A question I’ve had in my mind for a long time now is: why is self-employment tax for a sole proprietor based on 92.35% of self-employment income instead of the whole amount?
I’ll attempt to explain in this post.
SE Tax vs. FICA Tax
FICA taxes are withheld from employee wages and fund the employee’s Social Security and Medicare benefits.
The Social Security piece is 6.2% (up to the Social Security wage base for the year) and the Medicare piece is 1.45%. For most employees, that makes the FICA tax 7.65%.
Behind the scenes, the employer kicks in a matching 7.65% contribution on the employee’s behalf, making it a total of 15.3% of the employee’s wages going to the government (7.65 x 2 = 15.3).
A self-employed person does not draw a true wage, so there is no FICA withholding. Instead, the self-employed person pays self-employment tax of 15.3%. The tax is assessed on 92.35% of the person’s self-employment income.
Why 92.35% instead of 100%?
With the FICA tax on wages, the employer is incurring a 7.65% expense on each dollar paid to an employee. This is a real expense to the company.
Company X pays Employee Z $10,000 of gross wages. The company pays 7.65% FICA tax on those wages. Company X’s books will show $10,000 of salary expense, and $765 of payroll tax expense for FICA.
Company X gets to take a deduction for the company’s portion of FICA taxes. In order to achieve some equality between an employee/employer situation and a self-employed person, the self-employed person gets to take that 7.65% deduction into account when calculating self-employment tax (100 – 7.65 = 92.35)
One thing to be clear on: the 7.65% is NOT taken as a deduction on the Schedule C. It’s accounted for on Schedule SE.
Joe the Window Washer is self-employed. His net income from self-employment is $10,000. This is shown on Joe’s Schedule C. Joe then completes Schedule SE to calculate self-employment tax. On the Schedule SE, he’ll take $10,000 x .9235, which equals $9,235. The 15.3% self-employment tax is then assessed on $9,235.
If any readers out there have a simpler way of explaining, please leave a comment below or send me an e-mail!