General Practice, Solo & Small Firm DivisionMagazine
VOLUME 19, NUMBER 2 MARCH 2002
Breaking the Glass Slipper : Reflections on the Self-Employment Tax
By Patricia E. Dilley
The entire structure of Social Security is centered on the employer-employee relationship. Social Security's designers insisted on a contributory system in which all those earning benefits would provide evidence of their work and would be given a personal link to the program through direct payment of a wage tax dedicated solely to the benefits.
The original 1935 legislation covered only workers in industrial wage labor, primarily because of political concerns that proposing a broader social insurance program would impose administrative burdens. After World War II, Congress began to expand coverage under the program, and many categories of self-employed people were covered. The struggle to cover self-employed professionals reveals the administrative difficulty in assessing Social Security taxes outside the context of an employer's payroll. This is still evident in current SECA tax issues. The struggle also indicated the philosophical ambivalence of the original designers about covering highly paid independent professionals who would be less likely to need Social Security in retirement than would the originally targeted industrial workers.
SECA tax rates, credits, and deductions. The SECA tax deduction is designed to put the self-employed worker, after both income and SECA taxes are imposed on self-employment earnings, on a par with an employee after income and FICA taxes are have been imposed on wage income. This is a complex task because the equivalent of the FICA wage for the self-employed earner is a net figure, minus employer taxes imposed on self-employment income (SECA taxes).
As a result, there are two parts to the current statutory scheme. An income tax deduction is allowed under § 164(f) of one-half of the self-employment tax imposed under section 1401, in recognition of the fact that employee wages do not include the employer share of the FICA tax. In addition, under I.R.C. § 1402(12) a reduction is allowed in the self-employment tax base, as part of the definition of net earnings from self employment, equal to the FICA tax paid on net earnings from self-employment. Again this is in recognition of the fact that employee wages do not include the employer share of the FICA tax.
The FICA tax is assessed generally on all wages in covered employment, except for certain specifically excepted categories, but the SECA tax is assessed on NESE: the self-employed person's gross income derived from a trade or business, minus allowable deductions attributable to that trade or business, plus her distributive share of the net income or loss from a trade or business carried on by a partnership of which she is a general partner or a limited partner receiving payments in connection with services rendered to the partnership. The statute requires that only income "derived from a trade or business," minus deductions associated with that trade or business, be included in the SECA tax base.
Subchapter S corporations, partnerships, and limited liability companies. The dividing line between employee and self-employed can become blurred when a principal or sole shareholder-employee of a closely held corporation receives compensation for services performed outside her regular duties. In general, an S corporation shareholder's distributive share of corporate income will not be included in net earnings from self-employment. However, an S shareholder who is an officer of the corporation and who also performs substantial services for the corporation will be considered an employee whose reasonable compensation is subject to wage withholding under FICA. The distinction between distributions as dividends and distributions as earnings creates a somewhat arbitrary distinction, for FICA and SECA purposes, between sole proprietors who incorporate and obtain S corporation tax status and unincorporated sole proprietors. As a general rule, income from the corporation for S corporation shareholders will be taxed as ordinary net income, but not as earnings for FICA or SECA purposes. Employees of the S corporation will receive wages subject to FICA tax; therefore, where a shareholder behaves in a fashion that would lead to the conclusion that her relationship is one of performing services for the S corporation, employment taxes will be assessed.
Partners in limited partnerships are subject to special treatment under the SECA tax as a matter of state partnership law, in recognition of the different roles limited and general partners have traditionally been required to play in their partnership businesses. The FICA-SECA tax treatment of partnership income has relied on assumptions that the relationship between the partner and the business is the indicator of whether or not wages are being paid. The normal rule is contained in section 1402(a), which generally includes in the definition of "net earnings from self-employment" a partner's distributive share of the net income of the partnership derived from the partnership's trade or business. This provision also allows distributive shares of partnership losses from the partnership's trade or business, to reduce net income from self-employment. In order to trigger SECA tax on the partners' distributive shares of income, the partnership itself must be engaged in a trade or business.
Limited liability companies (LLCs) are becoming the preferred alternative to both S corporations and partnerships as a form of organization that provides many of the flow-through tax benefits of a partnership while providing shelter from personal liability for members that was previously available only to corporations. All states have enacted LLC statutes that provide specific guidelines for LLC agreements and operations. The IRS has issued guidelines allowing taxpayers to choose to have an LLC treated for federal income tax purposes as either a partnership or an association.
Problems of the SECA tax. There are two inherent dualities in the conceptual framework of the system. First, the SECA tax is both a revenue collection device and a benefit accrual system, just like the FICA tax on which it was modeled. The presumptions that have worked fairly well in the FICA context are not particularly applicable in the SECA context. Second, the SECA tax is an income tax that is required to perform like a wage tax_again, the FICA tax model has been imposed on fluid working and investment relationships and entities that do not fit squarely into the preexisting notions of what wages are and how they should be paid.
Another problem of the SECA tax is properly defining the tax base. The inherent difficulties of using an income tax to perform a wage tax function are clearest in considering how to define the wage portion of self-employed persons' total income.
A third problem concerns identifying the proper person who must pay SECA taxes. Several issues under current law can be highlighted in this connection. First is the problem of distinguishing the self-employed person from the employee and deciding who is simply an employee characterized as an independent contractor. Second is the issue of relying on common law or state law to provide categories to decide whether a person is a self-employed worker or a passive investor.
Modest suggestions. The principal source of difficulties in formulating and applying the self-employment tax appears to be the necessity to tie coverage of the self-employed under Social Security to a tax system based on wages. The tax system generally relies on categories and assumptions that enable us to make distinctions among types of income and to apply different rates of taxation to those types of income. Thus, separating of benefit accrual from revenue-raising should be possible, simply by using the appropriate assumptions and categories in a way that reduces the taxpayer's ability to manipulate definitions and income flows, eliminate their own taxes, and in effect create optional coverage under Social Security. A dual system-one for benefit accrual, the other for revenue collection-is consistent with Social Security's underlying principles and would result in less distortion of the tax system.
Patricia E. Dilley is a professor of law at the University of Florida Frederic G. Levin College of Law.
This article is an abridged and edited version of one that originally appeared on page 65 of The Tax Lawyer, Fall 2000 (54:1).