Income from Sporadic Sales of Scrap Metal Not Subject to Self-Employment Tax.

(Parker Tax Publishing APRIL 2016)

Applying an eight factor test, the Tax Court determined a taxpayer who sold leftover scrap steel from his failed steel fabrication business was not engaged in a trade or business, and thus the sales were not subject to self-employment tax under Code Sec. 1401. Ryther v. Comm'r, T.C. Memo. 2016-56,

Background

Thomas Ryther incorporated Knight Steel in 1997 and was its sole owner, officer, and board member. The firm fabricated steel frames, primarily for general contractors. Knight Steel's fortunes sagged after the stock market collapsed in 2000. In 2001 it fell behind on paying employment taxes, and the IRS assessed penalties. The company's troubles continued, and in 2004 a bankruptcy trustee took over to manage its liquidation. The trustee closed the business in April 2004 and the bankruptcy court discharged the company's debts the following January. In winding up Knight Steel's operations, the trustee focused on the company's cash and accounts receivable and chose to abandon the company's few items of tangible property - two run-down trailers, some well-used fabrication equipment, and a large pile of scrap steel - because they appeared to be worthless.

Before Knight Steel entered bankruptcy, Ryther had incorporated a second business, Mission Steel. When Knight Steel was liquidated, Mission Steel took control of its abandoned trailers and fabrication equipment and assumed its land leases. Ryther hoped to continue in the steel-fabrication business, but the new company never did much business.

Ryther discovered, however, that the large quantities scrap steel that had accumulated over the years had value and there was an active market. He also learned that wholesalers were willing to come to his lot, fill their trucks with the scrap, and pay for it on the spot. Over the course of 2004 to 2011 he sold scrap steel once or twice a month, to at least five different scrap wholesalers, in sales totaling over $300,000.

Ryther didn't file tax returns during these years. In 2012 he filed all seven missing returns, and reported his scrap sales as miscellaneous income. In 2013 the IRS assessed a deficiency after determining that Ryther's scrap selling was a trade or business and his income from those sales was therefore subject to self-employment tax.

Analysis

Code Sec. 1402 defines self-employment income as "net earnings from self-employment," which is defined as "the gross income derived by an individual from any trade or business carried on by such individual."

The sale of a taxpayer's own property is generally exempt from the definition of self-employment income. But an exception applies where the property is held primarily for sale to customers in the ordinary course of the trade or business (Code Sec. 1402(a)(3)(C)(ii)).

The Tax Court pointed out that neither Code Sec. 1402 nor its regulations define the term "property held primarily for sale to customers in the ordinary course of the trade or business." But, the court observed, the phrase appears in Code Sec. 1221(a)(1). Although Code 1221 doesn't define these phrase either, the court determined that case law under Code Sec. 1221(a)(1) explaining the phrase was relevant.

The court cited Williford v. Comm'r, T.C. Memo. 1992-450, in which a taxpayer who sold pieces of art was a part-time art dealer but claimed that his income from the sale of particular pieces at issue was capital gain because they were from his personal collection. There, the court had to decide if the specific pieces were "held primarily for sale to customers in the ordinary course of the trade or business." In finding the art was not so held, it used the following eight factors:

(1) frequency and regularity of sales;

(2) substantiality of sales;

(3) length of time the property was held;

(4) segregation of property from business property;

(5) purpose of acquisition;

(6) sales and advertising effort;

(7) time and effort spent on sales; and

(8) how the proceeds of the sales were used.

Applying the factors in the instant case, the court determined that three favored the taxpayer and the remaining five were neutral.

The court found factor 1 (frequency and regularity of sales) favored Ryther because he sold scrap on average only once or twice a month. The court was persuaded that a holding period of seven years indicated that Ryther wasn't holding his scrap for sale in the ordinary course of business, and therefore factor 3 (length of time the property was held) also favored Ryther. With regard to factor 8 (how the proceeds of the sales were used), the court noted it was undisputed that Ryther didn't use the proceeds to buy more scrap but instead to pay everyday expenses. Accordingly, the court concluded that factor 8 greatly favored Ryther.

Although the $300,000 in sales were substantial, the court said, because Ryther's sales were "sporadic" and generated large profits with little effort factor 2 (substantiality of sales) was neutral. The court found factor 4 (segregation of property from business property) was also neutral because Ryther had a single large pile of scrap, not collections of business scrap and personal scrap that he commingled. Factor 5 (purpose of acquisition) was neutral because there weren't enough facts for the court to determine when and why Ryther acquired the scrap. The court determined factor 6 (sales and advertising effort) was neutral because the market for scrap had established prices and sales could be made by simply picking up the phone and arranging delivery, and thus no other advertising would be ordinary. Because the amount of time Ryther actually spent researching scrap wholesalers and contacting them to arrange sales was unclear, the court found factor 7 (time and effort spent on sales) to be neutral.

Accordingly, the court determined that Ryther's scrap wasn't property primarily held for sale to customers in the ordinary course of a trade or business. Carrying on a business, the court said, citing Austin v. Comm'r, 263 F.2d 460 (9th Cir. 1959), implies an occupational undertaking to which one habitually devotes time, attention, or effort with substantial regularity; merely disposing of assets at intermittent intervals is not engaging in business.

The court thus held that the income Ryther realized from selling the scrap was exempt under Code Sec. 1402(a)(3)(C) from self-employment tax.

For a discussion on self-employment taxes, see Parker Tax ¶13,100.

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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