Many of the tax problems we help resolve at Rizzo & Diersen, S.C. involve small business owners who know how to provide a service but do not appear to understand the concept of self-employment taxes and their effect on the business. Several years ago, I wrote a short article discussing the importance for small business owners to understand this concept, properly plan for self-employment taxes, and timely pay them. Those principles are still true today, and with tax time already here, business owners who have not adequately planned or have not been paying throughout the year are in for a rude awakening.
As an employee, in order to receive social security payments when you retire, you and your employer must pay into the Social Security system during your working years. The Federal Insurance Contribution Act (FICA) is the federal legislation that requires that contributions be made by both the employee and the employer into the Social Security fund. This is usually done by the employer withholding from your paycheck 6.2% of your wages that are subject to Social Security tax (up to a certain limit) and 1.45% of your wages that are subject to Medicare tax for a total deduction from your paycheck of 7.65%. Your employer is then required to match this 7.65% for a total payment to the Internal Revenue Service of 15.3% of wages. It is important to note here that this is in addition to federal and state income tax withholding.
For the self-employed, usually sole proprietors and single-member entities, there is corresponding federal legislation called the Self-Employed Contribution Act (SECA). This is a double whammy to the self-employed because you are both the employee and the employer and, therefore, are responsible for the entire 15.3% on any earnings that your company makes, subject to the upper limit on the Social Security tax. These taxes are also subject to the estimated tax payment rules, the same as income tax.
Failure to pay these taxes can be devastating for both your business and you personally. That is because these types of taxes are considered “Trust Fund” taxes which means they cannot be discharged in bankruptcy and will be assessed against you personally. This means all your personal assets will become subject to levy and seizure in addition to your business assets.
Careful planning through the year will minimize the self-employment tax. Accountants and financial planners are able to counsel small business owners and assist business owners in implementing various strategies to minimize the self-employment tax liability. A common strategy used is to increase your business-related expenses, as this will cause a reduction in net income, and correspondingly reduce the amount of self-employment tax. Contrary to some beliefs, regular deductions, such as the standard deduction or itemized deductions, will not lower self-employment tax. Similarly, deductions for health insurance, IRA contributions, or 401(k) contributions will not reduce self-employment tax liability.
Same as many other taxes, whether we like it or not, self-employment tax is here to stay. Timely payments, planning, and learning how to minimize it will ensure that they do not become unmanageable.