Today we have a guest post from Martha L. Voelz, an associate with S.H. Jacobs & Associates LLC in New York that we met at New York Comic Con. As we mentioned in a recent post, Clark Kent has quit his job with the Daily Planet to become a blogger. Martha, who practices tax law, has written a post about some of the tax consequences of Kent’s newfound self-employment. As with all of our posts, this post is not legal advice, does not create an attorney-client relationship, and does not necessarily reflect the opinions or views of the author’s employer.
Being Your Own Boss — Tax Consequences
With Clark Kent preparing to strike it out on his own in Superman #13, there are several legal issues he faces as his own boss. As James Daily pointed out in his post, as an independent blogger and reporter Kent will have new intellectual property and liability issues. He also will have some tax differences as well. For this post, I am sticking to Federal tax issues, but Kent will likely have state and local tax issues too.
As an employee, Kent’s share of income, Social Security and Medicare taxes were calculated and paid to the Internal Revenue Service (“IRS”) by his employer. As his own employer, Kent now has to calculate and make these tax payments himself. Let’s start with the Social Security and Medicare tax differences, known as FICA and Self-Employment tax.
I. FICA v. Self Employment tax
When Kent received his pay stub from the Daily Planet, he would have seen withholding for his Federal income taxes and another line notation called FICA. FICA stands for Federal Insurance Contribution Act, and this covers Kent’s tax contribution to Social Security and Medicare. FICA is found in §§ 3101-3128 of the Internal Revenue Code, which is part of the United States Code.
The total FICA tax rate is 15.3%, which is normally paid equally between the employer and employee. Kent’s portion of FICA would normally be 7.65% and is broken down like this:
- Social Security – Kent would pay 6.2% tax on his wages (including certain benefits) capped for the year at $110,100 in 2012 and will be capped at $113,700 in 2013. Anything Kent earns over the cap is not subject to the Social Security tax.
- Medicare – Kent would pay 1.45% on his wages (including certain benefits). There is no yearly cap on this portion of the tax.
The reason for noting how FICA is normally paid is because in 2012 FICA is not working “normally”. In order to stimulate the economy, Congress reduced an employee’s portion of the Social Security part of FICA to 4.2% in 2011 and kept that reduction for 2012. This reduction is not set to continue in 2013. If Kent was working at the Daily Planet, when he received his first pay check of 2013 he might have been shocked by the reduction in his take-home pay and the sudden “increase” in the FICA line.
What makes this different for Kent as a self-employed taxpayer is that FICA does not apply. Instead self-employed taxpayers contribute to Social Security and Medicare under the Self-Employment Contributions Act of 1954, known as the Self-Employment Tax. This tax is found under §§1401-1403 of the Internal Revenue Code.
On its face, the Self-Employment Tax seems harsher because the taxpayer normally pays all 15.3% of the tax, which under FICA is split between the employer and employee. However, the same 2012 reduction to the employee portion of the Social Security tax applies to the Self-Employment Tax. This means in 2012 the Self-Employment Tax rate is 13.3% and the breakdown would be as follows:
- Social Security – Kent would pay 10.4% tax on his net earnings with the same income caps in 2012 and 2013 as FICA.
- Medicare – Kent would pay 2.9% on his net earnings.
There are some additional differences in how the Self-Employment Tax is calculated to even out the differences between this tax and FICA.
First, the Self-Employment Tax is calculated on net earnings of the business and not the gross income. Net earnings are the amount Kent earns reduced by certain business expenses he may have during the year. Second, a portion of the Self-Employment Tax Kent paid may be deductible on his federal income tax return. This in turn may put Kent in a lower tax bracket and reduce his federal income tax.
II. Estimated Tax Payments
By becoming self-employed, Kent will have to calculate and pay income tax and Self-Employment Tax on his own. He will have to do this by making estimated payments to the IRS using Form 1040-ES. This form will help Kent calculate both his Federal income and Self-Employment Taxes.
He will need to file and make payments for each quarter to avoid an underpayment penalty. Quarterly estimated payments are due April 15 (for January, February and March), July 15 for (April, May and June), October 15 (for July, August and September) and January 15 of the following year (for October, November and December). If the due date falls on a Saturday, Sunday or Holiday, then the due date is typically the following business day.
Filing and payment is considered completed on the mailing date, and it is a good idea for Kent to send anything to the IRS via Certified Mail Return Receipt. This is his insurance should the IRS allege he missed a payment or filing deadline. Alternatively, he can make his quarterly estimated payments using the Electronic Federal Tax Payment System.
III. Happy New Year! – 2013 Tax Surprises
There are a few tax surprises in store for Kent and the rest of us taxpayers between the 2012 and 2013, in addition to watching our Social Security tax payment revert back to its normal amount.
First, some taxpayers may have to make an Additional Medicare Tax payment. If Kent makes over $200,000, then an Additional Medicare Tax will kick in. For every dollar over $200,000, he will pay Medicare Tax at 2.35%. (I assume for the rest of this post that Kent is not getting married in 2013 and has a taxpayer filing status of “Single”.)
Second, the Federal income tax brackets are set to revert to tax rates we last saw under President Clinton. The bottom income tax rate goes from 10% to 15% up to a maximum tax rate of 39.6%. Assuming Kent has an adjusted gross income between $35,351 and $85,650, his tax rate will go from 25% to 28% in 2013. This assumes that Congress does not make tax code adjustments connected to the “Fiscal Cliff” situation, which is still up in the air as of this writing. [Ed. note: the fiscal cliff has apparently been avoided, but if Kent makes more than $400,000 per year then he would pay 39.6% on income above that level.]
One of the best things Kent can do is read up on his obligations as a self-employed taxpayer and check out the following IRS publications: Publication 334 –Tax Guide for Small Business and Publication 505 – Tax Witholding and Estimated Tax. If he doesn’t want to tackle this himself, hiring a certified public accountant is the best thing he can do. (Plus, the expense is a tax deduction in his new life as a self-employed reporter!)