HOW THE SELF-EMPLOYMENT TAX IS MISCALCULATED: Tax Laws Intended to Make Self-Employment Taxes Equivalent to Corresponding Employment Taxes Actually Result in an Underpayment of Self-Employment Taxes and an Overpayment of Federal Income Taxes

By Smith, Sheldon R.; Smith, Lynn R. | Strategic Finance, August 2017 | Go to article overview

HOW THE SELF-EMPLOYMENT TAX IS MISCALCULATED: Tax Laws Intended to Make Self-Employment Taxes Equivalent to Corresponding Employment Taxes Actually Result in an Underpayment of Self-Employment Taxes and an Overpayment of Federal Income Taxes


Smith, Sheldon R., Smith, Lynn R., Strategic Finance


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.

FIRST CHANGE

The first of these changes, in Internal Revenue Code (IRC) [section] 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% x SEI)

NESE = 92.35% x SEI

Yet corrected net earnings from self-employment (CNESE) should be calculated as:

CNESE = SEI - (7.65% x CNESE) 107.65% x CNESE = SEI

CNESE = SEI/107.65%

CNESE = 92.8936368% x 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% X 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% x 2) for NESE but has dropped to 2.9% (1.45% x 2) for CNESE.

For SEI amounts above $137,736. …

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