10/19/2012 03:53 pm ET Updated Dec 19, 2012

Give Small Business Owners a Break!

You may not have noticed it, but at the town hall debate on October 16th, Governor Romney torpedoed his own claim that he would give small businesses a break.

What is a small business?

The IRS uses Schedule C to define small business owners as "sole proprietors" of a small business. This is the definition of small business the presidential candidates are using.

Governor Romney defined the small business owner as one who pays personal income taxes on their business income. Not so fast governor! Before they even fill out their personal income tax forms, all small business owners pay a tax called the Self Employment (SE) tax.

What is the SE tax?

The SE tax is similar to FICA tax paid by the employer and employee for employees' Social Security and Medicare. Most of SE tax goes towards Social Security. A small percentage goes toward Medicare. If a small business makes more than $400 a year the SE tax must be paid on the small business' income up to $106,800.

The SE tax rate nearly quadrupled from 2.25 percent in 1951, the first year of its existence, to 15.3 percent in 2010. For last year and this year only, the SE rate is 2 percent less than that. It is 13.3 percent. This is what small businesses pay even before they record their small business income on Form 1040 and pay personal taxes on it.

The truth is that almost all small business owners pay taxes at a higher rate than Warren Buffet or Governor Romney himself!

What is the harm done by SE tax?

The SE tax is a flat tax imposed after business deductions are taken. The SE is truly a regressive tax. It affects the poorest of the small businesses the most, that is, the owners of businesses that make $106,800 or less per year down to $400 a year. These small business owners first must pay a flat tax of 15.3 percent (13.3 percent) on their business income and then pay personal income tax too on what is left after SE tax is deducted from their business earnings.

At the town hall debate Mr. Romney offered to eliminate all taxes on capital gains, dividend and interest income made by those earn less than $200,000. Big deal!

Most people in the smallest of the small business category do not make a lot of money from capital gains, dividends or interest. Most are employed working full-time in their businesses. They don't have time to make big business deals or risky investments. They aren't in a position to save money; they are busy paying off personal expenses and pouring any money left over into their business in order for it to survive.

President Obama's answer was not very satisfactory either.

In the first debate, President Obama separated sole proprietors into two groups. Obama declared that sole proprietors such as Donald Trump belonged in the top 3 percent of small business owners. These top 3 percent earn more than $250,000 a year. Those small businesses earning less than $250,000 a year belong to the bottom 97 percent. Obama indicated he would increase taxes on the top 3 percent and hold taxes steady for the bottom 97 percent.

Give the self-employed a real break

Small businesses making less than $106,800 a year need a permanent break from paying the employer half of the SE tax. That's because most small businesses making this amount are owned by persons who work alone. They should pay only the employee half of SE tax, i.e., 7.125 percent.

I would like to see all new small businesses making $106,800 or less be able to opt-out of paying SE tax that goes for Social Security for the first three years they are in business. That's because it takes two to three years to get a solo-operated small business off the ground. The new business owner would give up three years of credit or income earned towards Social Security. But as these small businesses grow, so too would Social Security. "How can that happen?" you ask.

The IRS encourages self-employed business owners to hire other independent contractors on a part-time or as-needed basis. Self-employed persons can deduct costs on Schedule C and pay less tax by hiring other self-employed persons or employees of small businesses. There are hundreds of services a sole proprietor might hire someone else to do, for example: bookkeeping, computer set-up and/or repair, legal assistance, office cleaning, tax accounting, telephone answering.

This frees the self-employed person to make more money by doing the services they bill their clients for.

This means a person aspiring to become self-employed can set up a small business by providing part-time or as-needed services to others and begin to attract enough clients over a period of two or three years to become a full-time sole proprietor. If they grow further, they may hire part-time and then full-time employees too. A few might even become wealthy.

This is the way to re-build America from the ground up. This is how to create new jobs for those whose old jobs have been shipped abroad.