Off-Duty Officer Pay Is Subject to Self-Employment Tax

Editor: Valrie Chambers, Ph.D., CPA

Employment Taxes

The applicability of self-employment tax to amounts paid to off-duty police officers continues to create questions for CPAs. A recent example is a Tax Court decision from December (Specks, T.C. Memo. 2012-343). A number of cases and some older revenue rulings provide valuable insight into the factors that determine whether the off-duty officer is performing services as an employee or independent contractor and, if deemed an employee, which entity is the employer—the police department or the third-party entity.

Carnell Specks was employed as a police officer for the Houston Police Department (HPD) and worked almost 2,200 hours for HPD during 2008. He also provided security services for several third-party businesses during off-duty hours. While providing security services to these third parties, Specks wore an HPD uniform and carried his personal firearm. The third parties did not train, supply, or equip Specks, and his relationship with each of the third parties was at-will. Further, each third party paid Specks directly on an hourly basis and did not withhold employment taxes or provide any fringe benefits. Specks’s compensation from the third parties was reported on Forms 1099-MISC, Miscellaneous Income.

At trial, Specks contended that he was an employee of the third parties and thus amounts paid to him were not subject to self-employment tax (initially the taxpayer treated the amounts received as additional compensation as an HPD officer). A tax is imposed on a taxpayer’s self-employment income (Sec. 1401); however, self-employment tax does not apply to compensation paid to an employee (Sec. 1402(c)(2)).

Whether an individual is an employee or an independent contractor is a question of fact determined by applying common law principles. Relevant factors include (1) the degree of control exercised by the principal over the details of the work, (2) which party invests in the facilities (equipment) used in the work, (3) the individual’s opportunity for profit and loss, (4) whether the principal has the right to discharge the individual, (5) whether the work is part of the principal’s regular business, (6) the permanency of the relationship, and (7) the relationship the parties believed they created (see, e.g., Weber, 103 T.C. 378 (1994), aff’d, 60 F.3d 1104 (4th Cir. 1995); and Rosato, T.C. Memo. 2010-39).

The court recognized that the relationship between Specks and the third parties had some aspects that are characteristic of an employer-employee relationship and others of a principal-independent contractor relationship. After weighing the above factors, giving greater weight to the third parties’ right to control Specks’s performance of his duties, the court concluded that Specks failed to prove that he was as an employee. Therefore, the amounts he received from the third parties were subject to self-employment tax.

A common procedure among many municipalities that allow their police officers to provide off-duty services to third parties is that the department approves the services in advance, and a “scheduler” or “coordinator” within the department serves as a liaison between the department and the third parties. Courts have ruled an independent contractor relationship exists between the police officer and third party in instances where the department sets the minimum off-duty pay rates; limits the maximum hours of off-duty work; and requires the officers to monitor their police radio while providing the services and to be subject to recall to regular duty (see Ladue, T.C. Summ. 2011-41; Cicciari, T.C. Memo. 2003-179; and Milian, T.C. Memo. 1999-366).

In the above cases, the Tax Court concluded that the off-duty services were performed for and were directly beneficial to the third-party entity. Any benefit the police department received from an increased police presence at the officers’ off-duty assignments is incidental and similar to the benefit to a police department when officers increase their presence in a community by driving their police cruisers home. Another factor considered is the ability to select and discharge at will. The approval to work off-duty projects and the ability to suspend the officer if department policies are not adhered to are not the same as the ability to hire and fire with regard to the off-duty positions; rather, they amount to incidental control. As the Tax Court found in Ladue, the police department is looking after its own interests in making sure that off-duty work does not interfere with on-duty employment, that the department’s image is not tarnished, and that the department knows where its officers are in case of an emergency.

Another important factor in these cases is the source and method of payment for the off-duty services. In the above cases, the third parties paid the officers directly and treated them as independent contractors, issuing Forms 1099-MISC.

A pair of revenue rulings issued in the 1970s contrast with the recent court rulings and suggest that, in the past several decades, municipalities have modified their practices in their involvement in the employment of off-duty police officers by third parties, to help ensure the municipalities are not deemed to be employing the officers when the officers work for third parties. The first ruling is Rev. Rul. 70-504, in which a municipality granted a license to an amusement company to operate a theater. The license required the theater to have an officer stationed at the theater and pay the officer remuneration at a rate equal to the rate of pay the officer received from the municipality. In addition, the officer worked directly under the police captain while at the theater and was subject exclusively to the captain’s direction and control. Further, the theater did not have any input on which officers were assigned to the theater. The IRS determined that the police officers were employees of the municipality.

Several years later, the IRS ruled that the off-duty police officers who volunteered for assignments to direct traffic at a local bank drive-in facility were employees of the city for employment tax purposes. In Rev. Rul. 74-162, a bank and the police department entered into an arrangement under which two off-duty police officers would report to the bank each day it was open to direct traffic. Each officer would work a four-hour shift, and the department would assign only officers who expressed an interest in such traffic control services. The assignments were made by two members of the police department who were designated by the department as the off-duty work coordinators. The bank had no voice in selecting the officers assigned to work there, did not negotiate with the individual officers, and did not tell them how to perform their duties. The remuneration the officers received for the traffic control assignments was established by the city council and collected by the police department. The police department coordinators authorized the payment of the additional pay to the officers for their off-duty services. The court ruled the police officers’ compensation for these assignments was as employees of the city, not the third party.

These two early revenue rulings contrast with the more recent court decisions on payments police officers receive from off-duty jobs with third parties and may explain why the IRS is increasingly pursuing self-employment taxes in these situations. While a municipality will usually monitor and coordinate the off-duty assignments and require the officers to adhere to the police department’s policies, the courts have recently ruled this level of control by the municipality is incidental. Further, when the factors distinguishing an independent contractor relationship outweigh the factors suggesting an employee-employer relationship, the courts have consistently ruled the amounts received by the police officer are considered self-employment income, subject to self-employment tax.