Many people who start their own business know that they are going to have to pay income taxes on the profits of their business. But they may not give taxes too much thought when they are starting out. During the first year of operations, just getting customers and doing the work of the business occupies all their time and attention. Staying afloat is the main goal. But eventually it comes time to do their tax returns. They assemble whatever records they have been able to keep. Many will go to a tax preparer. Some will prepare their own income tax returns. And some will give their business information to their spouse, who will prepare their joint return, or find an accountant to do it. Often, the new business person thinks that she won't owe much tax because she didn't make very much money in her business, what with startup expenses and time devoted to finding and winning customers. In any case, the new business person is often surprised. It's the SELF-EMPLOYMENT TAX !

The Federal government not only wants you to pay income taxes on your business profits, as well as on your wage income, interest income, and capital gains, but also wants you to pay the Self-Employment Tax on your business profits. If your business profit is less than $72,600 in 1999, the Self-Employment Tax is about 14%. (It's actually 15.3% times 92.35% of your net profit from business). Since 1/2 of the Self-Employment Tax is deductible from your other income on your Federal income tax return, the actual effective Self-Employment Tax rate ranges from about 10% to 12%, depending on your income tax bracket. I estimate that for people starting their own business, the effective Self-Employment Tax rate is 12%. This is 12 % of your profit in addition to 15% or 28% (possibly higher) of regular Federal income tax plus state income taxes. (Yes, it is possible to pay over 45% of your net profits in taxes!)

The Self-Employment Tax takes a big bite out of your pocket. And the new business person may not even see it coming. Because if you are not in business for yourself (as a sole proprietor or a partner), you might not know about the Self-Employment Tax. What is it? It is the social security tax and the medicare tax. The social security tax rate is 6.2% of gross wages and is taken out of practically every employee's paycheck. It is used to pay social security benefits (to current recipients). The social security tax is applied to the first $72,600 of wages (in 1999) that you are paid by each employer for the year. The maximum rate increases about $4,000 each year. The medicare tax rate is 1.45% of your wages, and there is NO LIMIT on the amount of wages subject to the medicare tax.

Now, you may be figuring that the total of social security and medicare tax rate is 7.65%. That's true. That is the total rate that is applied to the EMPLOYEE'S wages and withheld from each paycheck. But the EMPLOYER also pays the same amount for each and every employee. When the employer has to make a Federal Tax Deposit, the employer pays the Federal government 2 x 7.65% = 15.3% of employee gross wages, subject to the maximum social security wages, per employee.

Well, now that you are in business for yourself, the Federal government treats you as both the employee and employer!

The whole point of this paper is to urge new business people, or business owners who are finally operating profitably, to give some thought to income taxes and Self-Employment Taxes. You may want to discuss this matter with your accountant. It's a good idea to plan ahead for large expenses. And something that is around 12% of your net profit is a large expense.


Copyright © 1999 Ira M. Freed