Self Employment Taxes – Does The IRS tell you everything you to know?
Recently Marketwatch contributor Bill Bischoff wrote an interesting article titled “‘What the IRS doesn’t tell you about self-employment taxes”, where he asked the question “Do you owe the dreaded 15.3% self-employment (SE) tax on random non-employee income that you only collect occasionally or in a one-off circumstance?” His article attempts to make the case that you may not owe it for certain types of income circumstances.
What is the Self Employment Tax?
Back in 1935, the Federal government passed the what is known as the Federal Insurance Contribution Act (FICA), which was created for the purpose of bringing in tax revenue to help pay for Social Security and Medicare. This Fica tax is 15.3, (which is payroll tax), paid by both employers and employees, who both split the burden by each covering and paying half. Employers pay 7.65% and their employees pay 7.65%.
In 1954, the Federal government passed what is called the Self-Employed Contributions Act (SECA) to make self-employed individuals contribute taxes toward Social Security and Medicare. The rules of SECA established that without employers covering half the tax, the self-employed business person would now be on the hook for paying the entire 15.3%. This 15.3% tax is what is also called the self-employment tax.
Now Bill Bischoff says “the SE tax is the way the Feds collect Social Security and Medicare taxes on non-salary income from work-related activities.” The Marketwatch article states that For 2019, the SE tax rate is 15.3% on the first $132,900 of net SE income.
This IRS states that the SE tax rate consists of two parts:
- 12.4% for the social security taxes
- and 2.9% for Medicare taxes
The article also states if your self employed income is above the $132,900 threshold, the 12.4% Social Security tax part gets eliminated, but you are still liable for the 2.9% Medicare taxes.
Above the $132,900 threshold, the Social Security tax component goes away, but the 2.9% Medicare tax continues. And at higher income levels it can go up to 3.8%. If you are fully self-employed business owner, this is probably not groundbreaking news to you, you must likely plan for it. If you make your quarterly estimated Federal income tax payments to avoid an interest penalty charge, then are supposed to also include the Self Employment tax payment amount as well. As Mr. Bischoff says, it’s the “cost of doing business.”
What types of income are subject to the self-employed tax?
So Mr Bischoff poses the question of what would happen if a person who is not regularly self-employed, earns some extra income from some random work or one-off project that would be subject to the SE tax if you were regularly self-employed in the activity? Does this person owe SE tax or not? Mr. Bischoff states that “you don’t owe SE tax unless the income in question is from a trade or business” He cites a 1987 Supreme Court decision, Robert P. Groetzinger, 59 AFTR 2d 87-532 (1987) that it must be an activity that you conduct with continuity and regularity and with a profit motive. The case of Commissioner v. Groetzinger examined what is required for an activity to rise to the level of a “trade or business” for tax purposes. The particular question presented in this case was whether a full-time gambler who made wagers for his own account was engaged in a “trade or business.” In this particular case, the court concluded that “if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for livelihood, and is not a mere hobby,” it is a trade or business within the meaning of §162(a) of the Internal Revenue Code. So one can conclude that income that is earned from a sporadic or isolated activity is generally not subject to self-employment tax, because the random activity does not rise to the substantial level of a trade or business. Mr. Bischoff went on to bring a few examples to illustrate how this standard could be applied in real-life scenarios. Let’s dive into to them a bit.
Your Sideline Job is Closely Related to Your Regular Job (example 1)
His first example scenario says what if you are a self-employed construction manager who works regularly for just a few select construction outfits that you have a strong relationship with. Then somewhat randomly your neighbor asks you to supervise the construction of his new home and you end up collecting $25,000 for your duties. Even though such sideline work is not something you do with any regularity, (in fact this is first time you have done it at all), but this particular sideline work is so closely related to your regular self-employed work that you probably will owe SE tax on the $25,000. And if for some reason you were to get audited by the IRS, you can bet they will try to make that claim.
Your Sideline Job is Closely Related to Your Regular Job (example 2)
In his 2nd fictional example, you are employed by a construction firm as a construction supervisor. And in the same fashion, you agree to manage the construction of your neighbor’s new home in your “spare time” and you collect $25,000 for your efforts. And again, even though such sideline work is not something that you do with any regularity, (it’s actually your first time), this sideline work is closely related to your regular work as an employee of a construction company, so the IRS may attempt to make the claim that you owe SE tax on the $2,500. Why? Because you are in the business of being a construction contractor – as an employee or otherwise. Mr. Bischoff points out that “since you’ve never before done such work on a self-employed basis, you might beat the IRS if you get audited on the issue and are willing to fight. It’s up to you to decide if taking the position that you don’t owe SE tax on the $25,000 is worth the risk.”
A One-time Realtor gets Luck (part 1)
The next scenario he mentions is, you used to be a full-time realtor. But for the last couple of years you have taken on the role of being a stay at home dad, raising your young children. However, you still maintained your realtor license “just in case.” And this year you ‘get lucky’ and end up earning a $25,000 fee for referring an acquaintance to another realtor who ends up selling your acquaintance’s home for a large amount of money. The question now is:
Do you owe 15.3% SE tax on that $25,000 realtor referral fee? Mr. Bischoff’s perspective is “No,” because the person is not currently in the realtor business. And if you were get audited, the IRS may disagree, based on your past history of once being an active realtor. But he thinks that if the person was to fight it, they could end winning and not have to pay the SE tax.
A One-time Realtor gets Luck (part 2)
His final example explores another realtor scenario, where this time you tried to dabble as a part-time realtor a few years back, but you gave up since you never really made any real money from it. And like the previous example, you maintained your realtor license “just in case.” But this particular year, you get a lucky break, ending up earning a $25,000 fee for referring an acquaintance to another realtor who ends up selling your acquaintance’s home for a large amount of money. And the similar question is asked, “Do you owe 15.3% SE tax on the $25,000?” Mr. Bischoff’s opinion is that in this scenario, he feels it is “No,” beyond any shadow of a doubt. And what would happen if this person was to get lucky again the following year and earn another $15,000 referral fee? Would they owe another 15.3% SE tax on the $15,000? His opinion is that the answer would again be a “No”. If you were to get a lucky referral fee each year, Mr. Bischoff states that he does not think the person would end up owing a SE tax on these random referral fees that you end up collecting “just by answering the phone once in a while and making a call to another realtor.” He feels that this “sporadic-at-best activity is not a trade or business, because you don’t do it with continuity and regularity.” In the Marketwatch contributor’s humble opinion, he thinks you don’t owe SE tax on the referral fees. Now, in this scenario of getting lucky year after year, the IRS could disagree, but his guess if the person was to fight, they could win.
Random Income may be exempt from SE tax, but not all types of Taxes
Again, if your random income is exempt from the dreaded SE tax because it is not considered a trade or business that is done on a regular, continuous, and substantial basis, that does not necessarily mean you are exempt from Federal income taxes.
You are required to report random income on line 21 of Form 1040, Schedule 1 (Other Income and Adjustments to Income). You may owe state income tax, too. Now, one more caveat to consider is, if you take the “position that random income is SE-tax-exempt because it’s not from a trade or business, you give up the right to claim deductions for any related expenses,” said Mr. Bischoff.
So, we have now covered in detail how random income is usually exempt from paying SE tax. Now, Mr. Bischoff also mentioned that there are some categories of non-random income that are also SE-tax-exempt. You now understand that random income is usually SE-tax-exempt. Of course, there are categories of non-random income that are also SE-tax-exempt, such as some types of rental income that isn’t considered to be earned income. It’s not classified as investment income like capital gains, as interest and dividends are. Instead, it’s considered to be passive income by the IRS, and therefore is not subject to self-employment tax. It’s best to consult with a tax professional if you have any questions about your SE tax exposure, but also make certain that you really owe the tax before coughing it up. Knowing the tax rules is how smart people keep more money. Contact Thomas Huckabee CPA for any questions or a free consultation.