V. Select Committee on Ethics Advisory Opinion No. 13[1]

SUBJECT: GENERAL INTERPRETATION OF HOUSE RULE 25, DEALING WITH LIMITATIONS ON MEMBERS’ OUTSIDE EARNED INCOME

1. General

(a) Purpose of the rule. House Rule 25, was adopted on March 2, 1977 [as Rule 47] as part of the financial ethics code. Originally limited to Members, it was amended by the Ethics Reform Act of 1989 to include officers and senior employees.[2] Besides restricting the type of employment in which covered individuals can engage, the Rule limits the amount of “outside earned income” a Member, officer, or senior employee may have.[3] Two major considerations prompted adoption of the Rule. First, substantial payments to a Member, officer, or senior employee for rendering “personal services” to outside groups presents a significant and avoidable potential for conflict of interest. Second, it is inconsistent with the concept that being a Member, officer, or senior employee of Congress is a full-time job to permit substantial earnings from other employment.

(b) Annual Limitation generally. Clause 1 of the Rule prohibits a Member, officer, or senior employee from having outside earned income attributable to a calendar year which exceeds 15 percent of the annual rate of basic pay for level II of the Executive Schedule as of January 1 of such calendar year.[4] In order for an item to be counted against this limitation for a particular year: (i) it must be “outside earned income” within the meaning of Rule 25; and (ii) it must be attributable to that year. The Rule defines outside earned income to mean “wages, salaries, fees, and other amounts received or to be received as compensation for personal services actually rendered.”

Outside earned income is attributed to the year in which the Member’s, officer’s or employee’s right to receive it becomes certain (i.e., under the accrual method) rather than to the year of receipt. Therefore, receipt of income earned during a particular year cannot be deferred to a future year in which the Member, officer, or employee has less outside earned income or until after the individual retires from Congress. The limitation is not applicable to compensation for personal services rendered prior to the effective date of Rule 25, or prior to the effective date of the individual’s becoming a Member, officer, or employee, if later. Outside earned income is determined without regard to any community property law. That is, even though under applicable community property law one-half of any personal service income earned by an individual is deemed to belong to the spouse, all of such income is considered earned income of the Member, officer, or employee for purposes of the Rule.

(c) Real facts controlling. The limitations imposed by Rule 25 may not be avoided by the characterization or disposition of any payment for services rendered. In all cases, the real facts will control. For example, if a spouse, child, other relative of a Member, officer, or employee, or trust for the benefit of any of them, is paid an amount, however denominated, and the true consideration for the payment is services rendered by the Member, officer, or employee, the amount will be deemed outside earned income by the Member, officer, or employee. Similarly, the label or characterization placed on a transaction, arrangement or payment by the parties may be disregarded for purposes of the Rule. Thus, if amounts received or to be received by a Member, officer, or employee are in fact attributable to any significant extent to services rendered by the Member, officer, or employee, the characterization of such amounts as partnership distributive share, dividends, rent, interest, payment for a capital asset, or the like, will not serve to prevent the application of Rule 25 to such amounts. Moreover, the Rule applies to outside earned income realized in a medium other than money, for example, in property or services or through a bargain purchase or forbearance in consideration of personal services rendered.

In short, income may not be recharacterized in order to circumvent the Rule. Indeed, characterization of income is essentially irrelevant. For purposes of this Opinion, there are two types of income – earned and unearned. If the compensation received is essentially a return on equity, then it would generally not be considered to be earned income. If the income is not a return on equity, then such income would generally be considered to be earned income and subject to the limitation.

When such amounts received or to be received by a Member, officer, or employee are designated as salary, fees, or commissions, the overriding presumption is that such amounts, almost by definition, constitute compensation for personal services rendered. An honorarium from a speaking engagement, for example, is obviously outside earned income.[5] With respect to income from business ventures, the Committee is convinced that in the overwhelming majority of cases, there will be little or no difficulty in determining whether certain income is subject to the Rule. Again, the facts of each individual case will govern applicability of the Rule, but the principles set forth in this Opinion should be followed in making that determination.

2. Outside earned income from business ventures

This Advisory Opinion differentiates between businesses in which both capital and personal services are material income-producing factors and those in which personal service is the only material income-producing factor.

(a) Personal service businesses. Where a Member, officer, or employee owns or participates in a personal service business, such as a professional practice, in which capital is not a material income-producing factor, his entire share of the profits is deemed to be outside earned income for purposes of the Rule, except to the extent he can demonstrate that his income in fact represents a return on investment. In general, capital is not a material income-producing factor where gross income of the business consists principally of fees, commissions or other compensation for personal services performed by an individual. Thus, the practice of one’s profession by a doctor,[6] lawyer, insurance broker, or real estate agent will not, as such, be treated as a business in which capital is a material income-producing factor. Even where the practitioner may have a substantial investment in professional equipment or in the physical plant constituting the office from which he conducts his practice, the capital investment would be regarding as only incidental to the professional practice.[7]

Law practices. Since there are a number of attorneys serving in the House of Representatives, for purposes of example, application of the Rule to the practice of law is specifically addressed in this Opinion. Those Members, officers, and senior employees who previously maintained an active affiliation with a law firm generally find it necessary to enter into a buy-out agreement with their partners in order to liquidate their equity in the firm. This is perfectly appropriate. Amounts received or receivable by a Member, officer, or employee in payment for an interest in a law firm or similar organization upon retirement from it would not constitute outside earned income so long as the amounts payable do not, in effect, represent a continuing participation in the law firm and the total amount payable is not in excess of the fair maker value of the interest of the Member, officer, or employee. Normally such arrangements call for fixed payments at annual or more frequent intervals over a period of years. In some cases, however, the retiring partner and those continuing the business are unable to agree on a value for one or more assets of the business, such as contingent fee cases or accounts receivable of dubious value, and the buy-out agreement may accordingly provide that the retiring partner will be paid a share of such items, if, as and when they are collected.

Payments to a Member, officer, or employee under a buy-out agreement will not be deemed to be outside earned income where the arrangements are entered into in good faith and agreed to by all the partners, and reflect the usual and customary value of the equity generally accorded to partners in similar law practices in the same geographic area. A buy-out agreement should also be reasonably calculated to avoid the Member’s, officer’s, or employee’s participation in post-withdrawal profits. In general, the proceeds resulting from a buy-out agreement are taxed as capital gains. If such an agreement is not limited to liquidation of the Member’s, officer’s or employee’s equity in the firm, and includes payments which might be taxable as earned income, any such payments under the agreement might be such to the earned income limitation. The Committee notes that Rule 25, clause 2, prohibits a Member, officer, or employee from receiving compensation for affiliating with or being employed by a firm, partnership, association, corporation, or other entity which provides professional services involving a fiduciary relationship. Even if no compensation is received, the Member, officer, or employee may not permit his or her name to be used by any such firm, partnership, association, corporation, or other entity. This limitation parallels the American Bar Association Code of Ethics, which states in part: “A layer who assumes . . . a legislative post shall not permit his name to remain in the name of a law firm or to be used in the professional notice of the firm during any significant period in which he is not actively and regularly practicing law as a member of the firm.” (ABA Disciplinary Rule 2-102B).

(b) Business where capital is a material income-producing factor. Capital is a material income producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital, as reflected, for example, by a substantial investment in inventories, plant, machinery or other productive equipment. This Opinion discusses the application of the Rule in such cases to income from a fully taxable corporation and income from an unincorporated business or Subchapter S corporation.

(1) Taxable corporations

If a Member, officer, or employee renders services to a fully taxable business corporation, he or she will not be deemed to realize outside earned income from such services beyond the amount of salary or other form of extra compensation designated as consideration for the personal service rendered. In those cases where the sole financial interest of the Member, officer, or employee is stock in the corporation, an increase in the net assets of the corporation would not be considered to be subject to the limitation. An increase in the value of stock or other property is not ordinarily treated as earned income either for tax purposes or under generally accepted accounting principles; and any increase in the corporation’s net profits would be subject first to corporate income tax and then to personal income tax before the Member, officer, or employee receives any resulting increment to his or her wealth through a dividend or sale of stock. The foregoing has not application, of course, to income which a Member, officer, or employee earns through personal efforts in dealings with third parties but causes to be paid to a corporation and distributed. For example, if a Member, officer, or employee incorporates for the purpose of conducting a personal service, and all fees are paid to the corporation from which “profits” are then drawn, all such amounts would be considered outside earned income.

In sum, if a Member, officer, or employee renders services to a taxable corporation, only the salary or other compensation received for those services would be subject to the limitation, but not any increase in the corporation’s assets or a share of the profits. This ruling is consistent with the intent of the Commission on Administrative Review which recommended the limitation on outside earned income. In its report (House Document No. 95-73), the Commission stated that “. . . Members should be able to render personal services to manage or protect their equity . . . without having to allocate these personal services toward the 15 percent limitation.”

(2) Subchapter S corporations, partnerships, unincorporated businesses

In those cases where the Member, officer, or employee has an ownership interest in a business for which he or she also performs services, as in a subchapter S corporation or a partnership, some part of the individual’s share of the profits of that business may reflect the value of services, and thus would be considered outside earned income. The determining factor is whether the Member’s, officer’s, or employee’s personal services generate significant income for the business. Of course, if the Member, officer, or employee receives formal income from the business, for example, payments designated as salary or fees, such amounts would be considered earned income. Additionally, in those cases where other partners or associates are providing capital and managerial experience, and the principal role of the Member, officer, or employee is to refer clients to the business or to help retain existing customers or clients, the Member, officer, or employee would be deemed to be rendering income- producing services, even though the actual time involved might be minimal. However, if the Member, officer, or employee is engaged primarily in the general oversight and management or protection of his or her investment, such services would not be deemed to generate significant income. Such non-income generating services would include consultation with other management officials, analysis of financial and other reports, participation in formal meetings, and making decisions concerning the general operations and investment strategy of the business. The application of the Rule to the various types of business organizations as discussed in this Opinion applies equally to a business owned or controlled by the Member, officer, or employee or the individual’s family. Again, the determining factor is whether or not the personal services of the Member, officer, or employee actually generate any significant income for the business. In those situations where the services rendered by the Members, officers, or employees are incidental and do not generate significant income, no part of a share of the profits or any increase in the assets of the business would be deemed to be outside earned income.

The Committee emphasizes that the definition of earned income in Rule 25, which excludes amounts received by a Member, officer, or employee from a family controlled business “so long as the personal services actually rendered by the individual do not generate a significant amount of income,” was simply intended to assure Members, officers, and employees that they could continue to make decisions and take actions necessary to manage or protect their equity in a family trade or business, and would not be forced to divest themselves of their family business interests. As with any business, a Member, officer, or employee would not be required to allocate a share of the profits of the business as outside earned income when the facts and circumstances show that the income is in reality a return on investment. For example, if the Member, officer, or employee owns a hardware store and the services rendered are incidental, such as occasionally serving customers, the income received from the business is basically a return on equity, (i.e., profits from the sale of hardware goods) and is not generated by the services of the Member, officer, or employee. Similarly, if the Member, officer, or employee gives overall direction to the management of the business for a family owned farm, the income received from the farming operations is not generated by the personal services of the Member, officer, or employee, but rather is basically a return on equity from the sale of crops or dairy products. These types of businesses are distinguishable from a personal service business where income is essentially produced by the services of the individual affiliated with the organization.[8]

(3) When income is attributable

(a) Income from pre-effective date services. The Rule excludes from earned income any compensation derived by a Member, officer, or employee for personal services rendered prior to the effective date of the Rule or prior to the effective date becoming a Member, officer, or employee, if later. This provision would serve to exclude from the limitation, for example, most renewal commissions paid to a Member, officer, or employee with respect to life insurance policies sold prior to the effective date, or similar commissions received by a Member, officer, or employee with respect to pre-employment leases in which the individual was the leasing agent. In most such arrangements, payment of the commission is not contingent upon the performance of any future services by the recipient; the only contingency is that the insured or lessee continue to pay premiums or rent, as the case may be. The exclusion would also apply to a fee received by a Member, officer, or employee who was a lawyer where all the work had been done prior to the effective date. However, this exclusion would not apply to income derived from the continuing or future business of clients brought into the firm prior to the effective date of the Rule.

(b) Application of the limitation to part years. Where an individual becomes a Member, officer, or employee during any calendar year, the Rule applies only to outside earned income of the individual attributable to periods after the effective date of becoming a Member, officer, or employee. For the balance of the calendar year, the applicable limitation will be 15% of the Executive Level II salary for that part of the year, and only outside earned income attributable to that part is counted against the limitation.

(4) Other provisions

(a) Payments attributed to deferred compensation plans. Amounts received by a Member, officer, or employee from a tax-qualified pension, profit sharing or stock bonus plan are not treated as outside earned income, as provided in the Rule, nor are contributions to such a plan counted as outside earned income. Amounts received by a Member, officer, or employee from a non-qualified deferred compensation plan which were earned in a year prior to the effective date of the Rule or the individual coming to Congress are not outside earned income for the year received under the principle explained in section 3(a), provided no part of the consideration for such payments is current services. Amounts set aside for a Member, officer, or employee under a non- qualified deferred compensation plan for services rendered after the Rule’s effective date or coming to Congress will generally constitute outside earned income of the Member, officer, or employee for that year, even though they will not be received until a later year, unless receipt is subject to a substantial risk of forfeiture.

(b) Assignment of income to charities. Notwithstanding the general holding of this Opinion that a Member, officer, or employee cannot deflect the application of the Rule by assigning to another income which in fact was earned through rendering services, earned income assigned by a Member, officer, or employee to a tax-exempt charity will not be counted as part of the outside earned income of the Member, officer, or employee, provided the individual is not a “disqualified person” with respect to the recipient organization within the meaning of section 4946(a) of the Internal Revenue Code. For the purposes of this portion of the Rule, such income would not be deemed to have been “received” by the Member, officer, or employee provided that he did not personally benefit in any way from such income.[9]

(c) Honoraria. Clause 1(a)(1)(B) of Rule 25 provides that a Member, officer, or employee of the House may not receive any honorarium. Clause 3(c) defines “honorarium” to exclude any actual and necessary travel expenses incurred by the Member, officer, or employee in connection with the event. Payment of actual and necessary travel expenses of a relative accompanying the Member, officer, or employee are also excluded from the limitation.

A payment in lieu of an honorarium may be made directly by the sponsor of an event to a qualified charitable organization on behalf of a Member, officer, or employee. No such payment may exceed $2,000, nor may it be made to a charitable organization from which the Member, officer, or employee or a parent, sibling, spouse, child, or dependent relative of the Member, officer, or employee derives any financial benefit.[10] Section 7701(k) of the Internal Revenue Code provides that an amount so paid to a charitable organization is not deemed income to the Member, officer, or employee for tax purposes, nor is any charitable deduction allowed.