self-employment tax explanation

You're missing something basic. The law says to multiply by .9235.

1. The Social Security Administration collects the money.
2. What you see as a disparity is due to the independent contractor being treated as his/her employer. You would get the same result if A's employer was allowed to pay both sides of FICA and Medicare.

Really? If A's employer paid both sides of FICA and Medicare, why wouldn't it simply pay 15.3% of 50K, which is $7650? I know this is trivial, but it's interesting to me and I'd like to fully understand it. Thanks!

The computation is not that simple -- you are actually doing a circular calculation. The .9235 formula gives the answer that equals 1/2 of the tax actually paid. Remember, you deduct the 1/2 in calculating the tax you pay. If you just take 1/2 of the .153% of Schedule C income, you get a deduction that is more than 1/2 of the final tax. By using the .9235 rate, the deduction allowed is 1/2 of the tax paid. Lanny K. Williams, CPA Nawarat, Williams & Co., Ltd. Income Tax Services for Expatriate Americans

True, but the law is mathematically incorrect, the OP is completely correct from a math-only standpoint. I suppose no one cares because (1) the error is in the taxpayer's favor and (2) it's hard enough for many people to grasp as it is without actually making the math correct. The only other post I have ever seen regarding this was in this very group on Nov 13, 2001, from Michael Wing, CPA. Try the following or if it doesn't work search the group archives on Google for "92.89 tax".

It's like this:

If the employer forks over $100, the employee's gross pay is $92.89 (not $92.35). The employee's share of FICA is $92.89

• 7.65% = .11. This equals the employer's match, which is the difference between what the employer forked over and the employee's gross wages, or 0 - 92.89 = .11.

-Mark Bole

The computation is not that simple -- you are actually doing a circular calculation. The .9235 formula gives the answer that equals 1/2 of the tax actually paid. Remember, you deduct the 1/2 in calculating the tax you pay. If you just take 1/2 of the .153% of Schedule C income, you get a deduction that is more than 1/2 of the final tax. By using the .9235 rate, the deduction allowed is 1/2 of the tax paid. Lanny K. Williams, CPA Nawarat, Williams & Co., Ltd. Income Tax Services for Expatriate Americans

Whoever wrote the law just didn't understand math very well and came up with a conclusion that seemed reasonable, though it was inaccurate. Normally the solution would be to go to congress to have them correct their mistake. But, as you say, since it's in the taxpayer's favor that's unlikely to happen any time soon. Stu

[...] [snip]

Can you elaborate on that?

Sorry but I can't let go of this yet -- comes from being a math major. We all agree that the whole point of this is to treat the self-employed person, who wears both the employer and employee hats, comparably to a separate employer/employee arrangement. We all understand why the total profit has to be reduced first before calculating the employee's FICA and the employer's matching share of FICA. What we don't yet agree on is that a minor algebraic error was made when the reduction factor was written into law. Here's another approach that might make it easier to understand: work backwards on the Schedule SE. Suppose the line 3 amount, net profit, is $1,000. This represents the total out-of-pocket cost to the employer for this employee. Line 4, net earnings from self-employment, will be $923.50, which is supposed to represent the gross wages that the person wearing the employer hat would pay to the person wearing the employee hat. We now correctly apply

15.3% to this number on line 5, giving $141.30, which represents the employee's 7.65% and employer's matching 7.65% of gross wages. Or, to restate, the employer's match is one half of the total, or $70.65. If we add the employer's match of $70.65 to the employee's gross wages of $923.50 on line 4, as we would in a true employer/employee arrangement, we get $994.15 total out of pocket from the employer. But we started with $1,000 on line 3 -- hence the error. If we applied the mathematically correct rate of 92.89% on line 4, the problem would go away. But the error favors the self-employed individual in that they pay slightly less SE tax on themselves than they would on an employee being paid the same, so who's complaining?

-Mark Bole

Mathematically, the statute is incorrect. Sec. 1402(a)(12) provides that, in determining the "self employment net earnings" (i.e., the base of the SE tax)(which I'll call SENE for short here), the taxpayer is allowed a deduction in lieu of the deduction provided in Sec. 164(f) in the amount of the SENE determined without the 1402(a)(12) deduction (which amount I'll call SENEX), times one half the sum of the rates imposed by Secs. 1401(a) and (b). Thus, in determining SENE, the taxpayer determines SENE by subtracting from SENEX an amount equal to 7.65% of SENEX. In other words, under Sec. 1402(a), SENE equals SENEX *

1-.0765 = SENEX * 0.9235. However, if one were to compute SENE by treating half of the ultimate SE tax as the analogue of an employer's portion, one would need to determine the amount of the deduction to be taken against SENEX in arriving at SENE. In other words, if x is the amount to be deducted as the analogue to the employer's portion, then SENE = SENEX - x. Of course, x is equal to 1/2 * 15.3% * SENE, or, in other words, x = 7.65% * SENE. Thus, since we first have to get a definite number for SENE, which we can only arrive at in terms of SENEX, we start with SENE = SENEX - (7.65% * SENE)

Which gives us SENEX = SENE * (1.0765)

Which gives SENE = SENEX / (1.0765)

Which, when put back into our equation for x, yields:

x = 0.0765 * [SENEX / (1.0765)]

Which yields:

x = SENEX * (0.0765 / 1.0765)

Which simplifies to:

x = SENEX * 0.071063632....

In other words, the amount that should be allowed as a deduction from SENEX in determining SENE is an amount equal to approximately 7.106% of SENEX which, if we round to only two significant digits, is 7.11% of SENEX. Therefore, to be mathematically correct, Sec. 1402(a)(12) should permit a deduction in the amount of the product of SENEX times .0711 and not in the amount of the product of SENEX times .0765. More likely than not, this sort of computation simply taxed the brains of the statute-writers in 1983 when paragraph

1402(a)(12) was added by P.L. 98-21. It was simply easier, in the rush of getting the amendment typed up and ready for a vote by Congress, to subtract 1/2 of the 15.3% SE tax being imposed, rather than to work through the mathematical issues. Also, and more charitably, the rates were changing, which would have meant that the computation I just went through above would have to be worked out each time the rates changed, so they may have simply settled on allowing a deduction for 1/2 of whatever the rates happened to be at the time. That being said, I doubt if that error will ever be corrected short of as part of an overall, comprehensive reform of the tax code; something we are unlikely to see in the near future.

Note, the operative word here is TOTAL money involved. This includes the employers share of the FICA. The employee is not taxed on the TOTAL money, only the wages. The employer is not taxed on the TOTAL money, only the wages.

This not comparing apples to apples. You are comparing a different amount than in the first example. You are comparing TOTAL money with Schedule C profit. So, I think in answer to your question, yes you are missing something basic here. You're using two different amounts of "profit" to come up with two different answers and expecting them to be the same answer.

So what?

By the way, your assertion that the law is "incorrect" is based upon your assumption regarding what the law intends. A safer assumption is that the law intends what it accomplishes.

Thank you everyone for weighing in on this topic. After reading all of your posts, I think I understand the situation: as I originally suggested and then three posters confirmed, there appears to be a minor algebraic error in how the SE tax is calculated. Nobody really complains (myself included) because the error falls in the taxpayer's favor. Very interesting! Thanks for your time!

-Casey

I agree with you that it's *possible* that the law intends exactly what it accomplishes. However, this possibility seems very unlikely. I think it's more likely that it *intends* to do what most people understand its intent to be--namely, to reduce the burden on the self-employed individual by the amount of fica taxes that an employer would otherwise pay. Therefore, the law is indeed mathematically incorrect, because it does not exactly accomplish its intent (it's off by a fraction of a percent).