Winning a Fight with the IRS

I’m very, very excited about the content I have to share with you today. The story comes from someone who found EPF while searching for resources regarding grad student taxes and how to argue with the IRS. After emailing back and forth a few times about how to approach her problem, she offered to share her research and work with you through EPF. I will refer to this reader as Amanda in this post. Thank you, Amanda, for sharing your story with the EPF community!

In 2012, Amanda received an external fellowship. She received a 1099-MISC and reported the income on her 1040 that year in line 21.

All was fine until a few months ago, when Amanda received a letter from the IRS asking for several thousand dollars in back taxes and fines. The IRS claimed that she owed FICA taxes on the fellowship. She looked at the tax code and at a bunch of cases and constructed the argument and letter below. I hope Amanda’s research will also help put to bed some of the debates we have had on this topic in the past! (But remember that neither Amanda nor I are tax professionals or lawyers or anything like that, so please use this letter only for reference.)

To the Internal Revenue Service:

I have been asked to agree to changes to my tax return, primarily to the addition of a self-employment tax on the [$X] I received from [Fellowship Organization] and which I reported in line 21 as income from a scholarship or fellowship on a 1099-MISC. I do not agree to these changes. I do not owe a self-employment tax because I was not self-employed and instead was receiving a scholarship meant to help me complete my [degree].

According to Topic 554 on the IRS website, the self-employment tax applies “if you are a sole proprietor (including an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC)), or are otherwise in business for yourself” (Attachment 1). However, I was not involved in a business relationship or partnership with [Fellowship Organization]. [Details about the terms of the fellowship with an attachment.]

According to Parker’s Tax Library, “a fellowship grant allow[s] the taxpayer to perform research and studies primarily to further his own education, training, and academic excellence and, thus, the grant [is] not compensation subject to self-employment tax” (Attachment 3). This has been well-established in the court case Spiegelman v. Commissioner, 102 T.C. 394 (1994), which reaffirmed that “[Scholarships and fellowship grants] do not constitute income from a trade or business and, hence, are not to be included in the recipient’s net earnings from self-employment for purposes of the Self-Employment Contributions Act. The terms ‘fellowship grant’ and ‘trade or business’ are inconsistent and mutually exclusive” (Attachment 4). The case also held that private fellowships are FICA exempt: “a scholarship or fellowship grant are not considered to be ‘wages’ for FICA and FUTA purposes, even though they may be otherwise taxable” (Attachment 4).

In conclusion, the [$X] was not compensation for any services or business that I performed for [Fellowship Organization], but instead was a fellowship grant intended to further my own education. It therefore does not meet the definition of “self-employment” under the IRS code. I would be happy to amend my return to clarify the situation better, but I am clearly not liable for the self-employment tax.

I urge you to contact me if you have any further questions.

Sincerely,

Amanda

What can we learn from Amanda’s research and example?

1) The IRS is both fallible and (can be) reasonable. They were wrong about Amanda’s 2012 taxes, but they did listen to her and it was all resolved without her having to pay any extra money.

2) The IRS code is a great reference, but so are the cases. Where the code is ambiguous, as it is for fellowships and FICA taxes, you can look for a relevant case.

3) You should report your fellowship and scholarship income in line 7 of the 1040 with “SCH” written next to it instead of following the instructions for the 1099-MISC. I don’t know this for sure, but I’d guess that the IRS wouldn’t have flagged Amanda’s return if the fellowship had been reported in line 7.

4) Fellowships are not subject to FICA even though they are subject to income tax. This comes directly out of the case Amanda referenced, Spiegelman v. Commissioner:

“Accordingly, even though part of a section 117 scholarship or fellowship grant must be included in the recipient’s gross income because of the limitations prescribed in [former] section 117(b)(2) of the Code, no part of the grant is subject to the tax on self-employment income imposed by section 1401 of the Code.”

Basically, there are not just two types of income you can be paid by another party, wages and self-employment. There is (at least) also the existence of a scholarship or fellowship, which is exempt from FICA taxes (both the employer and the employee side).

I want to personally thank Amada again for her research as she has confirmed for me that I do not owe FICA taxes on the income from my current fellowship. I think it’s easy to understand that grad students at universities do not owe FICA tax on their earnings because of the student exemption for wages. Postdocs and post-grad fellows, however, don’t have student exemptions. But if your pay is from a fellowship, it is not considered wages and is not subject to FICA, whether you are a student or not.

Have you ever disputed an IRS edit to your taxes, and did you win or lose? Have you ever received pay that you owed income tax on but not FICA?

photo modified from neal1973