Self-Employment Tax Planning for 2021by
As the sting of the 2020 tax season lingers, CPA Mike Pusey takes a look at self-employment tax issues with an eye towards planning for 2021. We hope that his advice will offer some relief or guidance for you and your gig-working and freelance clients.
Let’s start off with a bit of a basic overview of self-employment taxes. For 2020, the self-employment tax rate is 15.3 percent - 12.4 percent social security plus 2.9 percent Medicare. The 12.4 percent is twice the FICA rate of 7.6 percent. The 12.4 percent applies to a maximum of $137,700 in 2020. The 2021 maximum base for the tax is $142,800.
The 2.9 percent Medicare tax applies to all self-employment income, whereas the 12.4 percent rate applies to a base with a maximum as reduced by wages.
The rationale is that since wages are subject to FICA, the counterpart of the self-employment tax, there needs to be a reduction in the self-employment tax base for the individual’s wage income of the year.
It is beyond our scope, but we note there is an additional 0.9 percent Additional Medicare tax over certain income thresholds (See Questions and Answers for the Additional Medicare Tax on irs.gov). The self-employment tax is figured on Form 1040, Schedule SE. As indicated, wage income generally reduces that individual’s base for computing the self-employment tax.
There is a portion of the SE tax that is deductible. The rationale for allowing such a deduction is that the self-employed individual pays “both halves” of the tax whereas in an employment context, the tax is split between the employee and employer.
We also note that when computing the self-employment tax, the self-employment income is multiplied by a factor of 92.35 percent (100 percent minus 50 percent of 15.3 percent). Another consideration is that paying more self-employment tax may ultimately increase social security benefits down the road.
With this brief introduction to the basics, we turn to some planning perspectives focused on reducing the self-employment tax.
Net Operating Losses
Under the CARES Act, assuming calendar year taxpayers, NOLs in 2018-2020 can be carried back five years, and carried forward indefinitely without limitation. Net operating loss situations tend to maximize the self-employment tax.
The NOL deduction isn’t deductible against the self-employment tax (Sec. 1402(a)(4). Business deductions lodged in the NOL carryback or carryover won’t yield reductions in the self-employment tax, whereas they may reduce the self-employment tax if incurred in another year.
The issue in the DeCrescenzo case was whether an NOL carryover reduced the base for computing the self-employment tax. The taxpayer stipulated that if he lost the case, which he did, there would be penalty additions. The Tax Court cited a long line of cases, including appellate court decisions, upholding the inability of the NOL carryover or carryback to reduce the self-employment tax base (Joseph DeCrescenzo, T.C. Memo 2012-51, 2/27/12).
Theoretically, the taxpayer could have only the following business items: $100,000 of self-employment income on December 31st and $100,000 of self-employment expenses on the following day. Our taxpayer has broken even over two days and over two tax years, but managed to incur self-employment income (before adjustment) of $100,000.
Accordingly, one aspect of planning deductions is that if the result is to increase the NOL carryback or carryover, the deductions are wasted in so far as self-employment tax savings. Similarly, accelerating income in a manner to reduce the NOL carryback or carryover could effectively avoid self-employment tax on such income, presuming it would incur tax in another year.
High Business Income Years
Consideration may be given to increasing business taxable income in a year in which the maximum subject to self-employment tax has already been reached. Given the maximum income subject to tax in a year, an amount that is indexed and so changes annually, accelerating business income in such year may avoid the self-employment tax. The same income may incur the tax in a later year.
Large business income isn’t necessarily going to translate into a year of large taxable income, although one generally expects that “bunching” business income in a particular year is likely to incur income tax at a high rate.
Accelerating deductions, whether decisions to pay expenses or opting to maximize depreciation via Section 179, should also consider whether such deductions are wasted in so far as the self-employment tax. The “math” here can be complicated, but planning with respect to the self-employment tax should be one aspect of the strategy.
Shifting Income to Corporations
Income earned by a C corporation isn’t subject to self-employment tax – barring an assignment of income issue that says the shareholder earned it individually. Income earned by an S corporation doesn’t flow-through as income automatically subject to self-employment tax.
Payments to shareholders of closely-held corporations, whether C or S corporations, are regularly scrutinized in an IRS audit to consider whether payments called dividends, rents, etc., may be disguised wages that should be subject to payroll taxes.
But generally, part of the strategy considerations in whether to incorporate, via the C corporation or S corporation route, is whether there may be a reduction in self-employment tax. For a recent general discussion of the income tax math of incorporating (See Incorporating Your Business – A Planning Opportunity and a Puzzle, Rojas & Pusey, rojascpa.com, "Articles").
Self-employment tax implications are easily overlooked. They should be an important part of year-end planning, as well as planning throughout the year. Tax professionals are attuned to planning with a view to federal-state implications, but we also need to keep in mind the self-employment tax.
Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...