Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 66-56

1966-1 C.B. 87

Sec. 401

Sec. 911

IRS Headnote

Interest income is derived from the investment of capital and is not `earned income' for the purpose of computing allowable contributions and deductions under a self-employed retirement plan qualified under section 401 of the Internal Revenue Code of 1954. However, if interest income is derived from financing activities which are an integral part of a taxpayer's business in which he also renders personal services, such interest income would enter into the computation of the amount which may be considered `earned income' where both personal services and capital are material income-producing factors.

Full Text

Rev. Rul. 66-56

Advice has been requested whether interest income, derived from the financing activities of a real estate broker, constitutes `earned income' for purposes of section 401(c)(2) of the Internal Revenue Code of 1954.

In his business as a real estate broker, which the taxpayer conducts by himself on a full-time basis, he performs substantial personal services including solicitation of home buyers and sellers, escorting prospective buyers on house visits, arranging appraisal, financing, and legal services, and other related tasks. In the course of conducting such business, the taxpayer often finances sales of real estate with his own capital, performs the necessary paper work incident to such financing, and receives a substantial amount of interest income from such financing.

The taxpayer has established a self-employed retirement plan which is qualified under section 401 of the Code. The amount of the taxpayer's `earned income' serves as a basis for calculating allowable contributions and deductions under the plan.

Section 1401-10(c)(3)(i) of the Income Tax Regulations states the general rule that for purposes of section 401 of the Code, the term `earned income' includes only that portion of an individual's net earnings from self-employment which is compensation for personal services actually rendered within the meaning of section 911(b) of the Code. The term `earned income,' as defined in section 911(b) of the Code, means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income. However, in the event a self-employed individual renders personal services on a full-time, or substantially full-time basis to only one trade or business in which capital is a material income-producing factor, the amount of such individual's earned income from the trade or business for purposes of section 401 of the Code is considered to be not less than so much of his share in the net profits of such trade or business as does not exceed $2,500.

Interest income is derived from the investment of capital and not from the performance of personal services. Therefore, it is not earned income as defined in section 911(b) of the Code. However, the aggregate of the duties performed in soliciting house buyers and sellers and arranging sales do constitute the performance of substantial personal services in the operation of the real estate business in which the financing of sales of real estate is an integral part. The interest income derived from such financing constitutes part of the net profits from the business.

It is clear, therefore, that both personal services and capital are material income-producing factors. Accordingly, under the facts present in the case, the taxpayer's earned income from his real estate business, for purposes of the self-employed retirement plan, is equal to a reasonable allowance as compensation for the personal services he actually renders, not in excess of the greater of 30 percent of the net profits from the business, including the interest income derived from financing sales of real estate, or so much of the net profits of such business as does not exceed $2,500.