MODIFICATION TO COX STRATEGY

Author Ken Schneider informed The CPA Journal about an important distinction in the use of the Cox strategy.

In his article in October's Federal Taxation column, he described the Cox strategy, a technique that permits qualifying self-employed taxpayers to enjoy two tax benefits by renting business property owned by the taxpayer and his spouse as tenants by the entireties. First, the rental payments made by the self-employed taxpayer reduce net earnings from self-employment and, consequently, the taxpayer's self-employment tax liability. In addition, the article states that the rental payments received by the spouse are classified as passive income, against which passive losses may be offset.

The benefit of reducing self-employment tax liability is available without restriction. The article fails to disclose that the rental payments received by the spouse are properly classified as passive income only if the rents are paid pursuant to a "written binding contract" entered into before February 19, 1988 [See Treas. regulation section 1.469-11(c)(1)(ii)]. For rental contracts executed on or after this date, the income recharacterization rules for self-rented property, specifically Treas. regulation section 1.469-2(f)(6), reclassify such rental income as "nonpassive." As a result, the rental income from new leases between spouses cannot be offset by the taxpayer's passive losses.

Although the income recharacterization rules severely limit the use of the Cox strategy to circumvent the passive loss rules, this technique remains worthy of consideration as a useful method for reducing a taxpayer's self-employment tax. *