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Payroll Taxes

When a person reaches a point in their working career where they want to start their own business, part of the planning process has to account for the federal and state taxes that will be owed. Most people have an idea of the income tax ramifications of their business profits, but forget that there is an equivalent to payroll taxes as well, which is called the self-employment tax. The combination of both taxes will need to be paid through quarterly estimated tax payments and can leave budding entreprenuers cursing the tax rates in our country and feeling that the odds are stacked against small businesses.

To understand the self-employment tax, let’s first look at employment taxes associated with being an employee. Andrew begins his first full-time job and receives a salary that is paid bi-weekly. He notes that his gross pay is adjusted by federal and state income tax withholding and also FICA Social Security at 6.2 percent and FICA Medicare at 1.45 percent for a total of 7.65 percent in payroll taxes. This does not bother Andrew, because he is focused on the net pay he receives and does his cursory budgeting based on what he brings home. As long as his income tax withholding is set correctly, Andrew will not have a tax due when he files his tax return and may enjoy a refund.   

What Andrew does not realize nor particularly care about is that his employer also pays the same 7.65 percent in FICA (Federal Insurance Contributions Act) Social Security and Medicare taxes. The federal government is receiving 15.3 percent of employee wages, one-half from the employee and one-half from the employer, to support Social Security and Medicare. The collection of FICA Social Security ends on wages above $132,900; however, the FICA Medicare portion does continue with an additional 0.9 percent tax on incomes over $200,000.

Twenty years goes by and Andrew now wants to be self-employed. He determines that his projected net income from his business will replace his gross wages. He meets with his accountant and finds out that going out on his own is not as great as it seems. Now he is responsible for both halves of the payroll tax determined on Schedule SE (Self-Employment Tax) filed with his Form 1040 tax return.

Since he pays about 25 percent of his income in federal and state income taxes, adding the self-employment tax will yield about 40 percent of his income going out in taxes. That takes many new small business owners by surprise and it requires discipline for them to set that 40 percent aside and pay it in to the government as quarterly estimated taxes. If they do not, their next income tax return will have a large tax due that may set them back for years.

Starting a business? The best thing you can do is meet with your tax advisor to avoid surprises and transition your mindset from employee to business owner. Have a great start to summer!