The Self-Employment Tax Trap: Business Deductions
I grew up around self-employed people. My dad was self-employed, my mom and brothers have been self-employed, and now I am. For the last few years of my life, I worked closely with CPAs, in a financial planner capacity of course, which fortunately prepared me for some of the tax consequences that came along with being your own boss. Before my intimate experience with taxes, the tax code, and planning in general, I was used to hearing, “We’ll expense it” or “It’s deductible” for various things such as trips, lunches, fishing & hunting trips; whether for business or not. While it is true that all of the above can be expensed, if related to business of course, few people think about the long-term consequence of not paying their share of self-employment taxes.
If the term self-employment tax is new, then you’re probably new to being an entrepreneur so I’ll provide a brief explanation. Self-employment tax is the equivalent to paying the employee & employer portion of FICA (6.2% Social Security tax+ 1.45% Medicare tax x 2); a total of 15.3%. But you don’t have to pay 15.3% on the total income earned. You have to net out your business income against your business expenses to figure out your self-employment tax due.
So what if your business is doing great and you have some extra money in your pocket, would you WANT to pay more taxes or look for more business expenses to reduce taxes? Let’s be honest, no one really WANTS to pay more taxes so generally we take a few extra lunches with clients, buy some really cool Yeti cups, shirts with logos, or maybe even take a business trip to a conference (with the wife & kids maybe). But do we really need these things? Maybe yes, maybe no. In any case, by justifiably lowering your self-employment income with additional business expenses, one lowers the amount of self-employment tax they have to pay on their income…Sounds like a no brainer right?
Things aren’t quite that simple. Paying lower self-employment tax on your income ultimately leads to lower social security benefits (Remember SE tax = SS Tax & Medicare Tax). So why does it matter if social security benefits will be cut by 25% by 2030 something? I’ll be the optimist for you guys and say that I truly believe congress will make some changes to kick the social security benefit cuts down the road. Besides, 75% of a higher benefit is better than 75% of a lower benefit right?
I have been in quite a few meetings where small business owners all want to do a financial plan where they do not want to count on social security and their plan projections fail. Like it or not, social security plays a big part in retirement planning because it is like your pension and adjusts for inflation.
The worst part about this tax trap is the person getting the short end of the stick is… your spouse. Countless times, I see one spouse pursuing their entrepreneurial dreams while the other spouse supports the household until the dream is realized. Then success kicks in and the business deductions increase lowering how much is paid into social security. Time goes by and the entrepreneurial spouse passes away leaving their social security benefit to their spouse; however, the benefit is smaller than expected… I know what some may be thinking, social security is ways away for me. This is where it counts the most, when you’re older, have little bit of work life left in you, and when health issues arise. Social Security benefits are calculated by the average of your highest 35 years of wages; that’s an entire working career from the time you’re 30…
What Should I Do? Pay taxes?
The short answer, it depends. If you’re just starting, like I am, your expenses outweigh your income so there’s nothing you can really do about that. If you’re already established, you may need some marketing material and other business related expenses. But if you find yourself contemplating whether you really need that fishing shirt with your company logo, go to that extra conference with the family, or take that expensive business lunch deduction, you may want to think twice.
As an alternative, here are a few things to do with the extra cash flow after you pay your self-employment taxes:
Fund a retirement plan
Fund a Health Savings Account (must be coupled with a high deductible health plan)
Fund your emergency fund (really needed if you have unstable income)
Fund a 529 Education Savings Plan (tax deductible in some states)
All of the above help increase your net worth in some fashion vs. expensing items where ultimately your money goes into someone else’s pocket. Not only do you increase your net worth but you also increase your social security benefit because each of the items listed above does not reduce self-employment income tax (some reduce federal income tax but that’s another blog for another time).
MyLife Financial is a fee-only financial advisory firm providing objective and independent advice virtually. Our clients are busy professionals that face daunting questions of how today's financial decisions will affect their long-term financial success. Everything written is strictly for informational use only. Please seek the advice of your CPA, Attorney, or financial professional before implementing any strategies.
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