Employees in the United States pay Social Security and Medicare taxes through employer withholding. These taxes are matched by employers, and both the employee and employer taxes are submitted to the U.S. federal government. Individuals who are self-employed pay both the employee and employer share of these taxes. Starting in 1990, two tax law changes became effective in an attempt to make the self-employment taxes equivalent to the employee-employer payroll taxes.
The first of these changes, in Internal Revenue Code (IRC) §1402(a)(12), allows self-employment income (SEI) to be reduced by 7.65% (the sum of the 6.2% Social Security tax and the 1.45% Medicare tax) when calculating net earnings from self-employment (NESE). The argument for this change was so that a self-employed individual wouldn’t have to pay self-employment taxes on the amount representing the employer’s share of the taxes.
But this reduction understates NESE in two ways and, thus, self-employment taxes also are understated. (The illustrations provided here assume that the individual has only SEI and no employee earnings.)
First, by multiplying by 92.35%, SEI is reduced too much. The incorrect calculation currently used is derived as:
NESE = SEI – (7.65% × SEI)
NESE = 92.35% × SEI
Yet corrected net earnings from self-employment (CNESE) should be calculated as:
CNESE = SEI – (7.65% × CNESE)
107.65% × CNESE = SEI
CNESE = SEI/107.65%
CNESE = 92.8936368% × SEI
This calculates the reduction as 7.65% of the amount on which self-employment taxes are actually paid (CNESE) rather than on 7.65% of the SEI. The difference is that multiplying by 92.35% (1 – 7.65%) isn’t the same as dividing by 107.65% (1 + 7.65%). Because CNESE is larger than NESE, using NESE for calculating self-employment taxes understates the amount of taxes that should actually be paid.
Second, for earnings above the Social Security earnings base ($127,200 for 2017), all SEI is still multiplied by 92.35% in calculating NESE. This reduces SEI too much for amounts beyond the Social Security earnings base because the employer would no longer be paying the 6.2% Social Security tax. But the reduction assumes the employer is still paying both the 6.2% Social Security tax and the 1.45% Medicare tax. While NESE is still calculated as 92.35% of SEI, the correct calculation of CNESE would be calculated with only a 1.45% reduction of amounts above $127,200. And again, the percentage reduction would be based on CNESE, not SEI.
The correct formula for amounts where CNESE is above $127,200 would be CNESE = 98.5707245% × SEI - $7,773.68. Again, CNESE would exceed NESE in the range where CNESE is above $127,200. Therefore, using NESE for calculating self-employment taxes understates the amount of taxes that should actually be paid.
The amount of the underpayment of self-employment taxes depends on the amount of SEI. Ignoring the $400 floor for self-employment taxes, as SEI increases from $0 up to $136,930.80 (the amount of SEI at which CNESE equals $127,200), the understatement of self-employment taxes increases from $0 to $113.89.
As SEI increases from $136,930.80 up to $137,736.87 (the amount of SEI at which NESE equals $127,200), the understatement decreases from $113.89 to $23.04. Even though CNESE is larger than NESE in this range, the marginal self-employment tax rate is still 15.3% (7.65% × 2) for NESE but has dropped to 2.9% (1.45% × 2) for CNESE.
For SEI amounts above $137,736.87, the underpayment starts at $23.04 and increases, theoretically with no upper limit, as SEI increases. But the underpayment would be bounded practically by the maximum amount of SEI an individual would report in one year. For SEI of $1 million, the understatement of self-employment taxes would be $1,578.57.
The second of the tax law changes is in IRC §164(f). It allows self-employed individuals to deduct one-half of the self-employment taxes in calculating adjusted gross income (AGI) on an income tax return. This deduction allows self-employed individuals to deduct the portion of the self-employment tax representing the employer’s share in calculating taxable income.
Since self-employment taxes are understated, this deduction for AGI is also understated. The result is an overstated AGI, an overstatement of taxable income, and an overpayment of federal income taxes. For states that have an income tax with federal AGI as the starting point, the overstatement of AGI on the federal tax return can also lead to an overstatement of state taxable income and state income taxes.
The understatements of NESE and self-employment taxes have additional implications:
- Those whose SEI puts them below the Social Security maximum earnings base for the year will be credited on the Social Security records with the lower NESE rather than the higher CNESE amount for the year. Thus, when the Social Security Administration calculates their average indexed monthly earnings (AIME) and primary insurance amount (PIA), those amounts will also be understated, resulting in lower Social Security benefits during retirement.
- The understatement of self-employment taxes could also result in an understatement of the 0.9% additional Medicare tax legislated in the Affordable Care Act, depending on the taxpayer’s income and filing status.
- Since CNESE is larger than NESE, a self-employed individual would get to the Social Security maximum earnings base sooner using the CNESE calculation than the NESE calculation. In addition, if the taxpayer also has employee earnings, the coordination between employee earnings and self-employment earnings in reaching the maximum earnings base would also be different if CNESE were used rather than NESE.
- If the taxpayer has net investment income along with SEI, the understatement of NESE could understate the net investment income tax.
- For those with very small amounts of SEI close to the $400 floor, using CNESE will result in a self-employment tax liability at smaller amounts of SEI than when using NESE.
A change to the tax code to use CNESE rather than NESE for the calculation of self-employment taxes would make the calculations more consistent with their intended purpose. Using CNESE would also make the amount on which self-employment taxes are paid the same as the net amount of self-employment income included in AGI on the income tax return and resolve the other issues mentioned.
© 2017 Sheldon R. Smith and Lynn R. Smith