If you are an employee, your employer deducts certain payroll taxes from your paycheck and forwards them to the U.S. Treasury on your behalf. These payroll taxes include the Federal Insurance Contributions Act (or FICA) tax, which represents a 6.2% Social Security Tax and a 1.45% Medicare tax, totaling 7.65%. Your employer is also responsible for matching this deduction and paying for you (and on your behalf) another 6.2% Social Security Tax and a 1.45% Medicare tax, totaling 7.65%. In total, there is a 15.3% tax due for Social Security and Medicare that is paid 50% by you and 50% by your employer. However, what happens if the taxpayer does not have an employer and earns income from self-employment either as a sole proprietor or a partner in a partnership? In that event, the taxpayer is responsible for paying the FULL 15.3% of Social Security tax and Medicare tax to the federal government. This assessment is known as the self-employment tax.
The 15.3% self-employment is assessed against the "net earnings from self-employment", which are defined in 26 U.S.C. §1402(a) as including the following:
- Gross income derived by an individual from any trade or business carried on by the individual MINUS
- Ordinary and necessary deductions allowed under the Internal Revenue Code attributable to that trade or business PLUS
- Distributive share of income (whether or not actually distributed) carried on by a partnership of which the individual is a partner after calculating gains and losses.
"Net earnings from self-employment" DO NOT include the following:
- Rental income from real estate and personal property leased with the real estate (including crops shares) UNLESS rents are received in the course of a trade or business as a real estate dealer or the owner or tenant materially participated in the production of agricultural or horticultural commodities on leased land. 26 U.S.C. §1402(a)(1).
- Dividends on any share or stock, and interest on any bond, debenture, note, or certificate or other evidence of indebtedness UNLESS such dividends and interest are received in the course of a trade or business as a dealer in stocks or securities. 26 U.S.C. §1402(a)(2).
- Gain or loss from the sale or exchange of a capital asset. 26 U.S.C. §1402(a)(3)(A).
- Gain or loss from the sale, exchange, involuntary conversion or other disposition of property if the property is neither property that would be includible in inventory on hand or held primarily for sale to customers in the ordinary course of a trade or business. 26 U.S.C. §1402(a)(3)(B).
- The rental value of any parsonage or any parsonage allowance of an individual who is duly ordained, commissioned or licensed minister of a church or member of a religious order (although other income derived from the performance of services are subject to self-employment income). 26 U.S.C. §1402(a)(8).
The following deductions or exclusions DO NOT apply to the calculation of the self-employment tax:
- The deduction for personal exemptions. 26 U.S.C. §1402(a)(7).
- The exclusion of income from sources within Guam, American Samoa or the Northern Mariana Islands. 26 U.S.C. §1402(a)(9).
- The foreign earned income exclusion. 26 U.S.C. §1402(a)(11).
- The qualified business income deduction under Section 199A. 26 U.S.C. §1402(a)(16).
However, the self-employment tax does not apply to the following "net earnings from self-employment":
- The portion of Social Security income equal to the contribution and benefit base (although the excess amount is taxable). 26 U.S.C. §1402(b)(1).
- Self-employment income earnings for the year are less than $400.00 (or less than $108.28 for a church employee). 26 U.S.C. §1402(b)(2).
The self-employment tax is paid with quarterly estimated payments during the tax year. Then, at the end of the fiscal year, the taxpayer must reconcile these amounts paid by attaching Schedule SE with Form 1040. If the taxpayer has self-employment income in excess of $200,000 (or $250,000 if married filing jointly), then he or she will have to pay an additional Medicare tax of 0.9% on the excess. 26 U.S.C. §1401(c). The self-employment tax is in additional to any federal income tax that is due or payable with the estimated payments or the annual income tax return.
Fortunately, the Internal Revenue Code allows a deductible expense for the self-employment tax with respect to the 7.65% portion that would have been paid by the taxpayer's fictional employer. 26 U.S.C. §1402(a)(12). Another way to phrase this is that only 92.35% of self-employment net earnings is subject to the tax. This is an above-the-line deduction, meaning that it can be taken whether or not the taxpayer is taking the standard deduction or itemizing his or her deductions. This can be claimed on Form 1040 (or Schedule 4 for the 2018 tax year).
Failure to pay the self-employment tax when liable can lead to several sanctions by the IRS. The taxpayer may be liable for the failure to pay penalty (26 U.S.C. §6651(a)(2)), the underpayment of estimated taxes penalty (26 U.S.C. §6654) or even the 75% fraud penalty on underpayment (26 U.S.C. §6663) if the Internal Revenue Service believes that he or she willfully or intentionally violated the law. When a Form 1099-MISC is issued to an independent contractor and reported to the IRS, it triggers a red flag that the recipient should have paid self-employment taxes on the reported amounts (unless an employer withheld and paid the FICA taxes). Once a discrepency is detected, the Internal Revenue Service can issue a CP-2000 notice (underreporter inquiry) assessing additional tax on a deficiency or even initiate an examination (audit). This can end up being a costly proposition, especially if the taxpayer was derelict in his or her duties over several tax years. However, penalties may be abated if a taxpayer can show reasonable cause to the IRS why the self-employment tax was not paid (e.g. reliance on IRS guidance or ambiguity in the tax code as applied to the taxpayer's situation). A tax lawyer can help mitigate or eliminate these sanctions if you find yourself in this unfortunate situation.
Ignoring your tax issues will only make matters worse, and the possible penalties and interest will continue to accrue if no action is taken. If you are facing an assessment or an examination by the federal government, it will pay to have a knowledgeable attorney in your corner. If you have questions about self-employment taxes or any other aspect of federal taxation, do not hesitate to contact the experienced tax professionals at Kershaw, Vititoe & Jedinak PLC today.