Ninth Circuit disallows Keogh deduction based on S income.

• Author: Barton, Peter C.

The Ninth Circuit recently ruled in Durando, 70 F3d 548 (1995), that shareholders' pro rata share of S income is not self-employment income for Keogh plan deduction purposes. It is surprising that Durando is the first case to rule on this issue since Congress created Keogh plans in 1962 and S corporations in 1958. There are approximately 1.8 million S corporations, all of which are affected by this ruling.

Keogh plans are retirement plans for self-employed individuals. Sec. 404 (a) (3) (A) and (a) (8) (D) allow self-employed taxpayers to deduct up to a maximum of 15% of earned income for contributions to a qualified retirement plan. A complex series of statutory sections define the meaning of "self-employed" and "earned income." Sec. 401 (c) (1) (B) defines "self-employed individual" as "an individual who has earned income." Sec. 401 (c) (2) (A) defines "earned income" as "net earnings from self-employment (as defined in section 1402 (a))." However, Sec. 401 (c) (2) (A) limits the net earnings for the Keogh plan deduction to net earnings from a trade or business "in which personal services of the taxpayer are a material income-producing factor." Sec. 1402 (a) defines "net earnings from self-employment" as the "gross income from any trade or business carried on by such individual...plus his distributive share...of income or loss...from any trade or business carried on by a partnership of which he is a member." There is no mention of S income in Sec. 1402 (a).

In Durando, Antonio and Naomiann Durando were sole proprietors, and were also shareholders in several S corporations in 1985 and 1987. They claimed Keogh retirement plan deductions of over $9,000 in each of those years, which was 15% of their combined Schedule C income plus their pro rata share of the S corporations' income. The Durandos did not report their share of the S corporations' income as net earnings for self-employment tax purposes. Although Antonio spent a substantial amount of time providing services to one of the S corporations, he received no compensation as an employee. Therefore, the only income he reported from the S corporations was as a shareholder.

The IRS disallowed the portion of the Keogh plan deductions based on the Durandos' share of income from the S corporations. The Durandos paid the deficiency and sued for a refund in Federal district court, where they lost.

The Court of Appeals ruled that passthrough income of an S corporation cannot be treated by the...