Self-Employed Taxpayers Get a Break

The Small Business Jobs Act of 2010, signed into law by President Obama on Monday, provides a new temporary tax break for self-employed taxpayers.

To understand the tax break, you first have to understand the tax. Currently, salaried employees who receive a W-2 pay FICA tax on their wages and their employer pays an equal amount of FICA tax.

Meanwhile, self-employed taxpayers pay a “self-employment tax” on net earnings from self-employment that represents both the employee and employer share of the FICA tax. An employee pays 7.65% of his/her wages in FICA tax, while a self-employed individual pays 15.3% in self-employment tax.

Currently, a self-employed individual can deduct 100% of the cost of health insurance premiums, including long-term care insurance premiums up to the dollar maximum allowed based on the taxpayer’s age. Because the deduction is claimed as an adjustment on Page 1 and not on Schedule C it reduces federal income tax but not the self-employment tax.

Here's where the tax break comes in. For tax year 2010 only, self-employed taxpayers can deduct these insurance premiums when calculating self-employment tax

The self-employment tax is calculated by multiplying 92.35% of the net earnings from self-employment by 15.3%. So if the net earnings from self-employment, determined on Schedule C, are $1,000, the self-employment tax is $141.30. A half of the self-employment tax can be deducted as an above-the-line adjustment to income, thus reducing the effective tax cost.

The actual effective self-employment tax rate depends on your federal income tax rate. Taking into account the 50% self-employment tax adjustment to income, the “effective” cost of the self-employment tax is:

  • 15% Bracket = 13.07%
  • 25% Bracket = 12.36%
  • 28% Bracket = 12.15%

So under the new law, a self-employed person who paid $18,000 in health insurance premiums for family coverage in 2010, and who is in the 28% federal tax bracket, can reduce his/her self-employment tax by up to $2,187.

The same rules that existed for deducting these premiums as an adjustment to income still apply.

  • The insurance policy does not have to be in the name of the business. It can be purchased in the individual self-employed person’s name.
  • Premium payments made in any month that the taxpayer or spouse is eligible to participate in an employer-subsidized health plan are not deductible.
  • The deduction is limited to the amount the net profit reported on Schedule C exceeds the adjustment to income for half the self-employment tax from Schedule SE and any Keogh, SEP or SIMPLE contributions. Under the new law, the limitation is determined without regard to the deduction for health insurance premiums; you would use the net profit from Schedule C before the new deduction.

The law also applies to partners with self-employment income passed through on a Form K-1.

This new law puts self-employed individuals, and Limited Liability Companies, “on par” with corporations.  Unfortunately it is good only for tax year 2010.

Because this tax benefit is for one year only, it joins the laundry list of temporary tax benefits that Congress must consider for extension each year.

For 2010, the income cap for the Social Security portion of the self-employment tax (12.4%), and the FICA tax (6.2%), is $106,800.  There is no limit on the income subject to the Medicare portion (2.9% or 1.45%).

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