Miner & Lemon Blog

Tax Savings Series Part 4 - "The Self-Employment Tax or All These Taxes Are Taxing My Patience"

The Self-Employment Tax or All These Taxes Are Taxing My Patience

            In today’s post we will consider the workings of the self-employment tax, along with methods for its reduction.

                IRC 1401 imposes a tax “on the self-employment income of every individual,” which is known as the Self-Employment Contributions Act (SECA) tax.  This tax is analogous to the Federal Insurance Contributions Act (FICA) tax, which is imposed on those who are employed by others.  There is, however, one significant difference, half of the FICA tax is paid by the employee and the other half is paid by the employer, whereas the self-employed individual must pay both halves.  The SECA tax is made up of two parts: a Social Security tax of 12.4%, which in 2008 is applied against self-employment income up to $102,000; and a Medicare tax of 2.9%, which is applied against all self-employment income. 

                When performing the calculation to determine the SECA tax obligation, it must be remembered that, again, even in the case of self-employed individuals conceptually there is still an employee’s portion and an employer’s portion.  The first step in the calculation is to multiply net earnings from self-employment by 7.65%, which represents the employer’s portion of the SECA tax.  The second step is to subtract the product of this computation from self-employment net earnings.  These first two steps function to ensure that self-employed individuals are not required to count amounts paid regarding the employer’s portion as net earnings from self-employment when determining the amount of SECA tax due.  The third step is to multiply the resulting amount by the applicable rates (15.3% on the first $102,000, 2.9% on everything above that) to determine the SECA tax obligation.  However, one-half of this amount can be taken as an above the line deduction, which ensures that the self-employed individual will not be required to pay income tax on the employer portion of the SECA tax.

                There are several effective methods for reducing the amount of the SECA tax obligation which revolve around the concept of transforming income from self-employment income to income which is excluded from self-employment income.  IRC 1402 lists numerous sources of income that are to be excluded from self-employment income.  Among these the more typically utilized are real estate rent, dividends, capital gains, and distributions related to limited partnership interests.

                There are several techniques which may be of benefit to farmers.  A farm business can be bifurcated into two limited liability companies: one company to own the land, and the other to conduct the farming operations.  The operating company would then pay reasonable rent to the land owning company.  The effect of this is to transform income that would otherwise be a part of “net earnings from self-employment” to income which is excluded.  Of course, either way the farmer would still be responsible for paying income tax on this income, but to the extent that the income is received as rental income the farmer is not responsible for paying SECA tax.

                Another method for increasing the amount of excluded income is to organize the farm as an S Corporation and pay out reasonable salaries and make distributions.  S Corporations are taxed as pass-through entities (similar to partnerships), which means that the shareholder or shareholders are taxed on the income produced by the business but that the corporation itself does not pay any tax (as would a C Corporation).  After the farm has been organized as an S Corporation it can then pay a reasonable salary to the farmer or farmers, to which salary the FICA tax would apply.  Why FICA and not SECA?  Because an individual who is employed by a corporation is not self-employed (for tax purposes), even if that individual owns 100% of the corporation that employs him or her.  Any amounts remaining after the payment of reasonable salaries could then be distributed free of any FICA or SECA tax obligations, although, of course, these amounts would still be subject to income tax.

                Finally, I would be remiss if I failed to mention that there are also various ways of dividing ownership interests in limited liability companies between active and passive that have been used to reduce SECA taxes.  In 1997, the IRS issued proposed regulations in an attempt to clarify SECA tax treatment as applied to limited liability companies.  But due to controversy, the proposed regulations were never adopted, and, as a result, application of the SECA tax to limited liability companies remains ambiguous.  However, it is unlikely that the IRS would challenge a taxpayer proceeding in conformity with the proposed regulations, and, if caution is exercised, this is a strategy that some farmers may find to be of benefit.

                Please join me next time for: Indiana Property Tax Reform or Indiana Property Tax Fiasco.