By Jackie Perlman, CPA, Senior Tax Research Coordinator
Congratulations on starting your own small business! You've devoted all of your time and energy to managing your new small business and making it a success. You know that you must now take care of paying your quarterly estimated taxes. Not a problem for you - you've taken our advice, kept excellent records, know to the penny what you've made so far, and can reasonably estimate how you'll do for the rest of the year.
Now you've come across a line on your estimated tax worksheet[1] that you've never had to bother with before: self-employment tax. What is that anyway? Do you have to pay extra tax just because you're self-employed? Well, not exactly.
As an employee, one-half of your social security tax and one-half of your Medicare tax was paid by you via payroll withholding. Your employer was responsible for paying in your share on your behalf, as well as the employer's half of these taxes. As a self-employed individual, you are required to pay both halves. Yes, that means all of it.
Self-employment (also known as SE tax) has two components: the social security retirement contribution and Medicare tax. For tax year 2006, the SE tax is computed as follows:
Step 1: Figure your earnings from self-employment on Schedule C.
Step 2: Multiply your earnings by 92.35 percent.
Step 3:
- If the result is less than $400, you do not owe-self employment tax.
- If the result is $400 to $94,200, multiply the amount in Step 2 by 15.3 percent.
- If the result is more than $94,200, multiply the amount in Step 2 by 2.9 percent and add $10,899.60.*
*$87,900 is the maximum amount subject to social security tax in 2006. Thus $11,680.80 ($94,200 x 12.4 percent social security component) is the maximum social security tax you can pay. The Medicare component of the SE tax is 2.9 percent, and there is no earnings cap.
But where did the 92.35 percent come from? It represents a small break allowed by the tax law. In effect, you get to reduce your earnings from self-employment by the employer's share of the taxes before applying the SE tax percentages: 100% - 7.65% = 92.35%.
Actually, you get another break as a self-employed individual. One-half of your SE tax is taken as an above-the-line tax deduction on your tax return, which helps to put you more on a par with an employee.
So, will you pay more federal income tax as a self-employed person? Let's compare two taxpayers. Henry is a self-employed salesman. For 2006, he has gross income of $75,000 and $10,000 of business expenses. Harriett has a full-time sales position at a company and earns $75,000 in salary and commissions. She has $10,000 in un-reimbursed employee business expenses. Both are single, have itemized tax deductions of $13,800 (other than Harriett's business expenses), and have no other income. The chart below shows the total tax that Henry and Harriett will pay in 2006.
|
Henry |
Harriett |
Gross income |
$75,000 |
$75,000 |
Business expenses |
-$10,000 |
N/A |
Earnings from self-employment |
$65,000 |
N/A |
One-half of SE tax |
-$ 4,592 |
N/A |
Adjusted gross income (AGI) |
$60,408 |
$75,000 |
Itemized tax deductions |
-$ 13,800 |
-$22,300 |
Exemption |
-$ 3,300 |
-$ 3,300 |
Taxable income |
$43,308 |
$49,400
|
Federal Income tax |
$ 7,385 |
$ 8,908 |
Social Security/Medicare tax |
$ 9,184 |
$ 5,738 |
Total tax |
$16,569 |
$14,646 |
As shown above, Harriett pays $5,738 ($75,000 x 7.65%) in social security and Medicare taxes. We know that Henry has to pay both "halves" of these taxes. Yet, his total tax, although higher, is not $5,738 higher than Harriett's. Why?
- Harriett's social security/Medicare tax is calculated on her gross income of $75,000. Henry's S/E tax is calculated on his earnings from self-employment (i.e. after deducting expenses) and is further adjusted as explained above. His calculation: $65,000 x 92.35% x 15.3%) = $9,184.
- Henry is able to deduct 100 percent of his expenses and one-half of his SE tax, so his income subject to federal income tax is lower.
- Harriett must reduce her employee business expense tax deduction by 2 percent of adjusted gross income (AGI). Her deductible employee business expense is therefore only $8,500 ($10,000 - ($75,000 x 2%)). Henry is able to deduct his $10,000 business expenses in full.
For the record: In our opening paragraph, we pointed out that your excellent recordkeeping made it easier to figure your estimated federal income taxes. You now know that the information is also needed to figure your estimated self-employment tax. Good records don't just make life easier for you and your tax professional during tax preparation. When business expenses are disallowed by the IRS and Tax Courts, very often it is not because the type of expense is not deductible but because the taxpayer has no records to back up the tax deduction. Both income and self-employment taxes are minimized by being able to deduct all allowable expenses. Good recordkeeping is your assurance that your tax deductions will be allowed in case of an audit.
[1] The worksheet is part of the Form 1040ES package.
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