EMPLOYMENT AND SELF-EMPLOYMENT TAXES
Step 2: Multiply the amount from Step 1 by 92.35 percent. The product is called net
16As we discussed in the Gross Income and Exclusions and Individual Deductions chapters, self-employed taxpayers report their self-employment earnings on Schedule C of Form 1040. Individuals who are partners in partnerships and who are actively involved in the partnerships’ business activities may be required to pay self- employment taxes on the income they are allocated from the partnerships. They would report these earnings on Schedule E of Form 1040.
What if: Suppose Courtney worked for her former employer Landmark Architects Inc. (LA), in Cincinnati for two weeks in January 2018 before moving to Kansas City. During those two weeks, Courtney would have earned $4,000 in salary. LA would have withheld $306 in FICA taxes from her final pay- check consisting of $248 of Social Security taxes ($4,000 × 6.2%) and $58 of Medicare taxes ($4,000 × 1.45%). How much excess Social Security tax would have been withheld from Courtney’s combined salaries from LA and EWD during 2018?
Answer: $248 ($4,000 wages earned with LA × 6.2% Social Security rate). Due to the $128,400 So- cial Security tax wage base for the year, Courtney’s Social Security tax liability is limited to $7,961 ($128,400 × 6.2%). However, through employer withholding, she would have paid a total of $8,209 in Social Security taxes, consisting of $248 withheld by LA ($4,000 × 6.2%) and $7,961 withheld by EWD ($128,400 × 6.2%). Thus, given these facts, Courtney’s excess Social Security tax withheld was $248 ($8,209 − $7,961). Courtney would get this amount back from the government through either lower taxes payable with her tax return or a larger tax refund.
Example 8-12
leaving 92.35 percent (100% – 7.65%) of the full amount subject to self- employment taxes. Note that the 7.65 percent consists of the 6.2 percent Social Security tax and 1.45 percent Medicare tax. Net earnings from self-employment is the base for the self-employment tax. If net earnings from self-employment is less than $400, the taxpayer is not subject to self-employment tax (but is still subject to income tax on the earnings).
Step 3: Compute the Social Security tax. The Social Security tax component of the self-employment tax equals 12.4 percent [the combined Social Security tax rate for employer and employee (6.2% + 6.2% = 12.4%)]
multiplied by the lesser of (a) the taxpayer’s net earnings from self- employment (from Step 2) or (b) $128,400 (the maximum tax base for the Social Security tax).
Step 4: Compute the Medicare tax. The Medicare tax component of the self- employment tax equals 2.9 percent [the combined Medicare tax rate for employer and employee (1.45% + 1.45% = 2.9%)] multiplied by the net earn- ings from self-employment (from Step 2).
Step 5: Compute the additional Medicare tax. The additional Medicare tax due on net self-employment earnings equals .9 percent multiplied by the greater of (1) zero or (2) net earnings from self-employment (from Step 2) less
$200,000 ($125,000 for married filing separately; $250,000 for married filing jointly). The additional Medicare tax is considered an “employee”
tax (and not a “self-employment” tax).
Note that, as we discussed in the Individual Deductions chapter, taxpayers are allowed to deduct the employer portion of their self-employment taxes as a for AGI deduction.
When a taxpayer receives both employee compensation and self-employment earnings in the same year, the calculation of Social Security and additional Medicare taxes is a bit more complicated. For the Social Security tax component, the taxpayer’s total earnings subject to the Social Security tax are capped at $128,400. In these
What if: Assume that Courtney’s only income for the year is her $18,000 in net self-employment in- come from her weekend consulting business. What amount of self-employment taxes and additional Medicare tax would Courtney be required to pay on this income?
Answer: $2,543 self-employment taxes and $0 of additional Medicare tax, computed as follows:
Step 1: $18,000 of net self-employment income subject to self-employment taxes.
Step 2: $18,000 × .9235 = $16,623. This is net earnings from self-employment.
Step 3: $16,623 × 12.4% = $2,061. This is Courtney’s Social Security tax payable for her self- employment income.
Step 4: $16,623 × 2.9% = $482. This is Courtney’s Medicare tax payable for her self- employment income.
Step 5: $0. Since Courtney’s net earnings from self-employment do not exceed $200,000, she is not subject to the additional Medicare tax.
Total $2,543 self-employment taxes [sum of Steps (3) and (4)] and $0 of additional Medicare tax [Step (5)].
Under these circumstances, Courtney would be able to deduct $1,272 as a for AGI deduction for the employer portion of self-employment taxes she paid [i.e., $16,623 × (6.2% + 1.45%)].
Example 8-13
situations, the taxpayer’s Social Security tax liability on the employee compensation is determined as if the employee had no self-employment income. The taxpayer then computes her Social Security tax on her net self-employment earnings. This ordering is favorable for taxpayers because it allows them to use up all or a portion of the Social Security wage base limit with their employee income (taxed at 6.2 percent) before they determine the Social Security tax on their net earnings from self-employment (taxed at 12.4 percent). Consequently, if an employee’s wages exceed the Social Security tax wage base limitation, she is not required to pay any Social Security tax on her self- employment earnings.
Likewise, the additional Medicare tax calculation is more complicated when (1) the taxpayer receives both employee compensation and self-employment earnings or (2) the taxpayer files married jointly with a spouse receiving employee compensation or net self-employment earnings. For taxpayers not filing married jointly, the addi- tional Medicare tax equals .9 percent of the taxpayer’s salary or wages and net self- employment earnings in excess of $200,000 ($125,000 for married filing separately).
For married filing jointly taxpayers, the additional Medicare tax equals .9 percent of the taxpayer’s and his or her spouse’s salary or wages and net self-employment earn- ings in excess of $250,000.
The calculation of the taxpayer’s Social Security and Medicare taxes on self-employment earnings in these settings can be determined as follows:17
Social Security Tax:
Step 1: Determine the limit on the Social Security portion of the self-employment tax base by subtracting the employee compensation from the Social Security wage base ($128,400 in 2018) (not below $0).
Step 2: Determine the net earnings from self-employment (self-employment earn- ings times 92.35 percent).
Step 3: Multiply the lesser of Steps 1 and 2 by 12.4 percent. This is the amount of Social Security taxes due on the self-employment income.
Medicare Tax:
Step 4: Multiply the amount from Step 2 by 2.9 percent, the combined Medicare tax rate for employer and employee.
Additional Medicare Tax:
Step 5: Add the amount from Step 2 and the taxpayer’s compensation. If married filing jointly, also add the spouse’s compensation and net earnings from self-employment (spouse’s self-employment earnings times 92.35 percent).
Step 6: Multiply the greater of [(a) zero or (b) the amount from Step 5 minus
$200,000 ($125,000 for married filing separately; $250,000 for married filing jointly)] by .9 percent.
Step 7: Take the amount from Step 6 and subtract the amount of the .9 percent additional Medicare tax withheld by the taxpayer’s employer (and his or her spouse’s employer if married filing jointly). This is the .9 percent addi- tional Medicare tax due on the self-employment income.
17If net earnings from self-employment is less than $400, the taxpayer is not subject to self-employment tax (but the taxpayer is still subject to income tax on the earnings).
What if: Let’s change the facts and assume that Courtney received $100,000 of taxable compensa- tion from EWD in 2018, and she received $180,000 in self-employment income from her consulting activities. What amount of self-employment taxes and additional Medicare tax is Courtney required to pay on her $180,000 of business income? Assume that Courtney’s employer correctly withheld
$6,200 of Social Security tax, $1,450 of Medicare tax, and $0 of additional Medicare tax.
Answer: $8,343 of self-employment taxes and $596 of additional Medicare tax, computed as follows:
Description Amount Explanation
(1) Social Security wage base limit less $ 28,400 $128,400 − $100,000, limited to $0 employee compensation subject to
Social Security tax
(2) Net earnings from self-employment 166,230 $180,000 × 92.35%
(3) Social Security portion of 3,522 [Lesser of Step (1) or (2)] × 12.4%,
self-employment tax rounded
(4) Medicare tax 4,821 Step (2) × 2.9%, rounded
Example 8-15
(continued on page 8-20) In 2018, Courtney received $142,800 in taxable compensation from EWD (see Example 8-11) and
$18,000 in self-employment income from her weekend consulting activities (see Example 6-2). What are Courtney’s self-employment taxes and additional Medicare tax payable on her $18,000 of income from self-employment? Assume that Courtney’s employer correctly withheld $7,961 of Social Security tax and $2,071 of Medicare tax.
Answer: $482 of self-employment taxes and $0 of additional Medicare tax, computed as follows:
Description Amount Explanation
(1) Social Security wage base limit less $ 0 $128,400 − $128,400, limited to $0 employee compensation subject to
Social Security tax
(2) Net earnings from self-employment 16,623 $18,000 × 92.35%
(3) Social Security portion of 0 [Lesser of Step (1) or (2)] × 12.4%
self-employment tax
(4) Medicare tax 482 Step (2) × 2.9%
(5) Sum of taxpayer’s compensation and 159,423 $142,800 + Step (2) net earnings from self-employment
(6) [Greater of (a) zero or (b) the amount 0 0 × 0.9%
from Step (5) minus $200,000] × 0.9%
(7) Step (6) less any additional Medicare 0 0 − 0 tax withheld by Courtney’s
employer
Steps (3) + (4) + (7) $ 482 $0 + $482 + $0. [$482 of self- employment taxes (3) + (4) and $0 of additional Medicare tax]
As we reported in Example 6-6, Courtney is entitled to a $241 for AGI deduction for the employer por- tion of the $482 self-employment taxes she incurred during the year ($16,623 × 1.45% employer portion of the Medicare tax rate = $241).
Example 8-14
Description Amount Explanation (5) Sum of taxpayer’s compensation and 266,230 $100,000 + Step (2) net earnings from self-employment
(6) [Greater of (a) zero or (b) the amount from 596 $66,230 × 0.9%, rounded Step (5) minus $200,000] × 0.9%
(7) Step (6) less any additional Medicare 596 $596 − $0 tax withheld by Courtney’s employer
Steps (3) + (4) + (7) $ 8,939 $3,522 + $4,821 + $596. [$8,343 of self-employment taxes (3) + (4) and
$596 of additional Medicare tax]
What if: Now let’s assume that Courtney is married and files jointly. Assume that Courtney re- ceived $100,000 of taxable compensation from EWD in 2018 and $180,000 in self-employment income from her weekend consulting activities. In addition, her husband received $75,000 of taxable compensation from his employer. What amount of self-employment taxes and additional Medicare tax is Courtney required to pay on her $180,000 of business income? Assume that Courtney’s employer correctly withheld $6,200 of Social Security tax, $1,450 of Medicare tax, and
$0 of additional Medicare tax, and that her husband’s employer correctly withheld $4,650 of Social Security tax, $1,088 of Medicare tax, and $0 of additional Medicare tax.
Answer: $8,343 of self-employment taxes and $821 of additional Medicare tax, computed as follows:
Description Amount Explanation
(1) Social Security wage base limit less $ 28,400 $128,400 − $100,000, limited to $0 employee compensation subject to
Social Security tax
(2) Net earnings from self-employment 166,230 $180,000 × 92.35%
(3) Social Security portion of 3,522 [Lesser of Step (1) or (2)] × 12.4%,
self-employment tax rounded
(4) Medicare tax 4,821 Step (2) × 2.9%, rounded
(5) Sum of taxpayer’s and spouse’s 341,230 $100,000 + $75,000 + Step (2) compensation and net earnings from
self-employment
(6) [Greater of (a) zero or (b) the amount 821 $91,230 × 0.9%, rounded from Step (5) minus $250,000] × 0.9%
(7) Step (6) less any additional Medicare 821 $821 − $0 tax withheld by Courtney’s employer
and her husband’s employer
Steps (3) + (4) + (7) $ 9,164 $3,522 + $4,821 + $821. [$8,343 of self-employment taxes (3) + (4) and
$821 of additional Medicare tax]
Unlike employees, whose employers withhold tax throughout the year on their be- half, self-employed taxpayers must satisfy their self-employment tax obligations through periodic, usually quarterly, estimated tax payments. Taxpayers who are employed and self-employed (an employee with a business on the side, like Courtney) may have their employers withhold enough taxes to cover both their income, self-employment, and additional Medicare tax obligations. Any self-employment or additional Medicare taxes not paid through these mechanisms must be paid with the self-employed taxpayer’s indi- vidual tax return.
Employee vs. Self-Employed (Independent Contractor)
Determining whether an individual should be taxed as an employee or as an independent contractor can be straightforward or quite complex, depending on the specific arrange- ment between the parties. In its published guidance, the IRS stipulates that an employer/
employee relationship exists when the party for whom services are performed has the right to direct or control the individual performing services.18 To assist taxpayers in de- ciding whether the party receiving services has the requisite amount of control over the individual providing services, the IRS has published a list of 20 factors to consider.19 A few of the factors suggesting independent contractor rather than employee status include the contractor’s ability to:
1. Set her own working hours.
2. Work part-time.
3. Work for more than one firm.
4. Realize either a profit or a loss from the activities.
5. Perform work somewhere other than on an employer’s premises.
6. Work without frequent oversight.
When these factors are absent, individuals are more likely to be classified as employees.
Rather than simply summing the number of factors in favor of independent contractor sta- tus and those in favor of employee status, however, taxpayers and their advisers should use the factors as guides in determining the overall substance of the contractual relationship.
Whether a taxpayer is classified as an employee or as an independent contractor (self-employed) has both tax and nontax consequences to the employer and the taxpayer.
The best classification for the taxpayer is situation-specific.
Employee vs. Independent Contractor Comparison The two primary tax differences between independent contractors and employees relate to (1) the amount of FICA taxes payable and (2) the deductibility of business expenses.20 However, there are several nontax factors to consider as well. In the previous section, we detailed how continued from page 8-1 . . .
Courtney was enjoying her work with EWD, but she also really liked her weekend consulting work. A couple of months ago, after she had played an integral part in completing a successful project, her boss jokingly mentioned that, if Courtney ever decided to leave EWD to work for herself as a full-time consultant, EWD would love to hire her back for contract work. This caused Courtney to start thinking about the possibilities of starting her own consulting business. She always had some interest in working for herself, but she is not at a point in her life where she can take significant financial risks even if it might mean a more satisfying career. Courtney knows that before making such a move she would need to seriously consider the nontax issues associated with self-employment and learn more about the tax consequences of working as an independent contractor. She is particularly interested in the tax consequences of working for EWD as an independent contractor (contract worker) relative to working for EWD as an employee. ■
18IRS Publication 1779. Independent Contractor or Employee brochure.
19Rev. Rul. 87-41, 1987-1 CB 296.
20Also, independent contractors generally receive a Form 1099 from each client reporting the gross income they received from the client during the year. Employees receive Form W-2 reporting the compensation the employee received from the employer during the year.
THE KEY FACTS Employee vs.
Independent Contractor
• Employees
• Less control over how, when, and where to per- form duties.
• Pay 6.2 percent Social Security tax subject to limit.
• Pay 1.45 percent Medicare tax.
• Pay additional Medicare tax of .9 percent on salary or wages above
$200,000 ($125,000 for married filing separate;
$250,000 of combined salary or wages for married filing joint).
• Independent contractors
• More control over how, when, and where to perform duties.
• Report income and expenses on Form 1040, Schedule C.
• Pay 12.4 percent Social Security tax subject to limit.
• Pay Medicare tax of 2.9 percent.
(continued)
to determine the FICA taxes payable for employees and independent contractors (self- employed taxpayers). In terms of the deductibility of business expenses, as we dis- cussed in the Individual Deductions chapter, employees who incur unreimbursed business expenses relating to their employment cannot deduct these expenses. In con- trast, as we also described in the Individual Deductions chapter, self-employed inde- pendent contractors are able to deduct expenses relating to their business activities as for AGI deductions, which they can deduct without restriction. While these factors appear to favor independent contractor status over employee status, note that employ- ees generally don’t incur many unreimbursed expenses relating to their employment.
Thus, even though independent contractors may be able to deduct more expenses than employees, they typically incur more costs in doing business.
When taxpayers are classified as independent contractors rather than employees, they are not eligible for nontaxable fringe benefits available to employees, such as health care insurance, retirement plan benefits, and others. Further, independent contractors are re- sponsible for paying their estimated tax liability throughout the year because the em- ployer does not withhold taxes from an independent contractor’s pay. However, as we mentioned above, taxpayers are allowed to deduct the employer portion of the self- employment taxes they pay.
From the employer’s perspective, it is generally less costly to hire an independent contractor than an employee, because the employer need not provide these benefits or withhold or pay any FICA taxes on behalf of an independent contractor. As a result, an employer may be willing to offer an apparently higher level of taxable compensa- tion to an independent contractor than to a similarly situated employee. However, after considering all relevant factors, the taxpayer may do better receiving less com- pensation as an employee than slightly higher compensation as an independent contractor.
ETHICS
Sudipta is an accounting major who works during the day and takes classes in the evening. He was excited to finally land his first accounting job doing the books for a local dry cleaners. In his new job, Sudipta works 30 hours a week at the dry cleaners’ main office. His excitement quickly dampened when he realized that his new em- ployer was not withholding any income taxes or
FICA taxes from his paycheck. Apparently, Sudipta’s employer is treating him as an indepen- dent contractor. Sudipta likes his job, appreciates the money he is earning, but recognizes that he should be treated as an employee instead of an independent contractor. What would you do if you were Sudipta?
What if: Let’s compare Courtney’s compensation as an employee with EWD to her compensation if she were to work for EWD as an independent contractor. Assume Courtney works an average of 40 hours per week for 50 weeks per year to earn a salary of $100,000; in addition she receives fringe benefits including a 5 percent contribution to her retirement plan, life insurance coverage, and health insurance coverage. Would Courtney be “made whole” in terms of her hourly rate if EWD agreed to pay her $55 an hour for her contract work (10 percent more than her hourly rate as an employee)?
Answer: Not very likely. As an independent contractor, Courtney must pay more costly self-employment taxes (at nearly twice the rate of employment taxes) under the new arrangement. In addition, she will be ineligible for the nontaxable fringe benefits (retirement plan contributions, life insurance, and health coverage) she was receiving as an employee and will not receive as a contractor.
Example 8-16
• Pay additional Medicare tax of .9 percent on net self-employment earn- ings above $200,000 ($125,000 for married filing separate;
$250,000 of combined salary or wages for married filing joint).
• Self-employment tax base is 92.35 percent of net self-employment income.
• Deduct the employer portion of self- employment taxes paid for AGI.
We’ve described how to calculate a taxpayer’s regular tax liability, alternative mini- mum tax liability, Social Security and Medicare tax liability, additional Medicare tax li- ability, and self-employment tax liability. These tax liabilities sum to a taxpayer’s gross tax liability. While Gram’s gross tax is simply her regular income tax liability of $199 (see Example 8-2), Courtney’s gross tax includes other taxes. Courtney’s gross tax liabil- ity is calculated in Exhibit 8-6.
EXHIBIT 8-6 Courtney’s Gross Tax
Description Amount Explanation
(1) Regular federal income tax $ 27,652 Example 8-3 (2) Alternative minimum tax 0 Example 8-9 (3) Self-employment tax 482 Example 8-14
Gross tax $ 28,134 (1) + (2) + (3)
Taxpayers reduce their gross tax by tax credits and tax prepayments (withholding and estimated tax payments) for the year. As indicated in Exhibit 8-7, if the gross tax exceeds the tax credits and prepayments, the taxpayer owes additional taxes when she files her tax
EXHIBIT 8-7 Formula for Computing Net Tax Due or Refund Gross tax
Minus: Tax credits Minus: Prepayments Net tax due (refund)
return. In contrast, if the prepayments exceed the gross tax after applying tax credits, the taxpayer is entitled to a tax refund. We next explore available tax credits and conclude the chapter by dealing with taxpayer prepayments.