Self employment tax is the tax imposed on business income when the owner is not an employee. Employees’ have social security tax and employers match that. Self employment tax is the same as social security tax, but since there is no employer, the self employed person pays the tax as part of their personal income tax return. For 2011 only, the employee share of social security & Medicare tax is 5.65% but the employer share is held at 7.65%. So the comparable rate for 2011 only for self employment tax is 13.3%, instead of the normal 15.3%.
The social security component of self employment tax is capped at $106,800 of earnings for 2011. The Medicare component of self employment tax has no cap or limit. As a general rule business income is subject to self employment tax and non-business income is exempt from self employment tax. As you would expect there are a host of IRS regulations and court cases that attempt to sort out what is business income and what is not.
Some common examples of earnings subject to self employment tax include;
1) CRP payment to a producer who is not drawing social security benefits.
2) Fiduciary payments to a professional such as an attorney or trust officer.
3) Farm and ranch income when the producer participates in production or management.
4) Partnership income of a general partner or manager of an LLC.
5) Business income of a disregarded entity (such as a single member LLC or Grantor trust.)
6) Director fees of a corporate board member.
Some common examples of earnings not subject to self employment tax include;
1) CPR payments to a producer who is drawing social security benefits.
2) Fiduciary payments to a non-professional fiduciary, such as a family member.
3) Fair market value rents received from a controlled corporation. (Real estate rent income).
4) Portfolio income (interest and dividend income).
5) Capital gain income.
6) Partnership income of a limited partner or limited LLC member.
7) Allocable income from a subchapter-S corporation.
8) Income taxed to a trust.
9) Retirement benefits, social security benefits and prizes.
Age is irrelevant to the determination of self employment tax. Even if a person is drawing social security benefits, the earnings from self employment are subject to self employment tax. Farm Income averaging reduces income tax but not self employment tax. Likewise, net operating losses and non-refundable credits reduce income tax but not self employment tax. Itemized deductions, standard deductions and personal exemptions reduce income tax but not self employment tax. Many taxpayers pay more self employment tax than income tax.
Crop share arrangements are sometimes taxable to the landlord. This issue is material participation in crop production or management. The crop share landlord that materially participates is subject to self employment tax while the landlord that does not materially participate in either production or management is exempt from self employment tax. Cash rents are normally exempt. Above market rents received from a related entity are often challenged as subject to self employment tax by IRS. Cattle keep (feeding the cows all winter or calving out someone else’s cows) is generally self employment income while summer pasture is generally rent that is exempt from self employment tax.
The self employment tax applicability to CRP payments is governed by internal revenue code statute rather than by court cases or IRS rulings. What congress did a couple of years ago was to write into the law that an individual that is receiving social security retirement or social security disability payments was exempt from self employment tax on their CRP payments. Generally all others receiving CRP payments are subject to self employment tax regardless of their level of activity in the farm. (IRS code section 1402).
Breeding livestock sold is reported on form 4797 instead of schedule F of the tax return and is exempt from self employment tax. Likewise sale of machinery or land is reported on form 4797 and is exempt from self employment tax. It is possible to convert ordinary income to capital gain property and thus reduce both income tax and self employment tax. An example of this is the sale of a yearling heifer is ordinary income while if held for another year, the two-year old cow is a capital gain item. Income from selling pairs must be split with the cow reported on the form 4797 and the calf reported on schedule F. Since pairs are sold for one price, a reasonable allocation of proceeds from the cow and proceeds from the calf needs to be made.
Although subchapter-S corporation income that is reported to the shareholder on form K-1 is exempt from self employment tax, as is the subchapter-S dividends, IRS will look to ensure that reasonable compensation is paid to the owner-employee and that payroll tax is reported on the wages. If an S corporation paid no owner or officer wages, and paid significant dividends, IRS would likely choose to do a payroll tax audit.
John Mitchell is a CPA with Casey Peterson and Assoc. in Rapid City, SD.