Is the self-employment tax an entrepreneurial disincentive?

After doing taxes this year, it seemed to me that self-employed individuals might be at a disadvantage when it comes to paying federal taxes.

I conveniently didn’t profit off of my self-employed venture (this blog) when you consider the cost of web hosting and cable internet, but anyone who makes a profit of more than $400 owes an additional 15.3% tax on 92.35% of that profit in order to cover their contribution to Social Security and Medicare. Based on my own historical W2s, Social Security and Medicare account for only 7.6% of my gross income.

So I set out to test the theory that the federal government imposes a financial disincentive on self-employment. In order to do so, let’s invent two people:

Sally works for company X. In 2006 she earned a gross salary of $50,000 a year.

Jim is a consultant. He often works many different jobs as an independent contractor, but in 2006 he worked solely for company X and invoiced the company for a total of $50,000 over the course of the year. Jim’s work expenses are minimal. Other than getting to and from work (usually walking), company X provides him with office supplies, workspace, and a computer.

When Sally fills out her 1040 form, she enters $50,000 from her W2 in the line marked “Wages, salaries, tips, etc.”

When Jim fills out his 1040 form, he enters 0 in that line, because all of his income was reported on a 1099-MISC form. He instead fills out Schedule C-EZ (Net Profit from Business), and considering his negligible business expenses, he enters all 50,000 in the line marked “Business income or (loss).”

Sally has no deductions, so her Adjusted Gross Income remains 50,000.

Jim, however, has to fill out schedule SE (Self-Employment Tax). His total earnings were $50,000, which he multiples times 0.9235 to figure what the government considers his net earnings: $46,175. His self-employment tax is 15.3% of that, or $7,065. He then deducts one half of that from his gross income ($3,532), giving him an Adjusted Gross Income of $46,468.

Sally takes the standard deduction plus one exemption (subtracting $8,450 from her AGI), leaving a taxable income of $41,550, and bringing her total taxes owed for the year to $6,951, 13.9% of her gross income.

Jim also takes the standard deduction plus one exemption, leaving a taxable income of $38,018, and bringing his taxes owed to $6,064 plus his self-employment tax from Schedule SE of $7,065, for a total tax burden of $13,129, or 26.3% of his gross income—almost twice that of Sally.

However, there are two things that Jim did not have deducted from his earnings that Sally did. Social Security and Medicare. Sally’s SS tax rate is 6.2%. In total she had $3,100 deducted from her paycheck for that. Her Medicare tax rate was around 1.45%. $725 was taken out for that. So in total, Sally’s take home pay was:

 50,000 gross
 -6,951 federal
 -3,100 social security
   -725 medicare
 ------
$39,224 net income (78.4% of gross)

Whereas Jim’s take home pay was:

 50,000 gross
-13,129 federal
-------
$36,871 net income (73.7% of gross)

That’s an annual difference of $2,353, nearly 5% of Jim’s gross income. That, it would seem, is the aforementioned financial disincentive, or the cost of Jim’s freedom (depending on how you look at it). I’m not joking (about the latter) either. The IRS says you are considered an employee if “the employer has the legal right to control the details of how the services are performed.” Thus Jim has to pay the government a fee of $2,353 every year in order for the simple freedom to determine “what will be done and how it will be done.”

That seemed strange to me, so I did a little research on the self-employment tax. According to the IRS website, the SE tax is indeed a means to levy the Social Security and Medicare taxes.

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.

The 15.3% SE tax consists of two parts, 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

But still, based on my past experience (where I got the 6.2% and 1.45% figures above), the self-employment tax rate is nearly double what actually gets deducted from my wages.

They go on to say that:

you can deduct half of your SE tax in figuring your adjusted gross income. Wage earners cannot deduct social security and Medicare taxes.

Though that only amounts to a tax relief of $887.

I wonder if historically self-employed persons were seen as more of a burden on Social Security after they stop working and Medicare while they are, whereas in the past many employers had pensions (now 401(k) plans), and medical plans, thus reducing somewhat the overall public burden.

This page describes the Social Security & Medicare Tax Rates from 1937 to the present, and contrasts the rates for employees vs. the self-employed:

Social Security Medicare Total
Employee 6.2% 1.45% 7.65%
Self-employed 12.4% 2.9% 15.3%

The difference hasn’t always been so severe. That changed in 1984. Stephanie suggested that maybe the employer pays the difference, confirmed by this site:

Employees have half that amount deducted from their pay, and they may feel they are paying less because their employer picks up the rest. However, when an employer looks at the cost of hiring you, he considers total cost, including payroll tax.

So in the end, it appears there is no real financial disincentive for being self-employed. Sally’s 50,000 salary really includes a hidden payroll tax paid by the employer. Her super-gross salary is something like $53,825, which consists of her stated salary plus the other half of the payroll tax paid by her employer on her behalf. Comparing a $50,000 salary to a $50,000 contractor is like comparing grapefruits to oranges.

Hilariously because Jim gets to deduct half of his self employment tax from his overall income (simply for paying it himself), he actually pays less overall tax, $887 dollars to be exact.

I should add that this exactly the opposite of what I expected. I set out to prove a disincentive, and ended up disproving it.

11 Comments

jackie

ryan was technicallly self employed last year, and of his 47,000 gross, after all deductions for “work expenses” (get a tax accountant) he ended up owing about $6000 total. i’d say self employment is a beautiful thing.

Oh, I know, and that’s probably more often the case—that an independent contractor’s expenses are greater than 0. But for the sake of comparison, I wanted to remove them from the equation.

On the other hand although you can often “find” expenses to reduce your taxes, those found expenses are presumably somewhat related to the self-employment (e.g. my web hosting and cable internet), and not trips to Europe or retirement savings or anything unrelated you’d want to spend your profit on.

Funny, rtg and I just did a similar comparison since I have been re-classed at my job and am staff instead of consultant now. Here’s the real trade-off: I am now fully insured and pensioned, but I take home $200 (20%) less each month.

Congrats on becoming permanently employed!

It’s funny, insurance is nice and all, but you’d think an employer would deign to make the move to permanent status a little more, umm, enticing than a $200/month pay cut. But congrats nonetheless.

me

I think with a difference of about $2300 it still sounds better to be working for yourself. If you plan to not have a single dollar in expenses then it may not be worth it, but the majority of self employed individuals will have a lot of deductions for office supplies, computers, etc.

Frank

I think that the comparison is actually closer than your conclusion suggests. While Jim does get to deduct half from his income Sally’s employer gets to deducts the half of her social secuity it pays. This tax savings for the employer could be paid back to Sally and then Sally and Jim would be in exactly the same position.

Kris

I was considered self employed (independent contractor) in 2005 but got a W2 from my employer that took out medicare, social security, and federal income taxes. Do I still have to pay self-employed taxes?

Ryan

Another thing to consider is how the business will file its taxes. For example. One of the promary advantages of an S-corp is that the owner can give himself a reasonable salary and take the rest of his profit has distributed earnings therby dodging 7.5% of the FICA. You do not get this advantage if you file as an LLC. However and LLC has its advantages if you own large equipment such as tractors and cars. You can sell these items at a stepped up basis and dodge a lot of tax that way.

The first comment is correct(a tax accountant is the best answer).

Naomi

This is really old so probably no-one will read this but it’s just for me to vent my frustration on having to pay self-employment tax. This year, 2007 I earned less money overall than in 2006 by almost a thousand dollars. However, this year I also work as both an employee and as self-employed. I happenned to make more money self-employed than I did employed. Last year, 2006 for making about 29,000 I owed about 3900 overall in taxes. This year, 2007, for making about 28,000 overal I owe one thousand dollars MORE in taxes because of the self-employment tax…. now I used to work in HR so I understand that normally the employer is paying taxes on you but it still seems rediculous to me that for someone who makes so little money I have to pay so much in taxes…. they’re basically leaving me with not enough to live off of.

Mandi

VENT VENT… I agree… I ended up paying 42% of my taxable income to the IRS this year. Crazy… I earned 41,000. And ended up with $23,000 left to pay state and live on. I have school loans to pay, and my mortgage, and I agree: barely enough to live on.

Mandi, 42% at $41k sounds rather high. Federal taxes plus social security and medicare should account for around 25-27%, and state tax depends on your state—but in California it would be around 8%, so total taxes would be around 35%. Might be worth having an accountant look over your taxes.

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