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Tax Tip: Self-Employment Taxes

Self-Employment taxes are Social Security and Medicare taxes.  If you are an employee, half of the taxes are withheld from your paychecks and the other half is paid by your employer.  If you are self-employed, you get to pay all of the taxes yourself.   Lucky you.

Self-employment taxes are assessed upon your net self-employment income over $400.  Without delving into all of the various types of self-employment income, it basically means being paid for your hard work and efforts.  It does not include interest income, dividends, capital gains, pensions or other investment income.  Some of the common forms of self-employed income include:

  • Net earnings from a trade or business
  • Consulting and director fees
  • Tips
  • Payments for any services you provide to another person (e.g., maintenance, repairs, cleaning)
  • Pass through income from a partnership or limited liability company

A portion of your self-employed income may be reported to you on a 1099-MISC or a partnership Schedule K-1, but it’s highly likely that some self-employed income won’t be reported to you.  The income is taxable to you even if you don’t receive a 1099, Schedule K-1 or other tax reporting statement, and getting paid in cash doesn’t mean you don’t have to report the income.

Just like an employee, the tax is divided between Social Security and Medicare.  The Social Security tax portion is assessed at 12.4% on the first $106,800 of income for 2010 and 2011.  Since there is no cap on Medicare earnings, you’ll pay 2.9% on all of your self-employed income, no matter how high it goes.  The good news is that you get to deduct half of the self-employment tax in computing your adjusted gross income.  The bad news is that if you’re married, you and your spouse are subject to the tax separately.

There is one taxpayer favorable provision that you want to take advantage of in 2010.  For this year only, you can deduct your self-employed health insurance premiums in determining your net self-employed income.  It’s a one-year benefit, unless Congress decides to extend it.

Special rules can apply to farmers, real estate professionals, ministers, and investors.  It can get complex rather quickly, and the myriad of potential issues are beyond the scope of this article.  If you have questions or wonder if certain income is subject to self-employment taxes or exempt, you should consult a tax professional. 

With an effective tax rate that can be over 15%, self-employment taxes add up quickly.  Better to get it right, than be surprised with an unexpected tax bill later.

Burdensome 1099 Tax Reporting

The tax gap is the deficiency between the amount of tax that should have been paid and the amount that is voluntarily reported and paid by taxpayers.  The IRS estimates the tax gap to be $350 billion annually.

Underreporting of income is a primary contributor to the tax gap.  Form 1099 reporting is one of the mechanisms the IRS uses to ensure that taxpayers report income they receive.  A 1099 is issued by the payer to the payee.  The IRS will match the income reported on the taxpayer’s return with the 1099, and a discrepancy will generate a notice. 

A Form 1099-MISC must be filed to report the payment of more than $600 for compensation for services.  This would typically involve people who perform independent and subcontract services (e.g., contractors, lawyers, consultants).  Payments to corporations for these services were exempt from 1099 reporting.

For years the IRS has advocated for an expansion of the reporting requirement to include corporations.  Not only did Congress act upon the suggestion last year, they expanded it. Included in the Patient Protection and Affordable Care Act (aka Obamacare) was a requirement for any business to issue a 1099-MISC to any person or entity for the purchase of more than $600 of goods or services during a calendar year, starting in 2012.

Under the old rules, a taxpayer had to track payments made for services rendered by nonemployees.  The new requirement will force businesses to track the purchase of goods and services.  For instance, if you purchase more than $600 of office supplies, lumber or gas from one retailer throughout the year, you must issue a 1099-MISC.  Imagine the paperwork and administrative nightmare this creates for any business to comply with these rules.

Not surprisingly, this expanded requirement has generated a tremendous firestorm of criticism, especially amongst small business owners.  This provision is supposed to generate $17 billion of revenue over ten years, but I doubt anyone quantified the cost of compliance, both for the IRS and for taxpayers. 

Personally, I think the net revenue generated from this provision is greatly overstated.  It might generate $17 billion in new revenue, but the IRS could easily spend more than that amount just to process the mountain of forms that will be filed.  

It’s been rather humorous to watch the politicians handle this issue.  Congress included this provision in the healthcare bill and President Obama signed it, yet over the past six months, there has been a parade of politicians, including the President, who have talked about how bad this requirement is for business and the need to get it reversed.  It’s funny; the same people who created the requirement are now championing its repeal.  Only in Washington is this considered normal.

Despite months of clamoring, Congress still hasn’t repealed this reporting requirement.  Last week, the Senate added it to a bill dealing with modernization and safety issues of the Federal Aviation Administration.  Most commentators and professionals expect it to be repealed; it’s just a matter of when.  I think Congress knows they will eliminate it too, which is why they aren’t rushing to pass the repeal.

To me, it’s just another example of the dysfunction that is prevalent in our nation’s Capitol.  They know it’s bad, and they know they’ll eliminate it.  Rather than having a simple vote to repeal the rule and move on to other business, it gets dragged out for months and wrapped into some political deal.  I ask… what does 1099 reporting have to do with a safety bill for the FAA?

The expansion of the 1099 reporting was a poorly conceived idea with little consideration of the real world compliance implications.  It never should have been enacted, and I expect it will be repealed this year.  If you’re a business owner, you can be thankful that this is one tax reporting requirement you’ll never have to comply with, but the sooner you know for sure, the better.

Tax Tips – Make an IRA Contribution

With the start of a new year, there is little that you can do to change your tax liability for last year.  It’s history now.  About all that is left is preparing your tax return correctly and making sure you don’t miss any deductions that you may be allowed. Like most tax rules, there are a few exceptions. 

One exception is making a contribution to an Individual Retirement Account (IRA).  You have until April 18, 2011 to make a 2010 IRA contribution. 

Be advised that there are many different rules regarding the amount you can contribute and deduct as an IRA contribution. 

The maximum contribution to an IRA for 2010 and 2011 is $5,000.  If you are at least age 50 by the end of the year, you can contribute an additional $1,000.

There are several rules regarding the deductibility of your IRA contribution.

  • Your deduction is limited to the lesser of the contribution limit ($5,000 or 6,000) or the amount of taxable compensation included in your gross income.
  • You can deduct the full amount if you are not an active participant in an employer-sponsored retirement plan (there is a box on your W-2 that will be checked if you are an active participant).
  • If you participate in an employer-sponsored pension plan, your contribution is fully deductible if your Adjusted Gross Income (AGI) is less than $109,000 if you’re a joint filer or $56,000 if you file as a single or head of household.  Your contribution will be limited if your AGI is above these amounts.
  • No deduction is allowed for a tax year in which the taxpayer turns 70½, or in subsequent years.
  • If your spouse doesn’t participate in an employer-sponsored pension plan, you can make a contribution on behalf of your spouse, provided that you have sufficient taxable compensation.

If you participate in an employer-sponsored pension plan, you can still make a nondeductible contribution.  The contribution will not be deductible, but the earnings of the IRA will continue to be tax-deferred, which means the earnings of the IRA will not be taxable until you withdraw the funds.

If you have not yet made a 2010 contribution to an IRA, it’s not too late.  You have until April 18th to make the contribution.  It is one thing that you can do in 2011 to reduce your 2010 tax liability.

Is It Bad to Pay Income Taxes?

I’ve been in the tax business for over 20 years.  Having dealt with scores of clients, I’ve talked with all kinds of people and dealt with a myriad of situations.  Although people may accept the requirement and necessity to pay taxes, there is a general disdain for paying taxes and filing tax returns.

I often hear people bemoaning the amount of taxes that need to be paid.  You may have heard someone say that they don’t want to make more money, because they’ll have to pay more taxes.  My response to that statement is rather blunt… that is stupid.  Sorry, if I’ve offended you, but let me explain why I was so brash in my comment. 

As I tell my clients there are worse things in the world than paying taxes.  Income taxes are assessed on income.  Thus, there is a general premise that you must earn income to require the assessment of taxes.  If you don’t pay taxes, it means you aren’t making money. Think about this… if you paid any taxes in 2008, you probably paid more taxes than Ford, General Motors, Chrysler and many of the big U.S. banks combined.  All of those companies lost billions of dollars in 2008.  As they were fighting for their survival, paying income taxes was not the most important concern of the executives, employees and shareholders.

With the extension of the Bush tax cuts, the top federal rate is 35%.  Add in state, local and Social Security taxes, and your top marginal tax rate could be 50-55%.   Even if your rate is 50%, you get to keep 50% of what you make.  Thus, for every extra dollar you make, you have 50 cents to spend.  As long as the tax rate is less than 100%, you will still come out ahead if you make more money and pay taxes. 

Many years ago, one of my wealthy clients told me that he was privileged to pay $1 million in taxes each year.  At the time, he was making over $2 million.  Although he lost over one-third of his income to taxes, he still had more than $1 million to spend.  Would you prefer make $50,000 a year and pay no tax or be in his situation?

Granted, you would probably like to pay less in taxes, as would my client who paid the $1 million, but that is a different discussion. 

The simple fact is that our government raises part of its revenue by levying an income tax.  You may not like the amount of tax that you pay, but there are worse things than paying taxes.  Furthermore, the more that you more you make, the more you pay, and as a result the more you pay, the more you have to spend.

Thus, I am of the opinion that paying income taxes is a good thing.