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IRS Denies Self-Employed Profits

03/08/2013 12:55 pm ET | Updated May 08, 2013

Self-employed business owners desperately need tax reform. But no meaningful tax reform for self-employed will take place until the IRS dumps its Chimera of self-employed being "two persons in one". The IRS taxes self-employed as if they are both an "employer and an employee", i.e., as if they are two persons in one body.

That's ridiculous! The self-employed person is neither an employer nor an employee. He or she is a unique hybrid - a self-employed worker without a boss.

Worse yet, the IRS uses its two-person-in-one myth for its own benefit while self-employed people get the shaft. Let's look at two examples:

The employer half

Employers pay for business expenses, such as computers, desks, copiers, and phones that their employees use at work. So employers get to deduct these business expenses on their taxes.

The IRS gives self-employed people the right to deduct their business expenses too. However, just as with comparing employee to self-employed salary levels, comparing deductions for employers with those of self-employed workers confuses watermelons with avocados.

Deductions by self-employed do not work the same as deductions for employers. Self-employed people do not get "economies of scale" from the deductions they take. Instead, self-employed spend money on the things deducted, but they don't profit from doing that. In fact they lose money on deductions.

Here's an example. In a small office there is an employee who is in charge of supplies. This worker goes shopping with a list of what everyone in the company needs. They incur the expense of that one trip, e.g., gasoline and/or mileage expenses, cost of their time, and the amount spent on the supplies.

But, by saving everyone else in the company the trouble of traveling to the store to buy their own office supplies, this employee saves a lot of money for their employer. This is the efficiency of division and specialization of labor that creates more revenue for large organizations.

When self-employed people spend time and money going to the office supply store, they get no extra return for doing that. In fact they lose money. That's because, unlike real employers, self-employed "employers" cannot deduct the cost of their own labor. In other words, the self-employed "employer-half" cannot deduct the cost of sending their "employee-half" to the office supply store. Neither "half" earns any money while they're out shopping.

Business-expense deductions for self-employed workers are a necessary liability, but they don't create more bang for their buck. What deductions do for self-employed workers is reduce the amount of Social Security they receive at retirement.

The employee half

If you follow the logic of the IRS, self-employed people never make a profit. Now this may seem unbelievable to you. But it's true.

All money that self-employed people make, above and beyond business expense deductions, is taxed as personal income. Even the amount they pay for SE tax is taxed again as personal income. See for yourself. The net business earnings on Line 31 of Schedule C is transferred to Line 12 of Form 1040. Here that amount is called "gross personal income" and taxed a second time.

(Yes, on Form 1040 there is a tax credit for the employer half of the the 15.4 percent. However, the employee-half of 7.5 percent of their income that went for SE tax is taxed twice. Furthermore, for lower-income taxpayers, tax credits often wind up being deferred, sometimes forever. For lower-income self-employed, the 7.5 percent employer-half of SE tax credit also gets taxed twice.)

In short, there is no 15 percent capital gains or even 25 percent corporate tax rate on profit made by self-employed people. Self-employed owe a tax rate between 25.4 percent and 43.4 percent on the "gross personal income" they earn from their business.

The bottom line

Neither the employer- nor employee-halves of self-employed workers can be compared to real employers or employees.

The self-employed "employer half" pays for his/her own business expenses, but does not increase his/her profits by doing so. Nor can an "employer half" deduct their employee-half's labor costs.

The income of the "employee half" of a self-employed worker can't be compared to that of an employee either - if a self-employed person takes any deductions, they will earn less money than an employee doing comparable work - at present and in the future.

For tax purposes the US government defines self-employed as more like employees than owners of a business. Self-employed are not Robert Kiyosaki's "Rich Dad" - business owners whose businesses can operate without them being present. By IRS (and SBA) definition, self-employed must play an "active role" in their own business. 100 percent of their labor costs are taxed as personal income.

This means in the IRS' eyes the "employer-half " of a sole-proprietorship business never makes a profit.

Let's dump IRS' "two-persons-in-one" fiction of the self-employed worker! Let's devise taxation that creates incentives for their businesses to grow and profit!