Thomas Ryther’s wholly owned corporation, Knight Steel, failed in 2004. Knight Steel had been in the business of fabricating steel frames and in the process of doing so generated scrap steel which it simply piled up. When Knight Steel passed through Chapter 7 on its way to the grave, the bankruptcy trustee abandoned that scrap steel because it appeared to be worthless.
Tom, however, who was financially challenged at this point, decided that since he had a large pile of scrap steel and needed money he’d look at whether he could get something for it. And Tom discovered that, far from being worthless, there was a ready market for the scrap steel. From 2004 to 2010 Tom sold various amounts of the steel to provide himself with cash.
Tom reported the amounts as ordinary income, but the IRS asserted that Tom should also pay self-employment tax on the amounts in question. The Tax Court, in the case of Ryther v. Commissioner, TC Memo 2016-56, took up the question of whether Tom owed self-employment tax on this income.
In this case the Court noted that self-employment income would normally be owed on net income “from any trade or business carried on by” Tom, with “trade or business” having the same meaning as it does under IRC Section 162.
The Court points out the Supreme Court “defined a trade or business as an activity engaged in for income or profit and performed with continuity and regularity. Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).”
The Court noted this question is a difficult one to apply in factual cases like this one, but noted there is an exclusion from inclusion of income from the sale of property in self-employment income at IRC §1402(a)(3)(C) which provides:
(3) there shall be excluded any gain or loss—
(C) from the sale, exchange, involuntary conversion, or other disposition of property if such property is neither—
(i) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, nor
(ii) property held primarily for sale to customers in the ordinary course of the trade or business;
The Court found that this test would be the key here—if the property was included as either types of property listed in IRC §1402(a)(3)(C)(i) or (ii) listed above then the income would be properly taxable as self-employment income while, if it did not fit those categories it would not be self-employment income.
The Court began by noting that the fact that Knight Steel carried on a trade or business of fabrication with these materials was not relevant, since Tom was not Knight Steel (which was now defunct in any event). Rather the question was whether the material represented such “tainted” items in the hands of Tom—was it either inventory or property held for sale to customers in the regular course of business?
But what does that mean? The Court notes that the same terms are used in the definition of capital assets under Section 1221. While in this case that was not the issue, the Court found the analysis used in cases where a determination was being made whether property was “inventory” or “held for sale in the regular course of business” in cases where the parties were arguing over capital gain treatment gave a useful test in this case.
Using the case of Williford v. Commissioner, TC Memo 1992-450 as a guide, the Tax Court determined that an eight factor test should be applied to see if this scrap metal would fall into the “inventory” or “held for sale to customers” category.
- Frequency and regularity of sales;
- Substantiality of sales;
- Length of time the property was held;
- Segregation of property from business property;
- Purpose of acquisition;
- Sales and advertising effort;
- Time and effort spent on sales; and
- How the proceeds of the sales were used.
As well, citing the case of Paullus v. Commissioner, T.C. Memo. 1996-419, the Court noted that Tom must also look at the trade or business issue, so additionally the Court decided it must look at:
- Is the taxpayer engaged in a trade or business?
- Is he holding the property primarily for sale in that business?
- Were the sales "ordinary" in the course of that business?
The court notes that Tom only sold scrap on average once or twice a month, thus not as frequently as one would expect someone holding inventory. The Court noted that buyers were easy to find, as there was a ready market for the property, so Tom’s infrequent sales seem more driven by the fact he wasn’t in the business.
Although he had sales that substantial to him over time, the Court found that due to fact his sales were sporadic and generated substantial profits when he made the sale, the factor was neutral.
Tom held the property for a long time despite the ready market to sell it, suggesting it wasn’t inventory he was holding for sale to customers.
While Tom did spend substantial time investigating scrap metal wholesalers and contacting them to sell his scrap, buyers didn’t come to browse his scrap as customers would—thus the court also found this factor neutral.
As well, the sales proceeds weren’t used to acquire more scrap. Had Tom been in the business of selling scrap most likely he would have used a portion of the sales proceeds to obtain more scrap to sell.
The Court therefore concludes:
We find that Ryther's scrap wasn't property primarily held for sale to customers in the ordinary course of a trade or business because the sales weren't part of a trade or business. “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. . . .” Austin, 263 F.2d at 464. We therefore also find that the income that Ryther realized from selling the scrap isn’t net earnings from self-employment under section 1402(a)(3)(C). As this is the only income in question, we conclude that Ryther isn't liable for self-employment tax.
Some readers might be wondering about a more basic problem—didn’t Tom really have income back when he obtained the scrap, given that (despite the view of the bankruptcy trustee) the scrap had real value?
The Court addressed this in a footnote, effectively concluding that neither party in the case had asked that question:
One might wonder why Ryther didn't have to include the value of the scrap in his taxable income for the year he took possession of it. Maybe the right treatment of the scrap was as treasure trove to Ryther on the day it was “reduced to undisputed possession.” See Rev. Rul. 61, 1953-1 C.B. 17. The amount of the income on that day would be measured by some calculation of “its value in United States currency.” Id. After that, Ryther would've had a basis in the scrap equal to the amount of the income. His future scrap sales would then have amounted to a recovery of basis (plus perhaps a little gain if the price of scrap had increased since the date he found it) instead of ordinary income. Neither party raised the issue, however, and we don’t need to consider it further.