Proposed Changes to Self-Employment Tax Rules
The Biden administration’s proposals reflected in the “Green Book” include significant revisions in the self-employment tax rules. Here’s what you need to know about what could be coming if these changes take effect.
Overview of Current Rules
The self-employed pay a 12.4 percent tax on earnings of up to $142,800 in 2021 ($137,700 in 2020). If the person has wages and self-employment income, the maximum subject to the self-employment tax is reduced by the wage income for the year.
The Section 199A deduction benefit that is a 20 percent of business income deduction for many taxpayers is income tax only. This deduction doesn’t reduce the base for the self-employment tax.
There is no net operating loss with the self-employment tax, so your base for computing the tax over two years is the positive business income of the one year, not the net business income over the income year and loss year (Section 1402(a)(4)).
There is also a 2.9 percent Medicare care on self-employment earnings.This is not subject to the maximum of $142,800 in 2021. This portion of the calculation is without limit, so the beginning rate figure in the calculation is the sum of 12.4 percent plus 2.9 percent, or 15.3 percent.
There is also more Medicare tax when the person has higher levels of earning income. This is a 0.9 percent addition to the Medicare tax calculation that applies above certain threshold amounts of self-employment income. The thresholds are $250,000 for married filing joint, $125,000 for married filing separate, and $200,000 for all others (See “Topic No. 554, Self-Employment Income, IRS.gov).
There are three possible rates that enter into the calculation – 12.4 percent and 2.9 percent and .9 percent. They are all found in the same Code provision (Section 1401(a), (b)(1) and (b)(2). See also sections 1402 and 1403 and the regulations under these provisions).
In computing the self-employment earnings tax, the business income is first reduced by a factor of 7.65 percent. This is half of the sum of 12.4 percent plus 2.9 percent or 50 percent of 15.3 percent (Section 1402(a)(12)). This adjustment remains the same even when the 0.9 percent Medicare tax is a factor.
There is an income tax deduction claimed in arriving at adjusted gross equal to half of the amount computed in the immediately preceding paragraph. This deduction is only for purposes of the income tax. It does not affect the computation of the self-employment tax.
There is also, generally, a deduction in arriving at adjusted gross income for the self-employed person’s personal health insurance premium. This deduction isn’t available in computing the self-employment tax.
Wages entering into the employer’s employee retention credit are subject to the normal payroll tax regimen (“COVID-19 -Related Employee Retention Credits: General Information FAQs,” IRS.gov, Question 13; see also the updates in the headings citing Notices 2021-20, and 2021-23, as well as changes in the Taxpayer Certainty and Disaster Tax Relief Act of 2020, and the American Rescue Plan Act of 2021).
The characterization of payouts to shareholders is a common tax issue which may involve payroll tax issues. In a C corporation context, the payouts may well be reported as wages subject to payroll taxes in order to achieve a compensation deduction at the corporate level.
The goal is often to avoid double taxation. In these circumstances, the IRS may argue payouts characterized as wages were to some degree nondeductible dividends. In such a case, the IRS may need to concede an overpayment of payroll taxes.
In an S corporation context, corporate income flows through to shareholders, so distributions generally may be characterized as dividends rather than wages subject to payroll taxes. In such a case, the IRS is usually found arguing dividend distributions are compensation subject to payroll tax (A recent example is Ward, TC Memo 2021-32, 3/15/21).
The IRS has found that such complexities as basis loss limitation under Section 704(d) and the at-risk loss limitation rules of Section 465 affect the computations of the self-employment tax (See Chief Counsel Advice 202009024, 2/28/20, discussed “Current Tax Developments, IRS Memorandum Argues that Loss Limits Apply in Computing Self-Employment Income of a Taxpayer,” Ed Zollars, Kaplan Financial Education, 3/6/20; currentfederaltaxdevelopments.com).
Proposals for Increased Self-Employment Taxes
We note that there were discussions of lifting any limit on the regular social security tax – the 12.4 percent tax base with its maximum that increases annually. However, this particular concept did not reach the Green Book.
One aspect of the proposals talks in terms of the sum of our 2.9 percent Medicare tax which applies to basically all self-employment income and the .9 percent Medicare tax that begins to apply at higher levels of income. The sum of these two Medicare taxes is 3.8 percent.
The Green Book discusses the relationship of this 3.8 percent amount and the 3.8 percent tax on net investment income under Section 1411. It notes the expansive reach of the two taxes while noting they are mutually exclusive. A particular taxable item isn’t to be subject to both provisions. It goes to argue for expanding the tax base.
Following is a notable quote from the Green Book proponents for this aspect of increased tax:
“Active owners of pass-through businesses are treated differently for purposes of the NIIT (net investment income tax) and SECA (Self-Employment Contributions Act) tax according to the legal form of their ownership and the legal form of the payment that they receive.
While general partners and sole proprietors pay SECA tax on earnings from their businesses, S corporation owner-employees and limited partners (their counterparts and sometimes competitors) pay employment taxes on only a portion of their earnings. LLC members often pay little or no SECA tax at all.
Although the NIIT reflects an intention to impose the 3.8 percent tax on both earned and unearned income of high-income taxpayers, certain income escapes both SECA tax and the NIIT, including the distributive shares of S corporation shareholder-employees, limited partners, and LLC members who claim the statutory exclusion for limited partners (Green Book, p. 65, 66).
We note Section 1402(a)(13) which basically excludes from self-employment tax “… the distributive share of any item of income or loss of a limited partner, as such, other than a guaranteed payment described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services…”
The purported expansion of the scope of the 2.9 percent tax of Section 1402(b)(1) and the .9 percent tax of Section 1402(b)(2) is more specifically discussed as follows:
For taxpayers with more than $400,000 in adjusted gross income, “the definition of net investment tax would be amended to include gross income and gain from any trades or businesses that is not otherwise subject to employment taxes.” (p. 66).
Query whether “net investment tax” shouldn’t read “net investment income” and note the use of “gross income,” a term which generally suggests sales reduced only by the cost of sales (Regs. 1.61-3). Also note the very expansive language focusing on any trade or business not otherwise subject to employment taxes.
The following shifts to a scope of “SECA” which seems to include the 12.4 percent and the 2.9 percent tax and the .9 percent tax (The White Paper refers to “SECA” as including the 12.4 percent tax. See its beginning discussion of “Current Law,” p. 65). So, we don’t think the topic is limited to expanding the scope of only the 2.9 percent and .9 percent taxes. S corporation proposals are specifically discussed as follows:
“…. S corporation owners who materially participate in the trade or business would be subject to SECA taxes on their distributive shares of the business’s income to the extent that this income exceeds certain threshold amounts. The exemptions from SECA tax provided under current law for certain types of S corporation income (e.g., rents, dividends, and capital gains) would continue to apply to these types of income.”
In terms of general principles encompassing partnerships and S corporations, the Green Book basically goes on to sum ordinary business income from S corporations assuming material participation and ordinary business income from limited partnership interests and LLCs classified as partnerships assuming material participation. This is termed “potential SECA income.” The text continues as follows:
“Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income, and (ii) the excess over $400,000 of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to SECA tax under current law. The $400,000 threshold amount would not be indexed for inflation.”
The concept in our quote would seem to focus on the lesser of (i) or (ii) despite the “and” linking the clauses.The discussion goes on to basically close with a proposed effective date for years beginning after December 31, 2021.
It’s next-to-last paragraph focuses on the very important concept of “material participation.”
“Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way. Often this means they work for the business for at least 500 hours per year. The statutory exception to SECA tax for limited partners would not exempt a limited partner from SECA tax if the limited partner otherwise materially participated.” (p. 67).
In Closing
The taxpayer’s time records here would apparently be to prove a lack of hours worked, rather than their usual role of proving hours worked. In general, there would seem to be quite a few taxpayers that could be affected by significant tax increases. The C corporation structure could also be reconsidered in this context.