Can one generate 'self-employed income' with a friend, to be able to contribute to IRA?

Question

Let's assume A is happily living from interest and capital gains, but for various reasons he would like to contribute to his IRA.
The IRS allows only contributions that come from income earned by working, be it employed or self-employed. Aside from the obvious solution of finding a job, can a construct as described below work?

He agrees with his friend B (that has a similar target) to do self-employed work for each other: A programs an application for B, and B programs another application for A (or they mow each other's lawns, whatever). Each gets a bill for $ 7000 from the other, and pays it.
Both use the self-employed income and put it completely into their IRAs, which makes it tax-deductable, and therefore irrelevant for any tax filings.   I understand there will be FICA tax to pay, 15.3%, so the plan has some cost; that would probably deter most people from it. Both can, however, deduct some cost and thereby reduce their other taxable income, which might reduce the net loss near zero, and it also helps to get the ten years minimum completed, to be able to draw a Social Security pension.
Also, you can't do it with a spouse or anyone living in the same household, it has to be a friend.

I cannot see anything illegal in that (assuming the work is really and verifiably done and delivered), it seems to be a "Backdoor IRA Contribution" method.
[Note: I am NOT asking for help or instructions to cheat the IRS or do anything other illegal - if this is illegal, please tell me why you think so].

Am I missing anything else here?

Is it legal, and does it cost 'only' the FICA tax?

Please don't get into arguing why would anyone want to put money in his IRA in this situation, or why not use a Roth instead, etc. That's not the point.

Answer 1

I'm not a lawyer or CPA or anything so I won't say it's totally legal. But here are some problems.

First, it's unclear from your description (especially the "mowing each other's lawn") idea whether in your scheme the work involved is actually worth $7000. If you mow someone's lawn once and they pay you $7000 so you can contribute to your IRA, that could be regarded as fraudulent inflation of income.

Second, your idea of "deducting some cost" to eliminate the loss of the FICA tax won't work. As described in IRS Publication 590-A (emphasis added):

If you are self-employed (a sole proprietor or a partner), compensation is the net earnings from your trade or business.

Thus any business costs you deduct will reduce your compensation and thus your allowable IRA contribution.

Third, there may be additional costs depending on the jurisdiction. In some jurisdictions (e.g., individual cities) it is technically requited to pay a fee for a business license in order to conduct any kind of business within the jursidiction. Although these often aren't enforced for very small businesses, if such a requirement exists you'd have to comply with it to be fully legal. Also, some states (such as Massachussetts) do not allow IRA contributions to be deducted on state income tax returns, meaning you could still have to pay state taxes on your earnings even if you contributed all of it to the IRA.

Overall the broad outlines of your scheme seem legal to me (although as I said I'm not an expert) apart from these sorts of details. But it's unclear why it would make sense to pay $1071 simply for the privilege of contributing to an IRA (assuming a $7000 amount as you noted -- which incidentally is $1000 over the limit unless these people are over 50).

Answer 2

"Each gets a bill for $ 7000 from the other, and pays it. Both use the self-employed income and put it completely into their IRAs, which makes it tax-deductible, and therefore irrelevant for any tax filings."

This is not true - the amounts will eventually be taxed, when they retire. For simplicity imagine you do this the year before you retire - you will be taxed next year if you take it out on retirement. If you do it 30 years before you retire, you will accrue gains on the invested amount tax deferred, but one way or another, you are incurring additional future income tax in order to enact this plan [which as already pointed out, is probably fraudulent and thus impossible anyway].