Self-Employed Fair Tax

by Dan Jacoby

Self-employed people pay too much tax.

The reason this is so is somewhat esoteric; I shall try to clarify it.

FICA stands for Federal Insurance Corporation of America. It comprises Social Security and Medicare. Both Social Security "Old Age and Survivor Insurance" (OASI) and "Disability Insurance" (DI), and Medicare Part A, "Hospitalization Insurance" (HI), are funded with dedicated taxes. Medicare Part B, "Supplemental Medical Insurance" (SMI), is funded from appropriations from the general fund.

Under current rules, employees pay 6.2% of their first $89,400 of income in Social Security tax. They also pay 1.45% of all their income in Medicare tax. Employers must match these payments. Self-employed people must pay both the employee and the employer portions. Currently, this means that self-employed people pay 12.4% of the first $89,400 for Social Security, and 2.9% of all income to Medicare. Since employees are only required to pay income tax on the portion of dedicated FICA taxes they pay, and not on the portion paid by employers, self-employed people are entitled to deduct half their FICA payments when figuring income tax.

The problem occurs when a self-employed person is considered as both employee and employer.

For example, when an employee has a salary of $50,000, FICA tax is paid based on $50,000 of income. But the employer also has to pay $3,825 in FICA tax, making the total cost to the employer not just the $50,000 salary but $53,825. A self-employed person with $53,825 in income, however, pays FICA not on the "employee's" portion of that income, namely $50,000, but instead must pay FICA on the entire $53,825. In other words, the self-employed person must pay FICA on an additional $3,825. While the self-employed person can deduct half of that when figuring income tax, it barely makes a dent in the additional payment.

Additionally, while a self-employed person's Social Security tax caps at $89,400 of income, while the "employer" of someone with that salary has a total cost of $96,239.10, so a self-employed person making something between $89,400 and $96,239.10 gets a break, it does not make up for the additional tax paid. Furthermore, the extra tax paid on Medicare continues to climb. The chart at the bottom shows the additional tax paid at various income levels.

The solution is to adjust three levels.

The first adjustment is the percentage of income paid to Social Security. The new percentage is equal to the 12.4% paid by employees and employers combined divided by the 107.65% of employee's income that represents the total cost to employers. The result rounds off to 11.52%. Additionally, this tax should be paid on the total cost to an employer for an employee who makes exactly the $89,400 cap. Rounding off, this comes to $96,240.

The second adjustment is the percentage paid to Medicare on the first $96,240 of self-employed income. Again, the formula is 2.9% divided by 107.65%, coming to 2.694%.

The final adjustment is the percentage paid to Medicare on income above $96,240. At this point, Social Security taxes are no longer paid, so the formula is 2.9% divided by 101.45%, the latter number being the percentage of employee's income that represents the total cost to employers. The result here is 2.86%.

The table immediately below shows the final result:

Proposed self-employment tax:

Employee

Self-Employed,
Current

Self-Employed,
Proposed

Social Security

6.2% of first $89,400; employer matches

12.4% of first $89,400;
1/2 tax deductible

11.52% of first $96,240;
1/2 tax deductible

Medicare

1.45% of all income; employer matches

2.9% of all income;
1/2 tax deductible

2.694% of first $96,240,
2.86% of rest of income;
1/2 tax deductible

Extra tax paid, $50,000 income

$517.92
$0.61

Extra tax paid, $100,000 income

$174.40
$1.28

Extra tax paid, $200,000 income

$204.44
$2.47

 

Copyright 2004, Dan Jacoby

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