How to Deal with the New $142,800 Base for Self-Employment TaxesTax Planning
What happens when lawmakers enact a new tax?
It starts small.
It looks easy.
In 1935, the self-employment tax topped out at $60. Those 1935 lawmakers must be twirling in their graves with the new rules for 2021, which levy the following taxes:
- A self-employment tax of up to $21,848, which comes from the 15.3 percent rate that applies to self employment income of up to $142,800.
- A 2.9 percent tax that applies to all self-employment income in excess of the base amount.
You know the expression “Don’t let the camel’s nose get under the tent”? It applies here.
Look at what has happened to self-employment taxes since they first came into being in 1935, assuming you earn at the base amount:
- $60 in 1935
- $60 in 1949
- $3,175 in 1980
- $7,849 in 1990
- $14,413 in 2006
- $21,848 in 2021
True Top Base: $154,629
To calculate your self-employment taxes, you take your net income from Schedule C of your Form 1040 and put it on your Schedule SE, where you multiply that number by 92.35 percent before applying the 15.3 percent tax rate.
Thus, to find your true net income subject to self-employment taxes, you have to divide by 92.35 percent.
This means that the true top base for self-employment taxes is $154,629 ($142,800 ÷ 92.35 percent). It also means that your true self-employment tax is 14.12955 percent on your net Schedule C income.
As proof: $154,629 x 14.12955 percent equals $21,848.
To put the rates in perspective, say you are single and earn $150,000. On the last dollar you earned—dollar number $150,000—how much federal tax did you pay? The answer in round numbers—39 cents (14 cents in self employment and 24 cents in federal income taxes).
Wow! That’s a lot. Then, if you live in a state with an income tax, add the state income tax on top of that.
Two things to know about tax planning:
- Your new deductions give you benefits starting at your highest tax rates.
- In most cases, the return on your planning is not a one-time event. Once your plan is in place, you reap the benefits year after year. Thus, good tax planning is like an annuity.
Here is a short checklist of some tax-planning ideas. Review these ideas so you can identify new business deductions for your tax return. You want business deductions because business deductions reduce both your income and your self-employment taxes.
- Eliminate the word “friend” from your vocabulary. From now on, these people are sources of business, so start talking business and asking for referrals over meals and beverages.
- Hire your children. This creates tax deductions for you, and it creates non-taxable or very low taxed income for the children. Also, wages paid by parents to children are exempt from payroll taxes.
- Learn how to combine business and personal trips so that the personal side of your trip becomes part of your business deduction under the travel rules (for example, traveling by cruise ship to a convention on St. Thomas).
- Properly classify business expansion expenses as immediate tax deductions rather than depreciable, amortizable, or (ouch!) non-deductible capital costs.
- Properly identify deductible start-up expenses ($5,000 up-front and the balance amortized) rather than letting them fall by the wayside (a common oversight).
- Correctly classify business meals that qualify for the 100 percent deduction rather than the 50 percent deduction.
- Know the entertainment facility rules so your vacation home can become a tax deduction.
- Identify the vehicle deduction method that gives you the best deductions (choosing between the IRS mileage method and the actual expense method).
- Correctly identify your maximum business miles, so you deduct the largest possible percentage of your vehicles.
- Use a 1031 exchange to defer taxes (perhaps until death, when the tax code marks up your assets to fair market value and the income taxes disappear).
- Qualify your office in your home as an administrative office.
- Use allocation methods that make your home-office deductions larger.
- If you are married with no employees, hire your spouse and install a Section 105 medical plan to move your medical deductions to Schedule C for maximum benefits.
- Operate as a one-person S corporation to save self-employment taxes.
- If you are single with no employees, operate as a C corporation and install a Section 105 medical plan so you can deduct all your medical expenses.
When you own the business, you have many opportunities to cut your taxes in meaningful ways.
The checklist in this article is not a complete list, but it should give you some ideas that will get you started on your savings. Keep in mind that when you put tax-planning ideas into practice, your savings likely apply year after year, giving you an annuity income.
Also, remember that your tax savings likely start at your highest tax rate. It would be best if you got started on your planning now. Pick one idea—and start there.