Do You Owe the Dreaded Self-Employment Tax?

From smSmallBiz

IF YOU'RE self-employed, don't forget one person you have to answer to: Uncle Sam.

When net earnings from self-employment top $400 a year, you have to file Schedule SE with your form 1040, and you may owe the dreaded self-employment tax, too. If so, that will be on top of any income taxes owed to the feds and your friendly state tax collector. Rest assured that I feel your pain, because I have to pay the SE tax myself. Here's what you need to know about this nasty element of the tax law.

SE Tax Basics

The purpose of the SE tax is to collect Social Security and Medicare taxes from self-employed folks. Now, if you're an employee, the first $97,500 of your wages (for 2007) are hit with the Social Security tax at a rate of 12.4%. All of your wages — no matter how high — face the Medicare tax at a rate of 2.9%. Half of these taxes are withheld from your paychecks while the other half get paid by your employer. Since you never actually see the half paid by your employer, you may be blissfully unaware of how high the Social Security and Medicare taxes really are.

In contrast, self-employed individuals cannot help but notice — because they have to pay both halves by writing checks to the government as part of their quarterly estimated tax payments. The bottom line is that for 2007, a self-employed person owes SE tax at a whopping 15.3% rate on the first $97,500 of SE income. Of that 15.3% rate, 12.4% is for the Social Security tax, and 2.9% is for the Medicare tax. If your SE income exceeds the $97,500 Social Security tax cutoff point, the extra income will be hit with a 2.9% SE tax rate to cover the Medicare tax.

Unfortunately, the SE tax is only going to get worse if you have a profitable and growing business. Why? Because the Social Security tax cutoff point is raised each year for inflation. Therefore, your SE tax bill is likely to increase every year because more of your SE income will be taxed at the maximum 15.3% rate. Even worse, the inflation rate used for the Social Security tax cutoff point is generally higher than the overall Consumer Price Index (CPI) inflation rate that you commonly hear about. For 2008, the Social Security tax cutoff point will increase from the current $97,500 to $102,000, which represents a 4.6% bump.

Calculating the SE Tax

You must fill out Schedule SE to calculate how much SE tax you owe. Here's the drill. Take your bottom-line net business income from Schedule C (if you're a sole proprietor), or Schedule E (if your self-employed business is treated as a partnership for tax purposes) or Schedule F (if you're a farmer). Multiply that bottom-line number by the factor of 0.9265 (don't ask the reason for this step; you don't want to know). The result is your SE income. As mentioned earlier, the first $97,500 of 2007 SE income gets taxed at 15.3% while any remainder gets taxed at 2.9%. Here's an example.

Say this year's Schedule C for your sole proprietorship business shows net business income of $200,000. Your SE income is $185,300 ($200,000 x 0.9265 = $185,300). The first $97,500 gets taxed at the maximum 15.3% rate. The remaining $87,800 gets taxed at 2.9%. So your SE tax bill adds up to $17,464 [($97,500 x 15.3%) + ($87,800 x 2.9%) = $17,464)].

Now let's say you have the same $200,000 of Schedule C income in 2008. Your SE income is the same $185,300. But this time, the first $102,000 gets taxed at the maximum 15.3% rate while the remaining $83,300 gets taxed at 2.9%. So your 2008 SE tax bill will be $18,022 [($102,000 x 15.3%) + ($83,300 x 2.9%) = $18,022)]. The $558 increase over 2007 is due to the higher Social Security tax cutoff point for 2008.

Say your spouse is also self-employed in a separate business and earns $200,000 of net Schedule C income from her venture. She must separately calculate her SE tax liability on her own Schedule SE and pay the maximum 15.3% rate up to the aforementioned Social Security tax cutoff point ($97,500 for 2007; $102,000 for 2008). So her SE tax bills will be exactly the same as yours. This is true even if you two file a joint Form 1040. Sadly, the tax law doesn't allow you to combine your SE incomes and make a unitary SE tax calculation — which would save you tons of money because you and your spouse would only have to pass through the Social Security tax cutoff point once instead of twice.

Now for a Little Good News

Enough gloom and doom. There are a few rays of sunshine even in this generally dreadful SE tax picture. Here's a sampling.

If you have a job and have Social Security tax taken out of your salary, you get credit for that on your Schedule SE. For example, say you have a $90,000 salary and earn $50,000 of SE income from a side business in 2007. You only have to pay the maximum 15.3% SE tax rate on the first $7,500 of the SE income because you get credit for already paying Social Security tax on the $90,000 of salary. However, you must still pay the 2.9% SE tax rate on the entire $50,000 of SE income to cover the Medicare tax. This all gets taken care of automatically if you fill out Schedule SE properly.

If you and your spouse are the co-owners of an unincorporated business in one of the nine community property states (which include California and Texas), the IRS generally allows you to treat one spouse as the sole owner for tax purposes. The IRS doesn't appear to care which one. That person then fills out one Schedule SE to calculate the entire SE tax hit from the husband-wife venture. This means you only have to go through the Social Security tax cutoff point once, which can greatly reduce your SE tax bill. Unfortunately, the instructions to Schedule SE make it anything but clear that this special loophole exists. But it does, according to IRS Revenue Procedure 2002-69. If you think you qualify, you may want to hire a tax pro to get involved with your return.

Last but not least, you generally don't have to pay SE tax on profits from selling business assets that are not considered inventory. For example, say you sell a small office building that has been used for years to house your unincorporated business. You don't have to put the gain on Schedule SE, so you don't owe any SE tax. Instead, you can generally treat the entire gain as a low-taxed long-term capital gain.

Bill Bischoff, a certified public accountant with more than 25 years of experience, has authored books and training courses for tax professionals, and frequently writes about consumer and small-business tax matters.

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