Barbara’s Blog

Self-employed individuals are at a disadvantage to owners of corporations when it comes to Social Security and Medicare taxes. These taxes, called “self-employment tax,” are levied on net earnings from self-employment. Thus, regardless of what self-employed individuals take out of the business, they are taxed on their share of all of the profits. In contrast, for owners of corporations (C or S), Social Security and Medicare taxes (in the form of FICA) are levied only on salary and other taxable compensation. While S corporation owners are also taxable on their share of profits for income tax purposes, these profits are not subject to FICA.

To make matters worse for self-employed individuals, net earnings for self-employment tax purposes do not reflect all of the business-related deductions such individuals are allowed to take. Net earnings are not reduced by:

• Health insurance premiums paid for a self-employed person, spouse, dependents, and children through age 26. This deduction is claimed as a personal write-off; it is an adjustment to gross income (an “above-the-line” deduction).
• Contributions to qualified retirement plans on behalf of a self-employed person. This deduction is also taken as an adjustment to gross income.
• Net operating loss carry-forwards. This write-off is deducted as a negative entry on the line for “other income” on Form 1040. (The recent case of DeCrescenz0 highlights this problem.)

Under the Small Business Tax Act, net earnings for purposes of self-employment tax were allowed to be reduced by health insurance premiums covering self-employed individuals and their families for 2010. This break ran only for one year.

Congress needs to make changes to create greater parity between self-employed individuals and corporate owners. Change the deductibility of all business-related deductions to allow self-employed individuals to claim them as business write-offs. This won’t change the income tax results (since write-offs on the personal portion of the return effectively produce the same income tax liability). It will, however, change the results for self-employment tax.

This change can produce significant tax savings since the self-employment tax usually is 15.3%, comprised of 12.4% for Social Security taxes on net earnings up to the wage base amount ($110,100 in 2012), plus 2.9% for Medicare taxes on all net earnings. In 2011 and 2012, there is a 2 percentage point reduction in the Social Security tax on the so-called employee portion of self-employment tax, but this rule is not set to run beyond this year.

It would also be helpful to allow the net operating loss carry-forward to be taken into account in figuring net earnings for self-employment tax in the carry-forward year.

These suggestions for tax reform are not new. However, if Congress is serious about job creation (and self-employment must be viewed as self-job creation), these easy fixes to the tax law will go a long way in helping unincorporated small business owners.

On December 23, the Temporary Payroll Tax Cut Continuation Act of 2011 was signed into law, extending through February 29, 2012, the two percentage point reduction in the employee share of Social Security taxes for FICA purposes. A similar reduction applies to the employee equivalent portion of self-employment tax for self-employed individuals.

What employers must do
You must implement the new payroll tax rate as soon as possible in 2012, but no later than the end of January. If you over-withhold any Social Security tax in January, you must make an offsetting adjustment to employee pay no later than March 31, 2012. (This rule also applies to payroll services that may not have sufficient time to implement the change for customers by January 1, 2012.)

Look for a revised quarterly employer tax return, Form 941, to be issued by the IRS shortly. This form is due on April 30, 2012, for the quarter ending March 31, 2012.

Impact on high earners
There is a new “recapture” rule for high-earners, who are those making more than $18,350 in wages during the two-month extension period. For such individuals, 2% of wages in excess of $18,350 (but not in excess of the annual wage base for 2012 of $110,100) will be recaptured on the 2012 return when it is filed in 2013. For example, let’s say an owner of a business has a salary of $15,000 per month. This means that in the first two months, she will receive $30,000 in wages, or $11,650 more than the $18,350 limit for this period. When she files her 2012 return, $233 (2% of $11,650) will be reported as an additional tax owed.

Final thought
Congress rushed to pay this provision by a voice vote. It failed to address the dozens of income tax rules that expire on December 31, 2011!