Durando v. U.S., 94-15716

• Decision Date: 16 November 1995
• Docket Number: No. 94-15716,94-15716
• Citation: 70 F.3d 548
• Parties: -7464, 64 USLW 2333, 95-2 USTC P 50,615, 19 Employee Benefits Cas. 2191, 95 Cal. Daily Op. Serv. 8757, 95 Daily Journal D.A.R. 15,187, Pens. Plan Guide P 23914T Antonio R. DURANDO; Naomiann N. Durando, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 548

70 F.3d 548

76 A.F.T.R.2d 95-7464, 64 USLW 2333,

95-2 USTC P 50,615,

19 Employee Benefits Cas. 2191,

95 Cal. Daily Op. Serv. 8757,

95 Daily Journal D.A.R. 15,187,

Pens. Plan Guide P 23914T

Antonio R. DURANDO; Naomiann N. Durando, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 94-15716.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Oct. 20, 1995.

Decided Nov. 16, 1995.

Antonio R. Durando, Naomiann N. Durando, Tucson, Arizona, pro se, for plaintiffs-appellants.

Bruce R. Ellison, Billie L. Crowe, Tax Division, United States Department of Justice Washington, D.C., for defendant-appellee.

Appeal from the United States District Court for the District of Arizona.

Before: SNEED, PREGERSON, and FERDINAND F. FERNANDEZ, Circuit Judges.

SNEED, Circuit Judge:

Appellants are self-employed legal and business advisors who own shares in, and provide services to, several S corporations. They appeal from the district court's grant of summary judgment against them in their income tax refund action against the United States. Their complaint alleged that the Internal Revenue Service (IRS) improperly disallowed Keogh plan deductions which they claimed in their 1985 and 1987 joint income tax returns based on their pro rata shares of pass-through income from the S corporations. Thus, the question for decision is whether S corporation pass-through income can be treated as net earnings from self-employment for Keogh plan deduction purposes. The district court, in granting summary judgment to the United States, answered the question negatively. We affirm.

I. JURISDICTION AND STANDARD OF REVIEW

Jurisdiction in the district court was proper under 28 U.S.C. Sec. 1346(a)(1) and 26 U.S.C. Sec. 7422. This court has jurisdiction under 28 U.S.C. Sec. 1291. The appeal was timely filed. Fed.R.App.P. 4(a).

The issue for review, which was submitted to the district court on cross-motions for summary judgment ¹ based on stipulated facts, is a legal one subject to de novo review. Transamerica Corp. v. United States, 999 F.2d 1362, 1364 (9th Cir.1993). Because this issue is one of first impression for the courts, the outcome depends largely on our construction of the relevant provisions of the Internal Revenue Code (Code). The district court's interpretation of the Code is also subject to de novo review. Katherine Lynn McCarthy Trust v. C.I.R., 817 F.2d 558, 559 (9th Cir.1987).

II. FACTS AND PROCEEDINGS BELOW

Antonio and Naomiann Durando, self-employed individuals and shareholders in several S corporations, ² in their 1985 and 1987 joint income tax returns claimed Keogh retirement plan deductions ³ of $9,318.81 and $9,110.25 respectively. They derived these figures by adding the amounts reported on their Schedules C (Profit (or Loss) From Business or Profession), to their pro rata shares of income from the S corporations, as reported on their Schedules K-1 (Shareholder's Share of Income, Credits, Deductions, etc.), and taking the allowable deduction of 15% of the total. ⁴ Although Antonio Durando allegedly spent a substantial amount of time providing business and legal services to at least one of the S corporations, appellants did not report their pro rata shares of income reported on Schedules K-1 as net earnings for self-employment tax purposes. ⁵

The IRS disallowed the portions of the Keogh plan deductions attributable to appellants' pro rata shares of income from the S corporations and issued a deficiency notice. After paying the deficiency and filing an unsuccessful refund claim with the IRS, appellants brought this suit in the district court to obtain a refund of 1985 and 1987 income taxes paid as a result of the IRS' disallowance of most of their Keogh deductions. On cross-motions for summary judgment, the district court ruled that pass-through income from an S corporation is not net earnings from self-employment for purposes of Keogh plan deductions, and granted summary judgment against the appellants. This timely appeal followed.

III. DISCUSSION

A.

In interpreting the Internal Revenue Code, we strictly construe Code provisions granting exemptions and deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84, 112 S.Ct. 1039, 1042-43, 117 L.Ed.2d 226 (1992); Grimes v. Commissioner, 806 F.2d 1451, 1453 (9th Cir.1986). The burden of proving an erroneous deficiency in a tax refund suit rests with the taxpayer. Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933); Niles By and Through Niles v. United States, 710 F.2d 1391, 1393 (9th Cir.1983). Courts give deference to IRS rulings and interpretations of the Code. Davis v. United States, 495 U.S. 472, 484, 110 S.Ct. 2014, 2021-22, 109 L.Ed.2d 457 (1990); Walt Disney Inc. v. Commissioner, 4 F.3d 735, 740 (9th Cir.1993).

To understand the issue the taxpayers present requires a description of the applicable statutory structure. A taxpayer may deduct from his reported income certain contributions to a qualified retirement plan. In order to qualify for deductions, the plan must be "of an employer for the exclusive benefit of his employees or their beneficiaries." I.R.C. Sec. 401(a). Section 404(a)(8) extends this benefit to self-employed individuals by expanding the definitions of the terms "employee" and "employer." "Employee" is defined to include self-employed individuals. I.R.C. Sec. 401(c)(1). "Employer" is expanded thus: "An individual who owns the entire interest in an unincorporated trade or business shall be treated as his own employer. A partnership shall be treated as the employer of each partner who is an employee within the meaning of [Section 401(c)(1) ]." I.R.C. Sec. 401(c)(4). These expanded definitions explicitly encompass partners and sole proprietors, but say nothing about S corporation shareholders.

Nor do the provisions that define "self-employed individual" encompass S corporation shareholders. A self-employed individual is one who has "earned income." I.R.C. Sec. 401(c)(1)(B). Earned income means "net earnings from self-employment (as defined in section 1402(a))." I.R.C. Sec. 401(c)(2)(A). Net earnings from self-employment means "the gross income derived by an individual from any trade or business carried on by such individual ... plus his distributive share ... from any trade or business carried on by a partnership of which he is a member," excluding dividends received on any share of stock. I.R.C. Sec. 1402(a).

Although these provisions explicitly encompass income derived from a sole proprietorship or a partnership within the meaning of net earnings from self-employment, no language exists indicating that S corporation pass-through income also constitutes net earnings from self-employment. Thus, the relevant Code provisions authorize both partners and sole proprietors, but not S corporation shareholders, to deduct contributions to qualified retirement plans.

Nor is this a problematic omission. S corporations can establish retirement plans for their employees, including those who are also shareholders. See I.R.C. Sec. 1372(a). Shareholders, like appellants, who provide services to an S corporation can be treated like employees and covered by that corporation's retirement plan. ⁶

This treatment is quite consistent with the nature of S corporations. Congress created S corporations to give small businesses the benefits of the corporate form, such as limited liability for shareholders, without the disadvantages of corporate taxation. See S.Rep. No. 1983, 85th Cong., 2d Sess. 87 (1958), reprinted in 1958-3 C.B. 922, 1137-47 (new subchapter "permits businesses to select the form of business organization desired, without the necessity of taking into account major differences in tax consequence"); Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates & Gifts Sec. 95.6.1 (2d ed. 1989). In most respects, S corporations are treated like C corporations. I.R.C. Sec. 1371(a) ("Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter, subchapter C shall apply to an S corporation and its shareholders."). ⁷ However, S corporations are taxed much like partnerships: rather than paying income tax itself, the corporation passes its income through to its shareholders, who report their pro rata shares on their individual income tax returns. I.R.C. Secs. 1363(a), 1366(a). ⁸ Nonetheless, there are fundamental structural and operational differences between corporations and partnerships. ⁹ See generally Bittker & Lokken, Federal Taxation of Income, Estates & Gifts Sec. 95.6.1.

These differences make it improper to treat income earned by a corporation through its trade or business as though it were earned directly by its shareholders, even when, as here, the shareholders' services help to produce that income. An S corporation's income passes through to its shareholders not because they helped to create that income, but because they are shareholders. See I.R.C. Sec. 1366(a).

B.

In an effort to overcome the logic of the organizing principle and statutory structure of S corporations, appellants attempt to rest their case on a few bits of inapplicable statutory and regulatory law. For example, appellants place great weight on Code sections 1366(b) and 1366(c), which concern the tax treatment of S corporation shareholders. Section 1366(b) states:

The character of any item included in a shareholder's pro rata share ... shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.

Appellants argue that this provision means that income to the corporation should be treated as self-employment income to its shareholders. ¹⁰ However, the IRS has ruled that S corporation pro rata shares are not included in net earnings for Self-Employment Contributions Act purposes. Rev.Rul. 59-221, 1959-1 C.B. 225. Appellants show no good reason why...