Closer Look at a Technical Self-Employment Tax Issue
By James Edward Maule, Professor of
Law
Villanova University School of Law, Villanova, PA
Several inquiries about the computation of the social security tax
were posed to me, and the analysis I presented in response should
satisfy the curiosity of others who have the same questions. The
questions involve the principle that when a self-employed individual
computes self-employment taxes, which is what self-employed
individuals pay in lieu of FICA, the individual's earnings from
self-employment are multiplied by .9235, even though the individual
also is permitted to deduct for income tax purposes one-half of the
self-employment tax.
The Questions
1. Why do the “discount” and the deduction co-exist?
The questioner suggested that the deduction and the
“discount” are redundant if the rationale is to put
self-employed individuals on par with employees.
2. Why does the discount apply to all earnings from self-employment
even though only the Medicare portion (2.9%) applies to all earnings
from self-employment?
The income tax deduction exists because employers deduct the
employer portion of FICA. By permitting the self-employed individual
to deduct one-half of the self-employment tax, the individual is being
put into the same income tax position as he or she would be if he or
she were two people, both an employer and an employee. For example,
assume R hires E and pays a salary of $10,000. R would withhold $765
from E's salary for FICA, and R also would pay $765 in FICA taxes, for
a total of $1,530. E's take home pay, ignoring other taxes and
withholdings, is $9,235. Ignoring other compensation costs and other
taxes, R would deduct $10,765. If, for simplicity sake, R is in a 30%
income tax bracket, R's income tax liability is reduced by $229.50 on
account of the $765 deduction. If E were self-employed and had net
earnings of $10,000, then, ignoring the “discount,” E
would pay a self-employment tax of $1,530. Without a deduction for
$765 of that tax, E would be in a less advantageous position than if E
were an employee. Thus, the income tax deduction of $765 for
self-employed E causes E to save income taxes of $229.50, assuming E
is in a 30% income tax bracket.
That part was easy. The second part of the question is more
difficult.
Let's return to E, who decides to quit employment and turn to
self-employment. Because E must now pay $1,530 rather than $765 in
social security taxes, lacking an employer who will kick in the other
$765, E must generate earnings from self-employment of $10,765 in
order to end up with $9,235 “take-home” compensation. If
the 15.3% self-employment tax rate is applied to $10,765, the
resulting tax is $1,647.05. This is more than the $1,530 paid by R and
E collectively when E was employed by R. With the
“discount,” only 92.35% of E's net earnings from
self-employment is taxed. Multiplying $10,765 by .9235 generates
taxable net earnings of $9,941.48. Close enough, I suppose, for
government work. The multiplier should be .9289, because $10,765
multiplied by .9289 is $9.999.60. Perhaps that is close
enough.
It appears that the “discount” and the income tax
deduction address two different equalization concerns, and do not
generate duplicate results. For example, after applying the
“discount,” self-employed E then incurs self-employment
taxes of $1,521.05 ($9,941.48 x .153), and only the deduction of
$760.52 of that tax puts E into the same position as E would have been
had E been employed by R.
The second question also is challenging. Does it make sense to
apply the discount to self-employment income exceeding the OASDI cap,
considering that employers and employees do not pay social security
taxes on wages exceeding the cap? The answer appears to be no. The
solution would be a more complicated computation of self-employment
taxes. If the Congress eliminates the OASDI cap, as some have
proposed, this part of the question disappears.
Let's return to that small discrepancy between a discount of .9235
and what I compute as an appropriate discount of .9289. Does such a
small difference matter? Yes. According to the IRS Statistics of
Income, Individual Income Tax Returns, 2005
(http://www.irs.gov/pub/irs-soi/07infallbulreturns.pdf),
roughly $22.7 billion was paid in self-employment taxes for 2005, the
latest year for which information is available. Working backwards,
this suggests that roughly $148,366,013,071 of taxable self-employment
income was reported ($22,700,000,000/.153). Working backwards yet
again, this suggests that before application of the .9235
“discount,” individuals reported earnings from
self-employment of $160,656,213,396 ($148,366,013,071/.9235). How much
self-employment tax would be reported if the a discount of .9289
rather than .9235 were applied? First, take $160,656,213,396 and
multiply by .9289, for a result of $149,233,556,624. Second, multiply
$149,233,556,624 by 15.3%, for a result of $22,832,734,163. That is an
annual increase of roughly $132,734,163 in self-employment taxes. It's
not much as a percentage of the currently reported total, but it would
be a welcome increase to the social security trust funds. It won't
solve the social security funding problem, but sometimes every little
bit helps. Of course, the income tax deduction for self-employment
taxes would increase by roughly $61,367,081, so there would be a bit
of a decrease in general fund revenues.
For more information, in the Tax Management Portfolios, see
Allman, 392 T.M., Withholding, Social Security and Unemployment
Taxes on Compensation, and in Tax Practice Series, see ¶3340,
Self-Employment Tax (SECA).
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