A reader of a recent post asked: "Nancy, I understand that a self-employed person has to shoulder the expenses that an ordinary wage or salaried person does not. But if those expenses are legitimate, and a self-employed person doesn't earn enough to pay SE tax, how can that person even make a living to survive? If they aren't making enough revenue to cover their costs of operating their business, how can they afford to cover their personal expenses to survive?"
This is the key question I'll discuss today. It's why I believe some self-employed workers need a break on paying SE tax.
The tax ceiling
For tax purposes, the IRS treats all income earned by unincorporated self-employed as personal income rather than profit. We, however, don't have to accept that notion. It is possible to define a measure to determine when self-employed workers who use IRS' Schedule C do earn a profit.
A self-employed person makes a profit after they earn enough in their business to cover the following expenses: (1) business expenses, (2) SE tax, (3) personal living expenses (i.e., the cost for their own labor, and (4) their personal income tax.
On the aggregate level, a smart economist ought to be able to estimate an average amount for personal living expenses and personal taxes by looking at statistics such as cost-of-living, multiples of the minimum wage, or the poverty line.
Actual cost of living will vary for each self-employed individual, but an average figure could be used for setting the minimum income below which no tax is owed. Why do I suggest self-employed be taxed only after they reach a higher minimum-income level?
The early years of self-employment
In the beginning it's a struggle just to pay for necessary business expenses. Many self-employed people see little or no money at all during their first year of business.
A self-employed person has to create business procedures, an office, forms, financial documents, and get their marketing campaign going. They need Internet and/or phone connections, printers, computers and even cars or trucks for business use.
They also need a good reputation that will attract new customers. That can mean a web site, Facebook site, and social media use. Word-of-mouth advertising is the best kind for bringing in new clients, and it takes the longest time to get results from it.
The list is pretty overwhelming and it all costs money, or at least time. That's time that isn't spent on actually serving customers. Because of the need to offer competitive market prices, set-up time and expenses aren't costs that can't be folded into client charges.
After the first year a self-employed business earns more than it spends, taxes can be devastating. In April, the self-employed worker has to pay 15.4 percent SE (Social Security/Medicare) tax for the current year AND their first quarterly estimated SE tax for the following year. Almost twenty percent of their earnings goes for SE tax on their business. And then they must pay personal income taxes on that money too!
Raise SE tax minimum- and maximum-income levels
Why not raise the minimum bar on how much money a self-employed person makes before they pay any SE tax? Right now that bar is extremely low. The minimum is $400 a year. Above that amount, they must pay a flat 15.4% SE tax until reaching maximum earnings of $110,000.
Surely self-employed workers should be able to cover their personal costs of living before they are asked to pay tax!
You may object that self-employed must be taxed exactly like employees for Social Security and Medicare. If so, please read my post, "IRS Denies Self-Employed Profits". A self-employed worker cannot earn as much as an employee doing comparable work because self-employed don't profit from economies of scale.
What if self-employed people paid zero the first year, and afterwards paid only the employee FICA-rate of 7.5% percent? How could the government compensate for its loss of revenue? Dr. Susan M. Pomeroy (the website geographer) suggests we also raise the maximum income level for levying SE tax on self-employed above the current $110,000 maximum for all workers.
Self-employed workers would pay a lower rate for SE tax at first but eventually they'd pay tax on greater incomes than employees do. To make this a no-cost tax reform, and ensure self-employed collect the same amount of Social Security as they do now, the government would need to set the new maximum income to a level where the IRS ultimately collected the same total amount of SE tax it gets from the current 15.4 percent rate.
Charging no SE tax on newly self-employed would relieve financial pressure as they build their business.
Charging a lower (or gradually-increasing) rate for SE tax on lower-income self-employed would help them survive during economic downturns and grow their businesses during economic upturns.
What do you think of these ideas?
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