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Proposed Changes to Self-Employment Tax Rules

The Biden administration has proposed significant revisions to the self-employment tax rules in “The Green Book.” Here’s what you need to know about these changes and how they could impact your taxes next year:

If you have wages and receive Self Employed Income, it’s reduced by their wage income for that year.

The Section 199A deduction benefit of 20% of business income for many taxpayers doesn’t reduce the base when computing self-employment tax. The self-employment tax has no net operating loss, so your base for computing the tax over two years is based on positive business income in one year and not what you lost during that time (Section 1402(a)(4)).

The Medicare tax rate for self-employment earnings is 2.9%. This tax on self-employment earnings applies only to the base amount, which was $182,000 in 2021. The amount you owe will depend primarily upon how much money was generated by this source, with some exceptions for certain expenses like medical insurance or equipment costs which are treated differently than other business-related expenditures. 

The higher your earning power, the more Medicare tax you will pay. There’s an added 0.9% burden on self-employed individuals above specific threshold amounts that apply to everyone – $250 thousand for married filing joint taxpayers and so forth (See IRS Topic No 554: Self Employed Income,

When filing your taxes, three possible rates enter into the calculation – 12%, 2%, and 90th percentile. These all can be found in Section 1401(a), (b)(1) &(2). See sections 1402-1403 with their respective regulations under these provisions).

The self-employment earnings tax is calculated by first reducing business income with a factor of 7.65%. Half comes from 12% + 2%, or 50%. This adjustment remains the same, even when considering the 0.9% Medicare Tax.

The tax code allows for an income tax deduction equal to half of what you calculated immediately preceding paragraph. This only applies if it’s being used as part of your taxes and doesn’t affect how much self-employment liability there may be. 

The self-employed person’s health insurance premium is generally deductible from their adjusted gross income. Still, it can be used for repayment purposes when claiming certain benefits like traditional IRAs or social security payments after retirement.

Wages that enter into the employer’s team member retention credit are subject to standard payroll tax regimen (see also “COVID-19 -Related Employee Retention Credits: General Information FAQ,” IRS).

One common tax issue which may involve payroll taxes is the characterization of payouts to shareholders. In a C corporation context, these payments can be reported as wages subject to corporate income tax to achieve an additional deduction for compensation at your company’s level.

The goal of the IRS is to achieve tax efficiency. If you made payments characterized as wages, then it could be argued those dividends were partly nondeductible and should not have been taxed at all or paid back with interest on top of what was already owed. This would result in an overpayment by your company’s payroll department.

In an S corporation, the IRS is usually found arguing that dividends distributed from a company’s profits are subject to payroll tax. However, there have been some recent cases where this argument did not hold up. It was determined that these payments were instead generally seen as wages that do not incur any related costs or obligations on behalf of either party (An example being Ward TC Memo 2021-32).

The IRS has found that these intricate rules, such as basis loss limitation under Section 704(d) and at-risk restrictions from 465, affect self-employment tax computations.

Self-Employment Tax Increase Proposals

There are discussions of lifting any limit on the regular social security tax, which is 12%, increasing annually. However, this particular concept did not reach into Green Book.

The proposals discuss a 3.8% Medicare tax that will apply to nearly all self-employment income and .9 percent, which starts using at higher levels of earnings, for example, over $200K per year (depending on what level one configures).

The Green Book is an invaluable resource for anyone looking to take advantage of their tax obligations. It discusses the relationship between these two taxes, noting that one cannot be subject to both provisions at once. It also argues why we need a more expansive base to avoid putting too many people in limbo due to limitations imposed by current law.

The green book states, “Active owners of pass-through businesses are treated differently for purposes of net investment income tax and SECA tax according to the legal form of their ownership and the legal structure of the payment that they receive.” S corporation owner-employees and limited partners only pay on a portion of their earnings. LLC members pay little or no SECA tax.

We see that Section 1402(a)(13) prevents self-employment tax from being imposed on “the distributive share of any item,” which is an income or loss arising from partnerships. This includes guaranteed payments described in 707(c).

The IRS has proposed expanding the scope of two existing tax provisions, which would affect both corporate and white-collar bonuses. The new tax would be imposed on taxpayers with more than $400,000 in adjusted gross income. The definition of “net investment” includes all sorts of trades or businesses that are not otherwise subject to employment taxes.

The White Paper mentions “SECA,” which includes the 12.4% tax and 2%. However, we don’t think this topic is limited only in the scope of taxes that are being imposed on individuals – it also pertains to how those who have income should be taxed currently under current law.

The new legislation would subject S corporations to SECA taxes on their distributive shares of the business’s income that exceed specific threshold amounts. The SECA tax will be implemented beginning in 2022, and it has been decided that the threshold amount for this new form of taxation would start at $400,000. This means you could potentially owe IRS taxes if your income exceeds this figure by even 1%. However, exemptions from this tax for types such as rents and dividends will still apply in some cases.

Material participation standards would generally apply to individuals who participate in a business with some level of ownership. Taxpayers are usually considered “material participants” if they work for at least 500 hours per year and have an active role throughout the operation, such as being on board or managing staff members. The exception provided by SECA tax code does not exempt limited partners from paying taxes related to self-employment income; this includes tangible property used exclusively by these types of partnerships (such as cars).

In conclusion, many self-employed taxpayers could be affected by significant tax increases. Many could see their taxes increase significantly if they are not correctly classified, especially when there is no documentation proving hours worked or where those records exist but do not appear in any database. It may be time to consider reviewing the tax rules for freelancers and independent contractors.