I remember an episode of a
popular sitcom from years ago, where someone looking at a paystub asked the
question “Who is FICA, and why is he getting all my money?” That line still makes me laugh. For profitable, self-employed entrepreneurs,
it’s not FICA who gets all the money, but IRS, in the form of self-employment
tax. It’s yet another tax imposition
that many businessmen and women don’t completely understand.
Let’s do some math:
- When you work for an employer, your gross wages are subjected to a few different taxes. There’s federal tax, state tax, and then there is Social Security tax and Medicare tax.
- Social Security and Medicare
tax form a duo, known as FICA tax, and they take 7.65% of your gross pay
each time you receive a paycheck.
- Your
employer, generous person that she is, has to then match your FICA tax
with an expenditure of her own, resulting in a second 7.65% paid to the
government.
- If you add those two percentages together, they come to 15.3%. Guess what percentage self-employment tax you pay on the profit from your business venture? You got it…15.3%. IRS decided years ago that if you chose to leave your job and start a new business venture, and you operated as a sole proprietorship (and in some cases, a partnership), you would be responsible for both parts of the FICA duo and the employer match. That was nice of them, huh?
- And did I mention that this is completely
separate from the income tax you have to pay on the profit? Your profit is assessed tax on three
different levels…federal, self-employment and state.
Now, it’s not all gloom and
doom. You are allowed to take an income
adjustment for ½ of the self-employment tax that you are assessed on your tax
return. But still, 15.3% is quite a
chunk. That’s why I tell my clients that
tax deductions for the self-employed are like gold. You need to make sure you don’t overlook any
of those allowable deductions, because the tax imposed on the profit is
steep.
Case in point:
Assume you’re in the 25% tax
bracket for federal purposes and 6% tax bracket for state. If your effective tax rate on the federal
return is around 18%, you will pay 39.3% tax on the profit from your business
(15.3% self-employment tax, 18% federal tax, and 6% state tax). WHOA!
That’s crazy!
In my experience, new clients who
have attempted to prepare their own taxes through a period of self-employment
do not deduct too much. They tend to be conservative
and not deduct enough. IRS is pretty
generous with small business tax deductions, so make sure you take advantage of
them. You’ll never get a letter from
IRS, telling you that you missed one.
