self-employment tax explanation


C

Casey

I have been self-employed for a few years, and I understand
how to calculate the SE tax. I have a question about the
implementation of one step that we take, specifically, the
way we arrive at net earnings. Perhaps someone can enlighten
me.

Currently, we multiply our net profit by .9235. I
understand that the idea behind doing this is to remove the
self-employment earnings that are really the *employer's*
share of the taxes so that we don't have to pay SE tax on
those as well. However, this to me means that the total
amount of taxes paid is slightly less than under a regular
employer/employee set up. It would seem more accurate to me
if, instead of multiplying by .9235, we divided by 1.0765.

Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.

Of course, if I've been unclear, please let me know.

Thanks,

-Casey
 
Last edited by a moderator:
Ad

Advertisements

B

Bill Brown

Casey said:
I have been self-employed for a few years, and I understand
how to calculate the SE tax. I have a question about the
implementation of one step that we take, specifically, the
way we arrive at net earnings. Perhaps someone can enlighten
me.

Currently, we multiply our net profit by .9235. I
understand that the idea behind doing this is to remove the
self-employment earnings that are really the *employer's*
share of the taxes so that we don't have to pay SE tax on
those as well. However, this to me means that the total
amount of taxes paid is slightly less than under a regular
employer/employee set up. It would seem more accurate to me
if, instead of multiplying by .9235, we divided by 1.0765.

Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.
You're missing something basic. The law says to multiply by
..9235.
 
Last edited by a moderator:
D

Dick Adams

Casey said:
I have been self-employed for a few years, and I understand
how to calculate the SE tax. I have a question about the
implementation of one step that we take, specifically, the
way we arrive at net earnings. Perhaps someone can enlighten
me.

Currently, we multiply our net profit by .9235. I
understand that the idea behind doing this is to remove the
self-employment earnings that are really the *employer's*
share of the taxes so that we don't have to pay SE tax on
those as well. However, this to me means that the total
amount of taxes paid is slightly less than under a regular
employer/employee set up. It would seem more accurate to me
if, instead of multiplying by .9235, we divided by 1.0765.

Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.

Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.
1. The Social Security Administration collects the money.
2. What you see as a $45 disparity is due to the independent
contractor being treated as his/her employer. You would
get the same result if A's employer was allowed to pay
both sides of FICA and Medicare.
 
Last edited by a moderator:
C

Casey

1. The Social Security Administration collects the money.
2. What you see as a $45 disparity is due to the independent
contractor being treated as his/her employer. You would
get the same result if A's employer was allowed to pay
both sides of FICA and Medicare.
Really? If A's employer paid both sides of FICA and
Medicare, why wouldn't it simply pay 15.3% of 50K, which is
$7650?

I know this is trivial, but it's interesting to me and I'd
like to fully understand it.

Thanks!
 
Last edited by a moderator:
L

L K Williams

Casey said:
Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.

Of course, if I've been unclear, please let me know.
The computation is not that simple -- you are actually doing
a circular calculation.

The .9235 formula gives the answer that equals 1/2 of the
tax actually paid. Remember, you deduct the 1/2 in
calculating the tax you pay. If you just take 1/2 of the
..153% of Schedule C income, you get a deduction that is more
than 1/2 of the final tax. By using the .9235 rate, the
deduction allowed is 1/2 of the tax paid.

Lanny K. Williams, CPA
Nawarat, Williams & Co., Ltd.
Income Tax Services for Expatriate Americans
 
Last edited by a moderator:
M

Mark Bole

You're missing something basic. The law says to multiply by
..9235.
True, but the law is mathematically incorrect, the OP is
completely correct from a math-only standpoint. I suppose
no one cares because (1) the error is in the taxpayer's
favor and (2) it's hard enough for many people to grasp as
it is without actually making the math correct.

The only other post I have ever seen regarding this was in
this very group on Nov 13, 2001, from Michael Wing, CPA.
Try the following or if it doesn't work search the group
archives on Google for "92.89 tax".

http://snipurl.com/1b0e4

It's like this:

If the employer forks over $100, the employee's gross pay is
$92.89 (not $92.35). The employee's share of FICA is $92.89
* 7.65% = $7.11. This equals the employer's match, which is
the difference between what the employer forked over and the
employee's gross wages, or $100 - 92.89 = $7.11.

-Mark Bole
 
Last edited by a moderator:
L

L K Williams

Casey said:
Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.

Of course, if I've been unclear, please let me know.
The computation is not that simple -- you are actually doing
a circular calculation.

The .9235 formula gives the answer that equals 1/2 of the
tax actually paid. Remember, you deduct the 1/2 in
calculating the tax you pay. If you just take 1/2 of the
..153% of Schedule C income, you get a deduction that is more
than 1/2 of the final tax. By using the .9235 rate, the
deduction allowed is 1/2 of the tax paid.

Lanny K. Williams, CPA
Nawarat, Williams & Co., Ltd.
Income Tax Services for Expatriate Americans
 
Last edited by a moderator:
S

Stuart A. Bronstein

True, but the law is mathematically incorrect, the OP is
completely correct from a math-only standpoint. I suppose
no one cares because (1) the error is in the taxpayer's
favor and (2) it's hard enough for many people to grasp as
it is without actually making the math correct.
Whoever wrote the law just didn't understand math very well
and came up with a conclusion that seemed reasonable, though
it was inaccurate.

Normally the solution would be to go to congress to have
them correct their mistake. But, as you say, since it's in
the taxpayer's favor that's unlikely to happen any time
soon.

Stu
 
Last edited by a moderator:
Ad

Advertisements

M

Mark Bole

L said:
Suppose person A is employed by firm B and has W-2 wages of
$50K. [...]
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:
[snip]

The computation is not that simple -- you are actually doing
a circular calculation.
Can you elaborate on that?
The .9235 formula gives the answer that equals 1/2 of the
tax actually paid. Remember, you deduct the 1/2 in
calculating the tax you pay. If you just take 1/2 of the
..153% of Schedule C income, you get a deduction that is more
than 1/2 of the final tax. By using the .9235 rate, the
deduction allowed is 1/2 of the tax paid.
Sorry but I can't let go of this yet -- comes from being a
math major.

We all agree that the whole point of this is to treat the
self-employed person, who wears both the employer and
employee hats, comparably to a separate employer/employee
arrangement. We all understand why the total profit has to
be reduced first before calculating the employee's FICA and
the employer's matching share of FICA. What we don't yet
agree on is that a minor algebraic error was made when the
reduction factor was written into law.

Here's another approach that might make it easier to
understand: work backwards on the Schedule SE.

Suppose the line 3 amount, net profit, is $1,000. This
represents the total out-of-pocket cost to the employer for
this employee. Line 4, net earnings from self-employment,
will be $923.50, which is supposed to represent the gross
wages that the person wearing the employer hat would pay to
the person wearing the employee hat. We now correctly apply
15.3% to this number on line 5, giving $141.30, which
represents the employee's 7.65% and employer's matching
7.65% of gross wages. Or, to restate, the employer's match
is one half of the total, or $70.65. If we add the
employer's match of $70.65 to the employee's gross wages of
$923.50 on line 4, as we would in a true employer/employee
arrangement, we get $994.15 total out of pocket from the
employer. But we started with $1,000 on line 3 -- hence the
error.

If we applied the mathematically correct rate of 92.89% on
line 4, the problem would go away.

But the error favors the self-employed individual in that
they pay slightly less SE tax on themselves than they would
on an employee being paid the same, so who's complaining?

-Mark Bole
 
Last edited by a moderator:
S

Shyster1040

Mathematically, the statute is incorrect. Sec. 1402(a)(12)
provides that, in determining the "self employment net
earnings" (i.e., the base of the SE tax)(which I'll call
SENE for short here), the taxpayer is allowed a deduction in
lieu of the deduction provided in Sec. 164(f) in the amount
of the SENE determined without the 1402(a)(12) deduction
(which amount I'll call SENEX), times one half the sum of
the rates imposed by Secs. 1401(a) and (b).

Thus, in determining SENE, the taxpayer determines SENE by
subtracting from SENEX an amount equal to 7.65% of SENEX.

In other words, under Sec. 1402(a), SENE equals SENEX *
1-.0765 = SENEX * 0.9235.

However, if one were to compute SENE by treating half of the
ultimate SE tax as the analogue of an employer's portion,
one would need to determine the amount of the deduction to
be taken against SENEX in arriving at SENE.

In other words, if x is the amount to be deducted as the
analogue to the employer's portion, then SENE = SENEX - x.

Of course, x is equal to 1/2 * 15.3% * SENE, or, in other
words, x = 7.65% * SENE.

Thus, since we first have to get a definite number for SENE,
which we can only arrive at in terms of SENEX, we start with
SENE = SENEX - (7.65% * SENE)
From that we get SENEX = SENE + (7.65% * SENE)
Which gives us SENEX = SENE * (1.0765)

Which gives SENE = SENEX / (1.0765)

Which, when put back into our equation for x, yields:

x = 0.0765 * [SENEX / (1.0765)]

Which yields:

x = SENEX * (0.0765 / 1.0765)

Which simplifies to:

x = SENEX * 0.071063632....

In other words, the amount that should be allowed as a
deduction from SENEX in determining SENE is an amount equal
to approximately 7.106% of SENEX which, if we round to only
two significant digits, is 7.11% of SENEX.

Therefore, to be mathematically correct, Sec. 1402(a)(12)
should permit a deduction in the amount of the product of
SENEX times .0711 and not in the amount of the product of
SENEX times .0765.

More likely than not, this sort of computation simply taxed
the brains of the statute-writers in 1983 when paragraph
1402(a)(12) was added by P.L. 98-21. It was simply easier,
in the rush of getting the amendment typed up and ready for
a vote by Congress, to subtract 1/2 of the 15.3% SE tax
being imposed, rather than to work through the mathematical
issues. Also, and more charitably, the rates were changing,
which would have meant that the computation I just went
through above would have to be worked out each time the
rates changed, so they may have simply settled on allowing a
deduction for 1/2 of whatever the rates happened to be at
the time.

That being said, I doubt if that error will ever be
corrected short of as part of an overall, comprehensive
reform of the tax code; something we are unlikely to see in
the near future.
 
Last edited by a moderator:
C

clj1219

Casey said:
Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Note, the operative word here is TOTAL money involved. This
includes the employers share of the FICA. The employee is
not taxed on the TOTAL money, only the wages. The employer
is not taxed on the TOTAL money, only the wages.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)
This not comparing apples to apples. You are comparing a
different amount than in the first example. You are
comparing TOTAL money with Schedule C profit.

So, I think in answer to your question, yes you are missing
something basic here. You're using two different amounts of
"profit" to come up with two different answers and expecting
them to be the same answer.
 
Last edited by a moderator:
B

Bill Brown

Mark Bole said:
True, but the law is mathematically incorrect, the OP is
completely correct from a math-only standpoint.
So what?

By the way, your assertion that the law is "incorrect" is
based upon your assumption regarding what the law intends.
A safer assumption is that the law intends what it
accomplishes.
 
Last edited by a moderator:
C

Casey

Thank you everyone for weighing in on this topic. After
reading all of your posts, I think I understand the
situation: as I originally suggested and then three posters
confirmed, there appears to be a minor algebraic error in
how the SE tax is calculated. Nobody really complains
(myself included) because the error falls in the taxpayer's
favor.

Very interesting! Thanks for your time!

-Casey
 
Last edited by a moderator:
Ad

Advertisements

C

Casey

I agree with you that it's *possible* that the law intends
exactly what it accomplishes. However, this possibility
seems very unlikely.

I think it's more likely that it *intends* to do what most
people understand its intent to be--namely, to reduce the
burden on the self-employed individual by the amount of fica
taxes that an employer would otherwise pay.

Therefore, the law is indeed mathematically incorrect,
because it does not exactly accomplish its intent (it's off
by a fraction of a percent).
 
Last edited by a moderator:

Ask a Question

Want to reply to this thread or ask your own question?

You'll need to choose a username for the site, which only take a couple of moments. After that, you can post your question and our members will help you out.

Ask a Question

Top