)(5)(A) of the Internal Revenue Code to provide that if community property laws apply to income that an individual derives from a trade or business (other than a partnership), the gross income and deductions derived from such trade or business shall be treated as the gross income and deductions of the spouse carrying on the trade or business and if jointly operated as the gross income and deductions of each spouse on the basis of his or her respective distributive share of the gross income and deductions. Therefore, SSA no longer follows the provisions of the Edwards Court Order or the instructions previously contained in RS 01802.410 through RS 01802.470 which are now obsolete.
B. Policy - Proper Splitting of SEI Income in a Community Property State
1. Trade or business income
Treat income and related deductions from a trade or business that is not a partnership as those of the person carrying on the trade or business.
2. Self-Employment Tax
Similarly, if any income from a trade or business other than a partnership is community income under State law, it is subject to self-employment tax as the income of the spouse carrying on the trade or business. The identity of the spouse carrying on the trade or business is determined by the facts in each case.
3. Partnership Income
If a spouse is a partner and his/her distributive share of any income or loss from a trade or business carried on by the partnership is community income, treat his/her respective share as net earnings from self-employment income (NESE). No part is treated as NESE by their spouse. If both spouses are partners, each spouse must claim his/her share when figuring NESE for self-employment tax purposes.
If separate returns are made by a husband and wife domiciled in a community property State and only one spouse is a member of the partnership, the part of his or her distributive share of any item (not considered NESE), which is community property or which is derived from community property, should he reported by the husband and wife in equal shares.
4. IRS Reference
Publication 555 - Community Property
C. Policy-Correction of Earnings Record
1. Tax year open to correction
If the wife’s income derived from a business individually or jointly owned by a husband and wife in a community property State was incorrectly designated to the husband’s earnings or vice versa the statute allows all of the incorrect earnings to be moved to the wife’s earnings record provided it is for a year open to correction.
2. Barred Year
If the earnings correction is for a year that is barred to correction only the amount of earnings posted to the incorrect earnings record (e.g., husband’s earnings record) can be moved to the correct earnings record (e.g., wife’s earnings record). RS 02201.022 and MSOM EM 023.004
3. Reallocation Examples
a. Example 1-Non- Barred Year – All of the SEI can be Reallocated
Lisa is married to Scott and owns and operates a restaurant in a community property State. Lisa works full time and makes all of the management decisions. Scott helps out on occasions. For the year 2004 their accountant erroneously reported all of the NESE ($90,000) under Scott’s social security number (SSN). Maximum SEI of $87,900 was posted to Scott’s earnings record. The year 2004 is not barred to correction. All of the SEI posted to Scott’s earnings record can be moved to Lisa’s earnings record.
b. Example 2 – Barred Year – Some of the SEI can Be Reallocated
Lisa is married to Scott and both own and operate a restaurant jointly in a community property State. Each spouse contributes 50 percent of the services rendered and makes management decisions. For the year 2000 their accountant makes a mistake and reports all of the NESE ($82,000) shown on the Schedule SE under Scott’s SSN. The maximum of $76,200 is posted to Scott’s earnings record. Because Scott is entitled to $41,000 (half of the NESE) only $35,200 can be moved to Lisa’s earnings record; the difference between 50 percent of Scott’s NESE ($41,000) and the maximum $76,200.
c. Example 3 – None of the SEI can be Reallocated
The facts are the same as an in Example 2 except the NESE is $155,000. Since each spouse was entitled to $77,500 (half of the NESE) and the maximum of $76,200 is posted to Scott’s record none of the posted earnings can be reallocated to Lisa’s earnings record.