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Subject Author Date
self-employment tax explanation Casey 02-19-2007
Posted by Casey on February 19, 2007, 8:46 pm
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 I have been self-employed for a few years, and I understand
how to calculate the SE tax. I have a question about the
implementation of one step that we take, specifically, the
way we arrive at net earnings. Perhaps someone can enlighten
me.

Currently, we multiply our net profit by .9235. I
understand that the idea behind doing this is to remove the
self-employment earnings that are really the *employer's*
share of the taxes so that we don't have to pay SE tax on
those as well. However, this to me means that the total
amount of taxes paid is slightly less than under a regular
employer/employee set up. It would seem more accurate to me
if, instead of multiplying by .9235, we divided by 1.0765.

Suppose person A is employed by firm B and has W-2 wages of
$50K.

Person A fica withheld: 50K * .0765 = $3825
Firm B matching withholding: $3825

The total money involved here is $53825 (this is the cost to
the firm of employing person B), and the IRS collects $7650.
Now, let's assume that person C is a self-employed
individual with Schedule C profits of $53825--we would
imagine that the end results would be the same, but they
aren't, because the 92.35% adjustment (to remove the
employer's contribution) actually removes *more* than the
employer paid in the previous example:

$53825 * .9235 = $49707
$49707 * .153 = $7605 (total that the IRS collects)

You can see that Person C pays his/her 15.3% on a slightly
smaller amount (49707) than A+B pay their taxes. This is
because with C, the 7.65% tax that is removed is 7.65% of
the *entire* amount (i.e. it includes the salary of A plus
the taxes paid of B) instead of just removing the taxes that
would have been paid in the previous scenario (which would
be B's taxes paid: 7.65% of A = $3825).

Dividing $53825 by 1.0765 instead of multiplying by .9235
would solve this problem.

Does anyone else agree with that, or am I missing something
basic here? I would appreciate anyone filling me in. Of
course, as a self-employed person, I'm not complaining about
this; I am just trying to figure out *why* it is.

Of course, if I've been unclear, please let me know.

Thanks,

-Casey

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Posted by Bill Brown on February 21, 2007, 6:47 pm
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> I have been self-employed for a few years, and I understand
> how to calculate the SE tax. I have a question about the
> implementation of one step that we take, specifically, the
> way we arrive at net earnings. Perhaps someone can enlighten
> me.
>
> Currently, we multiply our net profit by .9235. I
> understand that the idea behind doing this is to remove the
> self-employment earnings that are really the *employer's*
> share of the taxes so that we don't have to pay SE tax on
> those as well. However, this to me means that the total
> amount of taxes paid is slightly less than under a regular
> employer/employee set up. It would seem more accurate to me
> if, instead of multiplying by .9235, we divided by 1.0765.
>
> Suppose person A is employed by firm B and has W-2 wages of
> $50K.
>
> Person A fica withheld: 50K * .0765 = $3825
> Firm B matching withholding: $3825
>
> The total money involved here is $53825 (this is the cost to
> the firm of employing person B), and the IRS collects $7650.
> Now, let's assume that person C is a self-employed
> individual with Schedule C profits of $53825--we would
> imagine that the end results would be the same, but they
> aren't, because the 92.35% adjustment (to remove the
> employer's contribution) actually removes *more* than the
> employer paid in the previous example:
>
> $53825 * .9235 = $49707
> $49707 * .153 = $7605 (total that the IRS collects)
>
> You can see that Person C pays his/her 15.3% on a slightly
> smaller amount (49707) than A+B pay their taxes. This is
> because with C, the 7.65% tax that is removed is 7.65% of
> the *entire* amount (i.e. it includes the salary of A plus
> the taxes paid of B) instead of just removing the taxes that
> would have been paid in the previous scenario (which would
> be B's taxes paid: 7.65% of A = $3825).
>
> Dividing $53825 by 1.0765 instead of multiplying by .9235
> would solve this problem.
>
> Does anyone else agree with that, or am I missing something
> basic here? I would appreciate anyone filling me in. Of
> course, as a self-employed person, I'm not complaining about
> this; I am just trying to figure out *why* it is.

You're missing something basic. The law says to multiply by
.9235.

<< ======================================================= >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2006) - All rights reserved. >>
<< ======================================================= >>

Posted by Mark Bole on February 23, 2007, 6:50 am
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Bill Brown wrote:

>> I have been self-employed for a few years, and I understand
>> how to calculate the SE tax. I have a question about the
>> implementation of one step that we take, specifically, the
>> way we arrive at net earnings. Perhaps someone can enlighten
>> me.

>> Dividing $53825 by 1.0765 instead of multiplying by .9235
>> would solve this problem.
>>
>> Does anyone else agree with that, or am I missing something
>> basic here? I would appreciate anyone filling me in. Of
>> course, as a self-employed person, I'm not complaining about
>> this; I am just trying to figure out *why* it is.

> You're missing something basic. The law says to multiply by
> ..9235.

True, but the law is mathematically incorrect, the OP is
completely correct from a math-only standpoint. I suppose
no one cares because (1) the error is in the taxpayer's
favor and (2) it's hard enough for many people to grasp as
it is without actually making the math correct.

The only other post I have ever seen regarding this was in
this very group on Nov 13, 2001, from Michael Wing, CPA.
Try the following or if it doesn't work search the group
archives on Google for "92.89 tax".

http://snipurl.com/1b0e4

It's like this:

If the employer forks over $100, the employee's gross pay is
$92.89 (not $92.35). The employee's share of FICA is $92.89
* 7.65% = $7.11. This equals the employer's match, which is
the difference between what the employer forked over and the
employee's gross wages, or $100 - 92.89 = $7.11.

-Mark Bole

<< ======================================================= >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2006) - All rights reserved. >>
<< ======================================================= >>

Posted by Stuart A. Bronstein on February 25, 2007, 12:21 am
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> Bill Brown wrote:

>>> Dividing $53825 by 1.0765 instead of multiplying by .9235
>>> would solve this problem.

>> You're missing something basic. The law says to multiply by
>> ..9235.

> True, but the law is mathematically incorrect, the OP is
> completely correct from a math-only standpoint. I suppose
> no one cares because (1) the error is in the taxpayer's
> favor and (2) it's hard enough for many people to grasp as
> it is without actually making the math correct.

Whoever wrote the law just didn't understand math very well
and came up with a conclusion that seemed reasonable, though
it was inaccurate.

Normally the solution would be to go to congress to have
them correct their mistake. But, as you say, since it's in
the taxpayer's favor that's unlikely to happen any time
soon.

Stu

<< ======================================================= >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2006) - All rights reserved. >>
<< ======================================================= >>

Posted by Shyster1040 on February 25, 2007, 12:21 am
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Mathematically, the statute is incorrect. Sec. 1402(a)(12)
provides that, in determining the "self employment net
earnings" (i.e., the base of the SE tax)(which I'll call
SENE for short here), the taxpayer is allowed a deduction in
lieu of the deduction provided in Sec. 164(f) in the amount
of the SENE determined without the 1402(a)(12) deduction
(which amount I'll call SENEX), times one half the sum of
the rates imposed by Secs. 1401(a) and (b).

Thus, in determining SENE, the taxpayer determines SENE by
subtracting from SENEX an amount equal to 7.65% of SENEX.

In other words, under Sec. 1402(a), SENE equals SENEX *
1-.0765 = SENEX * 0.9235.

However, if one were to compute SENE by treating half of the
ultimate SE tax as the analogue of an employer's portion,
one would need to determine the amount of the deduction to
be taken against SENEX in arriving at SENE.

In other words, if x is the amount to be deducted as the
analogue to the employer's portion, then SENE = SENEX - x.

Of course, x is equal to 1/2 * 15.3% * SENE, or, in other
words, x = 7.65% * SENE.

Thus, since we first have to get a definite number for SENE,
which we can only arrive at in terms of SENEX, we start with
SENE = SENEX - (7.65% * SENE)

> From that we get SENEX = SENE + (7.65% * SENE)

Which gives us SENEX = SENE * (1.0765)

Which gives SENE = SENEX / (1.0765)

Which, when put back into our equation for x, yields:

x = 0.0765 * [SENEX / (1.0765)]

Which yields:

x = SENEX * (0.0765 / 1.0765)

Which simplifies to:

x = SENEX * 0.071063632....

In other words, the amount that should be allowed as a
deduction from SENEX in determining SENE is an amount equal
to approximately 7.106% of SENEX which, if we round to only
two significant digits, is 7.11% of SENEX.

Therefore, to be mathematically correct, Sec. 1402(a)(12)
should permit a deduction in the amount of the product of
SENEX times .0711 and not in the amount of the product of
SENEX times .0765.

More likely than not, this sort of computation simply taxed
the brains of the statute-writers in 1983 when paragraph
1402(a)(12) was added by P.L. 98-21. It was simply easier,
in the rush of getting the amendment typed up and ready for
a vote by Congress, to subtract 1/2 of the 15.3% SE tax
being imposed, rather than to work through the mathematical
issues. Also, and more charitably, the rates were changing,
which would have meant that the computation I just went
through above would have to be worked out each time the
rates changed, so they may have simply settled on allowing a
deduction for 1/2 of whatever the rates happened to be at
the time.

That being said, I doubt if that error will ever be
corrected short of as part of an overall, comprehensive
reform of the tax code; something we are unlikely to see in
the near future.

<< ======================================================= >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2006) - All rights reserved. >>
<< ======================================================= >>

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