The Tax Court held that a taxpayer's proceeds from sales of scrap steel over a seven-year period were not self-employment income subject to the self-employment tax.
Thomas Ryther was the sole owner, officer, and board member of Knight Steel (Knight), a corporation that fabricated steel frames, mostly for general contractors. Those contractors would bring large beams to Ryther, which he would cut to size and drill bolt holes in so that the contractors could easily assemble them into a frame at a construction site. Fabricating beams generated a considerable amount of scrap steel, which Ryther accumulated on a lot adjacent to his fabrication operation.
Knight's fortunes went downhill after the stock market collapsed in 2000, and in 2004 a Chapter 7 bankruptcy trustee took over the company to manage its liquidation. At that point, Knight's physical assets included the large pile of scrap steel that had built up from its operations and some superannuated equipment and trailers; however, the bankruptcy trustee, believing the scrap steel and the other assets were worthless, did not dispose of them in the liquidation and left them in Ryther's possession. Ryther made another go at steel fabrication using the equipment and trailers left from the Knight bankruptcy through a separate corporation called Mission Steel, but that venture was also unsuccessful.
With the failure of Mission Steel, Ryther needed money, but all he had was the scrap steel sitting on his property. Ryther was unaware throughout the Knight years that people would actually pay good money for scrap steel and had never attempted to sell any of it. However, in 2004, he finally came up with the idea of trying to sell the scrap. After doing some research, he discovered that scrap steel had not only value but also an active market.
Better yet, he found that wholesalers were willing to come to his lot, fill their trucks with scrap steel, and pay him cash for what they took. Over the next seven years, he sold scrap steel once or twice a month, to at least five scrap wholesalers, in sales that totaled over $317,000.
For the seven years he sold the scrap, Ryther dealt strictly in cash to avoid the IRS and did not file tax returns. Finally, in February 2012, he untimely filed all seven missing returns and reported his scrap sales as miscellaneous income. The IRS determined that the sales were a trade or business and his income from those sales was therefore subject to self-employment tax. In April 2013, the Service sent Ryther a notice of deficiency. In response, Ryther filed a petition in Tax Court challenging the IRS's determination.
The Tax Court's Decision
The Tax Court held that Ryther's income from the sale of the scrap steel was excluded from self-employment income and thus was not subject to self-employment tax. In making its decision, the court analyzed the scrap sales using an eight-factor test from Williford, T.C. Memo. 1992-450.
The Tax Court first discussed the general rules regarding the definition of self-employment income. Sec. 1402 defines self-employment income as "net earnings from self-employment," which it defines as "the gross income derived by an individual from any trade or business carried on by such individual." It further says that the phrase "trade or business" means the same in Sec. 1402 as it does in Sec. 162; however, Sec. 162 and the rest of the Code do not provide a definition of "trade or business." The Supreme Court filled this gap in Groetzinger, 480 U.S. 23 (1987), by defining a trade or business as an activity engaged in for income or profit and performed with continuity and regularity. Whether an activity is a trade or business is a question of fact.
In general, Sec. 1402(a)(3)(C) excludes a sale of a taxpayer's own property from the definition of self-employment income. However, this exclusion does not apply to property that is the stock in trade or other property of a kind that would properly be includible in inventory if on hand at the close of the tax year or property held primarily for sale to customers in the ordinary course of the trade or business. Ryther and the IRS agreed the scrap steel was not inventory, so the Tax Court addressed the second issue: whether Ryther held the scrap primarily for sale in the ordinary course of a trade or business.
On that point, the court further explained that Sec. 1402 and the regulations under it were silent as to what is included in property held primarily for sale to customers in the ordinary course of a trade or business. However, it observed that identical language is used in Sec. 1221(a) to define what property is not considered a capital asset and that the definition for purposes of Sec. 1221(a) would apply for purposes of Sec. 1402. Although Sec. 1221 and the regulations under that section also did not define the phrase, the Tax Court noted that courts had previously addressed the meaning of the phrase for purposes of Sec. 1221(a). Therefore, it looked to the case law under Sec. 1221 for a definition of the phrase and guidance on how to determine whether property is within that definition under a specific set of facts.
After reviewing the case law, the Tax Court concluded that it should use the test in Williford. In that case, 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 in his case was capital gain because they were from his personal collection. Thus, the court had to decide if the taxpayer held these particular pieces primarily for sale to customers in the ordinary course of a trade or business or as an investment. The test it used had eight factors:
- Frequency and regularity of sales;
- Substantiality of sales;
- Length of time the property was held;
- Segregation of property from business property;
- Purpose of the acquisition;
- Sales and advertising effort;
- Time and effort spent on sales; and
- How the proceeds of the sales were used.
Applying these factors to Ryther's scrap sales, the court found that the second factor was neutral because although the sales were substantial in amount (to Ryther), they were not ancillary to an ongoing business since he did nothing other than offer the scrap he had for sale. The fourth factor was neutral because Ryther had a single pile of scrap, not separate piles for business and personal use. The court found that the fifth factor, purpose of the acquisition, was neutral because, based on facts in the record, it could not determine what Ryther's actual purpose was for the scrap. The sixth factor was neutral because the scrap metal market was an active commodity market in which it was unnecessary for Ryther to expend any sales or advertising efforts to make sales. Similar to the fifth factor, the seventh factor was neutral because the court found it was "entirely unclear" how much time Ryther devoted to the scrap sales.
On the other hand, the Tax Court found that the first factor favored Ryther, stating that the fact that he sold the metal sporadically in small sales over a number of years did not make the sale a business any more than it would if he had sold it all in one large sale. The third factor favored Ryther because the court considered that given the characteristics of scrap metal as a product, only a short holding period would be indicative of sales in the ordinary course of business. The court found that the eighth factor "greatly" favored Ryther because he did not use any of his proceeds from the sales to purchase more scrap to sell, clearly indicating that he made the sales simply to liquidate the scrap.
Finding that five factors of the test were neutral and three favored Ryther (with one favoring him greatly), the court concluded that the sales were not in the ordinary course of a trade or business because they were not part of a trade or business. In closing, the court quoted Austin, 263 F.2d 460, 464 (9th Cir. 1959), rev'g T.C. Memo. 1958-71, "Carrying on a business . . . implies an occupational undertaking to which one habitually devotes time, attention, or effort with substantial regularity. Merely disposing of . . . assets at intermittent intervals, without more, is not engaging in business."
As the Tax Court noted, if one of Ryther's corporations had sold the scrap steel, there would be little doubt that the sales were part of the corporation's business; however, that is not what happened. Although Ryther was clearly trying to avoid paying any tax by taking only cash payments for the scrap and lying low, the IRS should not have been trying to get some extra payback by pushing a self-employment tax argument that clearly did not apply to the facts.
Ryther, T.C. Memo. 2016-56