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Professional Judgment
 
FICA and Partnerships

The Federal need analysis methodology uses income earned from work to calculate an allowance for the employee share of FICA taxes. In some cases, however, income is subjected to FICA taxes but not included in income earned from work. In those situations it is appropriate to use professional judgment to adjust income earned from work to include the missing FICA income.

This problem most often occurs with partnerships. Partnership income is usually reported on line 12 of the income tax return as part of Schedule C, and so is included in income earned from work. (Income earned from work is based on lines 7 (wages), 12 (business income), and 18 (farm income) of IRS Form 1040. It is not based on the gross receipts of the business.) On occasion, however, partnership income will be reported on line 17 instead of line 12. In that case it will not have been counted as part of income earned from work even though the taxpayer paid FICA on the income.

This problem does not occur with sole proprietorships, because income from a sole proprietorship is always listed on line 12 of the income tax return.

This problem does not occur with S corporations because the S corporation pass-thru income that is reported on line 17 is never subjected to FICA. Any money paid out in salaries (and the associated employer-paid taxes) is deducted on IRS Form 1120 (lines 12, 13, and 17) and so is never included in the amounts distributed by Schedule K (and ultimately arriving on line 17 of the 1040 by way of Schedule E). If the income is subjected to FICA, it is reported on the wages line (line 7) of the income tax return. The items listed on line 17 of the income tax return never include income earned from work.

A similar problem arises when lines 12 or 18 are negative. The FAFSA instructions would allow the negative values to offset the income, yielding too low a figure for income earned from work (and from that, too low a FICA allowance). Some financial aid administrators work around this problem by substituting zeroes for negative summands. But if AGI is zero, they need to use an assumption override to prevent the substitution of the income earned from work figure for AGI.

Another problem is line 7 of the 1040 is based on Box 1 of the W-2, and as such have retirement plan contributions (401(k), 403(b) and 457 plan deductions) excluded. These figures need to be added back in to calculate the correct income earned from work.

Technically, the FAFSA instructions are incorrect. Instead of directing families to calculate income earned from work by adding lines 7, 12 and 18 of the IRS Form 1040, they should tell families to add line 7 of IRS Form 1040 (or even better, Box 5 of the W-2 statements, to avoid excluding retirement plan contributions) to lines A.4 or B.6 of Schedule SE. The Schedule SE lines reduce net earnings to 92.35% (effectively subtracting the employer's contribution of 7.65%) before calculating FICA taxes. Lines 12 and 18 do not reflect this reduction. The Schedule SE lines also include partnership income from Schedule K-1 (Form 1065 line 15a and Form 1065-B box 9). To the extent that the purpose of reporting income earned from work is to enable the calculation of FICA taxes as an allowance against income, basing income earned from work on line 7 of Form 1040 and the net earnings from self-employment lines of Schedule SE is a more accurate approach. But until the US Department of Education corrects the FAFSA instructions, one is probably limited to making an adjustment for partnership income reported on line 17.

Another problem with the FICA calculations concerns families who were not required to file an income tax return. The US Department of Education has given conflicting guidance regarding this. In some cases they say to use Box 1 (wages, tips and other compensation) of the W-2 and in some cases Box 5 (medicare wages). Box 1 corresponds to line 7 of the 1040. Box 5 corresponds to medicare wages. Considering that income earned from work is used to calculate the FICA allowance, Box 5 is correct, but the school needs to also execute an assumption override to prevent the federal processor from substituting the income earned from work for the $0 AGI (which is assumed to be an error). If the school does not execute an assumption override, the amount of any 401(k), 403(b) and 457 plan deductions will be double-counted, once as part of AGI (from the income earned from work) and once on worksheet B.

See also Income Earned from Work.

 

 
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