3.10.2015

Self-Employment Tax….Merely FICA in Disguise?

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.