The hidden bite of the self-employment tax
Consider this simple example of an entrepreneur who generated $125,000 of income (after expenses) in his or her business last year. We’ll assume this person is single and takes the standard deduction. At that income level, the business owner would pay about $38,000 in taxes, or around 30 percent of his income. That’s a pretty high tax rate; way higher than Warren Buffett’s, Mitt Romney’s and even President Obama’s (which was reported at about 26 percent in 2010).
Why is it so high? Well, it’s not the income tax that’s really the issue. It’s the self-employment tax. This is the tax that business owners pay for Social Security and Medicare. It’s generally 15.3 percent on your first $106,800 of wages (but last year you got a 2 percent temporary rate cut, which will expire at the end of 2012). Of our sample entrepreneur's total $38,000 tax bill, about $14,500 is from the self-employment tax.
Plus, if you have any employees, you also get to pay half of their FICA taxes, which is the employee version of the Social Security and Medicare tax. That costs you another 7.65 percent. So not only are you paying your taxes, you’re paying some else’s too. And unfortunately, most employees don’t understand that you’re paying half of their taxes for their Social Security and Medicare benefits.
Wait. It gets worse.
This year, 2012, the taxable wage base for self-employment and FICA taxes jump to $110,100, which means you’ll owe even more in self-employment and FICA taxes for both you and any employees who make up to $110,100. And remember that you pay the Medicare tax of 2.9 percent on all your income, even the portion that’s higher the FICA wage base of $110,100.
If you’re concerned about tax rates as a business owner, the real challenge in the future will come from potential increases in the self-employment tax you pay on your wages and FICA tax you pay on your employees’ wages. There’s probably not much room for big income tax increases. We could see a jump in a few percentage points on the top end, but that’s probably about it.
What I would be afraid of is a push to subject all (or more) wages to self-employment and FICA taxes. For every dollar increase in the wage base, you owe 15.3 percent more in taxes on your income and 7.65 percent more on your employees’ wages.
Why a FICA hike is so tempting
It’s an easy way for Congress to try to back-door a tax hike without having to vote an “income” tax increase. You may have already seen some of these ideas batted around. Most people don’t understand how the self-employment and FICA taxes work or who pays them. And politicians can link the tax to the two main challenges we have with our Federal deficit, which are Social Security and Medicare.
As a business owner, keep your eye on how politicians react to the self-employment and FICA tax issues. That’s where the real battle is likely to be, and it could pose a big threat to the profitability of your business.