According to the plaintiffs, the emphasis in § 404(a)(8)(C) is on limiting the deduction to earned income, to prevent pension contributions for self-employed individuals from becoming the source of losses. They argue that the "shall be considered" language is intended to define at which point an expense which is clearly attributable to a trade or business can no longer be considered as such, in other words, when it surpasses earned income. This is different from the government's interpretation, which reads the "shall be considered" language to mean that an expense, which is not truly a business expense, may be considered to be such only by virtue of that section.
The government answers the plaintiffs' interpretation by arguing that it merely proves the government's point. A business person would not willingly "incur an expense that would result in a net loss for his business," unless the expense benefitted him personally. Reply at 7. Therefore, a Keogh contribution, although allowed as a deduction by virtue of § 404(a)(8)(C), cannot be considered an ordinary and necessary business expense outside of that context. Although this argument is specious, because a decision to take business losses in a given year is often supported by accounting practices which benefit the business itself, not merely the self-employed person, the government's conclusion is supported by both the statutory scheme and the legislative history.
The Senate Report on § 404(a) notes that while § 404 establishes no fixed maximum limitation for the amount deductible, "the new section 404(a)(8) provides that certain amounts contributed on behalf of self-employed individuals do not satisfy the requirements of sections 162 or 212 and are, therefore, not deductible." 1962 U.S. Code Cong. & Adm. News, p. 3004. Thus, § 404(a)(8) establishes the amounts excluded from the determination of the deduction from gross income: "The amounts to which the new section 404(a)(8) applies are contributions on behalf of self-employed individuals which exceed the earned income derived from the trade or business with respect to which the plan is established, and contributions which, under regulations prescribed by the Secretary or his delegate, are allocable to the purchase of life, accident, health, or other insurance." Id. Bearing in mind that prior to the passage of this section, self-employed individuals could not deduct their contributions to Keogh plans, it is clear that § 404(a)(8) both creates the conditions that allow for the deduction and limits the deduction. This understanding supports the government's analysis. The plaintiffs' argument that § 404(a)(8) establishes the point at which a contribution can no longer be deemed a business expense ignores the fact that such contributions have never before been considered business expenses.
The government buttresses its analysis by relying on § 62(a)(6). Section 62(a) defines the term "adjusted gross income" as gross income minus certain enumerated deductions. One of those deductions, set forth in § 62(a)(6), is for pension, profit-sharing and annuity plans of self-employed individuals. Section 62(a)(6) allows adjusted gross income to incorporate the deduction of § 404 "in the case of an individual who is an employee within the meaning of section 401(c)(1)."
The government explains that § 62(a)(6) was enacted at the same time as § 404(a)(8) as part of the Self-Employed Individuals Retirement Act of 1962. While § 62(a)(1) allowed a deduction for business expenses, § 62(a)(6) was a necessary addition to the tax code to incorporate a deduction for Keogh contributions in the calculation of adjusted gross income. Once again, the government suggests, Congress has incorporated an explicit reference to the deductibility of contributions of self-employed individuals. In each case, those contributions are explicitly set forth, not assumed to fall within the ambit of business expenses.
The plaintiffs maintain that the government's argument proves too much. The government's argument, they claim, does not explain the 1986 amendment to § 62(a)(6) which expanded the deduction from one that was limited to those contributions made on behalf of the self-employed person, to a deduction for all contributions under § 404, which includes those contributions made on behalf of a self-employed person's common law employees. Because § 404 includes contributions made on behalf of common law employees, an argument that a deduction under § 62(a)(6) is different from a deduction under § 62(a)(1) implies that contributions made on behalf of common law employees are not deductions "attributable to a trade or business." Such contributions are clearly deductions, however, because under § 1402(a) a self-employed person is entitled to deduct contributions to a qualified retirement plan to the extent that those contributions satisfy the requirements of § 404 and are for the benefit of common law employees.
In addition, the plaintiffs term the government's reference to § 62(a) a "red herring." They argue that the definition of "adjusted gross income" has nothing whatsoever to do with computing the proper deductions under § 162 or § 404. Moreover, they offer a different explanation for the specification of § 62(a)(6). Section 62(a)(1) excludes from trade or business expenses those expenses that "consist of the performance of services by the taxpayer as an employee." Therefore, because a self-employed individual is treated as both employer and employee, under § 404(a)(8), Congress had to clarify that the § 62(a)(1) exclusion did not extend to self-employed persons.
Both parties argue that § 62(a)(6) was enacted as a point of clarification. This assumption is supported by IRS Temporary Regulation § 1.62-1T(b), which explains that § 62 does not create new deductions, but instead specifies which previously enumerated deductions are allowed in computing gross income. Each party contends that § 62(a)(6) serves to clarify a different point. The plaintiffs believe that it was enacted to clarify the general right to treat contributions to Keogh plans as business expenses. The government maintains, on the other hand, that § 62(a)(6) serves to clarify that contributions to Keogh plans are to be treated as business expenses only when § 404(a) is specifically implicated.
The Senate Report states that "the bill also makes it clear that amounts contributed to a qualified retirement plan by a self-employed individual which are deductible, are treated as deductions from gross income in computing adjusted gross income. Thus, a self-employed individual may take this deduction and still qualify for the standard deduction." 1962 U.S. Code Cong. & Adm. News, p. 2990. In addition, the Senate Report explains that "the bill amends section 62 of the Internal Revenue Code of 1954, relating to the definition of 'adjusted gross income,' to provide that, in computing adjusted gross income, there shall be allowed, in the case of a self-employed individual, the deductions allowed under sections 404 and 405 for contributions on behalf of such an individual to a qualified pension, annuity, profit-sharing, or bond-purchase plan." Id. at 3017.
These passages from the legislative history of § 62(a)(6) appear to support the government's argument that Congress included § 62(a)(6) to allow Keogh contributions to be treated as deductible business expenses by virtue of the reference to § 404(a). In other words, Keogh contributions may be treated as an adjustment to gross income only because § 62(a)(6) incorporates the fictions created under § 404(a)(8). This interpretation is in keeping with the explicit nature of the rights created under the Self-Employed Individuals Retirement Act of 1962.
The plaintiffs devote the majority of their argument to the proposition that any doubt as to the deductibility of pension contributions for purposes of computing the self-employment tax is resolved by the fact that, when Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), it expressly intended to eliminate from the tax laws the historic discrimination against qualified retirement plans of unincorporated business and to place self-employed persons on an equal footing with common law employees. Because employer contributions to a qualified plan under 26 U.S.C. § 3121(a)(5) are not includable in wages for purposes of computing the Federal Insurance Contribution Act (FICA) tax of common-law employees, 26 U.S.C. §§ 3101 and 3111, this effort to create parity would be undermined if self-employed individuals could not deduct contributions to qualified plans before assessing the self-employment tax.
While Congress aimed to eliminate many of the differences between the treatment of self-employed individuals and other employers, it left some of the distinctions intact. For example, corporations, except for subchapter S corporations, are required to pay a tax on their income wholly apart from any tax on the income of the corporate owners, while sole-proprietorships are not. The Senate Report explicitly stated that the bill did not eradicate all differences in treatment:
[This bill] . . . is designed to encourage the establishment of voluntary retirement plans by self-employed persons by allowing self-employed individuals to be covered by qualified plans and by extending to them some of the favorable tax benefits present law now provides in the case of qualified retirement plans established by employers for their employees.
1962 U.S. Code Cong. & Adm. News, p. 2964. The Conference Report cited by the plaintiffs was only slightly less emphatic:
The conference agreement generally eliminates distinctions in the tax law between qualified pension, etc., plans of corporations and those of self-employed individuals (H.R. 10 plans). The agreement (1) repeals certain of the special rules for H.R. 10 plans, (2) extends other of the special rules to all qualified plans, including those maintained by corporate employers, and (3) generally applies the remainder of the special rules, with appropriate modifications, only to those plans (whether maintained by a corporate or noncorporate employer) which primarily benefit the employer's key employees . . . .
Conference Report No. 97-760 (97th Cong., 2d Sess.) reprinted in 1982-2 C.B. 600, 673. Nowhere does Congress assert that absolute parity was intended.
This court cannot assume that a deduction is available to the plaintiffs by virtue of Congress' statement that distinctions are "generally" eliminated. The Seventh Circuit has held firmly to the principle that "deductions are extensions of legislative grace and not matters of right." Jerome Mirza & Assoc. Ltd. v. United States, 882 F.2d 229, 232 (7th Cir. 1989). Accordingly, the court has held that "a deduction from income for tax purposes may be taken only when support for it can be found in the language of a statute, appurtenant regulations, or legislative history." Id., citing Hintz v. Comm'r, 712 F.2d 281, 284 (7th Cir. 1983). The taxpayer bears the burden of establishing that the claimed deductions are valid, and the Commissioner's determinations are presumed to be correct. Colonial Savings Assoc. & Subsidiaries v. Comm'r, 854 F.2d 1001, 1006 (7th Cir. 1988), cert. denied, 489 U.S. 1090, 103 L. Ed. 2d 859, 109 S. Ct. 1556 (1989).
While it is clear that Congress wished to eliminate certain, perhaps even most, of the distinctions between the contributions of a corporate employer and of a self-employed individual to qualified pension plans, this court can not presume in light of the legislative scheme that Congress wished to allow the deduction sought by the plaintiffs. Sections 62(a) and 404(a)(8) were enacted as part of the drive to eliminate the historic discrimination claimed by self-employed persons. While these changes were explicitly mandated under the Self-Employed Individuals Retirement Act of 1962, no comparable amendments were made to § 1402. The deductions allowed in each of these sections depend on the fictions allowed under § 404(a)(8). Nowhere has Congress mandated that the same fiction, that a self-employed individual's contribution to a Keogh plan constitutes a deduction attributable to his trade or business, should be extended to the calculation of gross income for purposes of the self-employment tax imposed under § 1401. Neither the legislative history nor the language of the relevant provisions of the tax code indicate that this was the intent of Congress. The plaintiff taxpayers have failed to sustain their burden of establishing that the claimed deductions are valid. Accordingly, the government's motion to dismiss is granted.