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Minimizing the self-employment tax bite.

In 1991 higher self-employment tax rates on higher maximum incomes continue the recent growth of self-employment taxes. The maximum amount of combined wages and self-employment income subject to tax increases from $51,300 to $53,400 in 1991.(1) The combined self-employment tax rate has reached 15.3%. Many self-employed taxpayers will now actually pay more in self-employment tax than income tax. The current status and recent history of self-employment tax rates and taxable base amounts are shown in Table

1. These higher rates and tax bases give additional importance to self-employment tax planning. This article will analyze these increases and changes in the self-employment tax and suggest tax planning alternatives.

Self-Employment Tax Deductions

The self-employment tax rate of 15.3% is double the 7.65% FICA-tax on wages paid by both employees and employers. Congress has now provided an adjustment to reduce the gross amount of income subject to self-employment tax to provide some equity for self employed taxpayers with employees whose employers pay one-half of their Social Security tax. This was Congress' attempt to help the self employed taxpayer meet the increases in rates and maximum amounts subject to tax.

Starting in 1990, self employed taxpayers may deduct one-half of their self-employment tax as an adjustment to their gross income.(2) Second, taxpayers are allowed to pay self-employment tax on the lower of maximum subject earnings or net earnings reduced by a 7.65 % deduction.(3) These new deductions replace the special 2% credit previously allowed against the 1989 rate of 15.02%.

Evaluation of First Deduction

The benefits of this deduction depend on the taxpayer's marginal income tax rate which often may include state and municipal income taxes as well as federal income taxes. it is possible for a taxpayer to have selfemployment income and not have any taxable income. In this event, there is no benefit from the new deduction and the taxpayer clearly would have been better off with the old 2% credit on the tax rate. If the taxpayer has taxable income equal to or exceeding the amount of this deduction which is subject only to the minimum federal tax rate of 15%, the formula for the benefit is:
 15 x.0765 x Self Employed
Earnings = 1.1475% of SE Earnings


This taxpayer would get more benefit with the previous 2% reduction in the unlikely event that he did not qualify for the second adjustment.

The break-even marginal income tax rate in comparing the new adjustment to the previous 2 % reduction is 26.144% (marginal rate x .0765 = .02). Combining federal, state and municipal income tax rates makes this adjustment by itself more to the advantage of many self employed taxpayers than the old 2% reduction. This adjustment is more beneficial for the higher income self employed taxpayers. Taxpayers are not any better off under the new rule as opposed to the old rule unless they have significant taxable income.

Evaluation of Second

Deduction

A second deduction starting in 1990 may reduce the net earnings subject to the self-employment tax for qualifying taxpayers. The self-employment Tax of 15.3% is computed on the lower of combined earnings subject to tax (maximum is $53,400) or 92.35% of all combined earnings (no maximum). Since total self-employed earnings are multiplied by .9235 to obtain the qualifying taxable amount, self employed taxpayers with earnings over $ 57,823 (.9235 x $57,823 = $53,400) receive no benefit from this adjustment. This deduction is to the benefit of lower income self employed taxpayers, although the maximum benefit occurs at exactly $53,400 (.153 [$53,400 $49,3151 = $625) of income subject to the tax.

This benefit is available on any self employed income below $53,400 in a lesser amount 1.153 (Income {.9235 x Income})]. For incomes over $53,400 the benefit declines from $625 at $53,400 to $-0- at $57,823. The taxpayer's benefit from this deduction falls well short of the previous 2% credit, since it amounts to 1.17% (.153 x .0765) of self employment earnings up to $53,400 and then recedes to nothing at $57,823.

Examples Illustrating Deductions

The following cases in Table 2 show applications of the 1991 selfemployment tax rules. Several interesting observations arise in these examples. Able obtains the maximum benefit ($625) from the one deduction that Baker is unable to benefit from at all. However, the higher marginal income tax rate of Baker on the second deduction more than doubles the benefit to Able, and Baker winds up paying less self-employment tax net of the deductions. Clearly, the deduction favoring higher income taxpayers amounts to more than the deduction for lower income taxpayers.

Self-Employment Tax Planning

A word of caution is in order. The reduction of a taxpayer's SE taxes or self employment income can reduce the amount of income creditable for computation of Social Security benefits. Although the present value of some lost future benefits is usually very small when compared to the tax savings, they certainly must be considered.

Planning for the reduction of self-employment taxes involves different approaches from the methods used to reduce federal income taxes. Self-employment taxes are not progressive like federal income taxes. Self-employment income up to $53,400 is subject to a flat 15.39o rate in 1991. Although the maximum income ceiling is indexed for inflation yearly, most individual planning revolves around lowering self employed income below the ceiling amount. Planning techniques described include:

1. Converting a partnership to an S corporation,

2 . Utilizing fringe benefits in lieu of compensation,

3 Choosing accelerated depreciation and immediate expensing of business assets,

4. Planning around the maximum ceiling ($53,400 in 1991), and (5) employing one's children. Incorporating a Partnership as an S Corporation.

Section 1402(a) defines the term "et earnings from self-employment" as including a partner's distributive share (even if not distributed) of the net income or loss from a trade or business operated by his partnership. Taxable income for self-employment tax equals taxable income for income tax purposes. If a partner has a distributive share of $50,000 earned income and is paid a salary of $20,000, all of the $50,000 will be subject to self-employment taxes.

In contrast, a shareholder's share of S corporation income is not subject to the self-employment tax(4). The taxpayer above conducting business in an S corporation would pay Social Security tax only on the $20,000 salary. The S corporation would pay a matching FICA amount, unemployment taxes, and withhold federal income tax. Self-employment tax savings depend on the taxpayer's marginal income tax rate and his state s income tax rate. But the self-employment tax saving is significant, even with a high marginal income tax rate, as Table 3 illustrates.

The tax saving increases substantially if the marginal income tax rate is lower. An individual cannot avoid FICA and unemployment taxes entirely by receiving a dividend" from the S corporation instead of reasonable compensation for services.(5)

It is possible to split an S corporation's income between family members. However, family members who provide capital and services to the S corporation are required to receive reasonable compensation in exchange. (6)

An S corporation can provide additional fringe benefits to employees in lieu of some salary increases and save on employee payroll taxes. The amount paid by an S corporation for fringe benefits is deductible from the corporation's gross income as a reasonable and necessary business expense (7) and are not included in the gross income of the employee.(8)

An S corporation cannot deduct its costs for providing certain fringe benefits to an employee-stockholder owning more than 2 % of the stock of the S corporation. Shareholder-employees also have to include the value of certain fringe benefits in their gross income.(8) Examples of these benefits include the cost of up to $50,000 of group-term insurance, the cost of meals and lodging furnished for the convenience of the employer, amounts paid to or for certain accident and health plans, and the $5,000 death benefit exclusion.

Accelerated Depreciation and Immediate Expensing of Assets

The time value of money alone makes it wise to accelerate business expenses for self-employment tax and income tax. Depreciation expense decreases net earnings from self employment.(10) Other advantages from accelerated depreciation of business assets can arise upon sale of these assets. Depreciation recapture under Section 1245 or 1250 on the later sale of assets does not increase earnings from self employment.(11) If the amount realized on the sale of a depreciable asset used in a business exceeds its adjusted basis resulting in recognition of a Section 1231 gain, the Section 1231 gain is not included in net earnings from self employment. (12) The difference in accelerated and straight-line depreciation is not subjected to self-employment tax when an asset is sold.

An election to expense up to $10,000 of depreciable tangible personal property under Section 179 accelerates expenses that can delay and with a timely sale reduce self-employment taxes. A subsequent gain on the sale of the property is not included in self employed income. However, if a taxpayer recaptures any excess depreciation or Section 179 expense amount because listed property use was reduced to 50% or less, these amounts are subject to self-employment tax.

When a taxpayer plans to dispose of an asset before its useful life is over, immediate expensing achieves the time value of money and a reduction of the self-employment tax. However, if a net operating loss is anticipated, it is better to not elect expensing. A net operating loss carried forward or back does not reduce self employment income.(13)

Hiring Children

If a taxpayer can employ his minor children in the family business, the sole proprietor may deduct the reasonable wages he pays his children as ordinary and necessary business expenses.(14) A child with sufficient earned income is entitled to a standard deduction of $3,250 in 1990 and an IRA deduction of $2,000.(15) Thus, a child could earn up to $5,250 in 1990 without incurring any tax liability. In addition, children under 18 are not liable for Social Security taxes.(16) Wages paid to spouses and children 18 and older are subject to employment taxes. Wages paid to children under 18 are also not subject to the federal unemployment tax.(17)

Planning Around the Maximum Ceiling

Once self employment income reaches the celling, the self-employment tax ends. For 1991, the ceiling is $53,400 reduced by wages subject to Social Security taxes. When taxpayers have self-employment income close to the celling in the current year it could be wise to accelerate income and/or delay expenses into the next year. This would be of advantage if self employment income is anticipated to be below the celling for the next year. Because the ceiling is generally increased yearly because of an adjustment for inflation, this is common. The taxpayer will increase his regular tax liability by accelerating income but will reduce his self-employment tax on this income.

Increases in Medicare Payroll Tax

The Revenue Reconciliation Act of 1990 (RRA 90) extends the 2.9% Medicare payroll tax to self employment income up to $12 5,000. This means that in 1991 self employed taxpayers, including outside directors, with self employment income between $53,400 and $125,000 will pay an additional 2.9% tax on that range of income. For self employed taxpayers with $125,000 of income, this amounts to an additional self-employment tax of $2,076. However, a self-employed taxpayer may deduct one-half of this self-employment tax increase for adjusted gross income, This would reduce a taxpayer's federal income tax by up to $322 at the 1991 top rate of 31%. This results in a net maximum tax rise of $1,754.

Conclusion

The self-employment tax has become increasingly important because of the recent tax increases. Planning for self-employment taxes could be more important for some self employed taxpayers than income tax planning. Fortunately, a number of tax planning techniques may be utilized to minimize the self-employment tax.
 Footnotes
 1 Section 1401 (a) and (b).
 2 Section 164 (f).
 3 Section 1402 (a) (12).
 4 Section 1366 (a) (1).
 5 Rev. Rul. 74-44, 1974-1 CB287.
 6 Section 1366 (e).
 7 Section 162.
 8 Sections 105 and 79.
 9 Section 1372.
 10 Section 1402 (a).
 11 Section 1402 (a) (3) (c).
 12 Id.
 13 Section 1402 (a) (4).
 14 Section 162 (a) (1)
 15 Section 63 (d) and 219 (b).
 16 Section 3121 (b) (3).
 17 Section 3306 (c) (5).
 18 P.L. 101-508, Part of the Omnibus
 Budget Reconciliation Act of 1990, November
5, 1990.
 Table 2
 Cases Showing Applications of
 the 1990 Self-Employment Tax Rules
 Able Baker
Net earnings from self employment $53,400 $90,000
Multiply earnings by .9235 $49,315 $83,115
Lesser of above amount or $51,300 $49,315 $53,400
Self-employment tax rate 15.3% 15.3%
Self-employment tax $7,545 $8,170
Marginal income tax rate 15% 31%
Deduction for income tax from SE tax $3,773 $4,085


(TABULAR DATA OMITTED)
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Author:Bunn, Radie; Lewis, Barry; Bottin, Ronald
Publication:The National Public Accountant
Date:Jul 1, 1991
Words:2179
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