Self Employment Tax Is A Killer!

Many people who go from being an employee to working as an independent contractor have sticker shock when they file their first tax return- it’s the self employment tax that’s the killer! This is an additional tax that is added on to your regular tax. It is your Social Security tax- FICA and Medicare tax that was withheld from your wages when you were an employee. But when you were an employee you only paid one half (7.65 % of your gross wages) and your employer paid the rest.

When you become an independent contractor you pay the whole thing. The bad part is that it’s based only on your self employment income which is the net income from your business. That means your itemized deductions don’t reduce the self employment tax. Another item is an IRA or 401(k) contribution- those don’t reduce the self employment income either.

So it becomes extremely important to allocate as many expenses as you can to your Schedule C- Profit or Loss from Trade or Business. That’s why we always try to deduct things like office in the home, auto expenses, equipment, etc. to get the self employment income down as much as possible. Oftentimes we see clients with little or no regular income tax due to large home mortgage interest deductions- but they still end up with a large self employment tax. So watch out!

Independent Contractor or Employee?

The IRS and California Franchise Tax Board are very aggressive in maintaining that everyone is an employee- but that doesn’t make it true! There is a lot of case law about this issue and criteria have been established over time that shows independent contractor status. Some of those are: more than one customer, letterhead and business cards, advertising product or services, use of own equipment, unsupervised, expertise in the field enabling person to work on their own, no set hours, can come and go as they please, to name a few.

Employers usually want workers to be independent contractors so they don’t have to pay the payroll taxes and do payroll tax reporting or cover the worker with employee benefits. The taxing authorities want to put the responsibility of paying the payroll taxes on the employer. It can be to your advantage to be independent if you have a lot of business-related expenses to be deducted from income. But have your tax professional do a projection to make sure it’s not going to cost you more money to be self employed than to be an employee.