As tax professionals, we have drafted many small business returns. In this profession, you start to notice patterns that emerge. One thing we’ve noticed in this economy is there are a vast number of people filing self-employment income for the first time. Self-employment is a wonderful way to free yourself from the dangers of an uncertain economy. But self-employment comes with a cost – It ruins any expected tax return refund.

Part of the issue is how self-employment income starts. Be it a good idea or just an odd side job, the process is the same. The person making the payment is required to send form 1099-MISC to the payee. (If they do not, they run the risk of losing the business deduction) The person being paid is required to include the income on their tax return, and they must pay double the employment tax. The essential problem occurs because former employees strike out on their own without knowing how these taxes work. These new small business owners never think to pre-pay these taxes. The end result is a huge tax bill that is payable when you file your first tax return.

The pattern that emerges comes from the confusion, disappointment and anger from the tax bill at the end. Often, these taxpayers have already spent the money they earned and are unable to pay the tax debt they owe when the return is filed. Because they were unaware of the real self-employment tax cost, they also may not have charged enough for their business services the first year. Nothing deflates the entrepreneurial spirit more than a small business taxpayer who finds their small business suddenly behind on its debts, and these small business taxpayers often give up when they see the real cost.

The most frustrating thing about this reality is that it is entirely policy driven, and therefore preventable. Self-employment tax is designed to mimic the employment taxes (Medicare and FICA) that are split between employees and employers. You can see the employee portion of this tax collected on a W-2 by looking at boxes 4 and 6. Employers must pay the same amount again, and that is how the social security system is funded. A self-employed person pays this same tax on Schedule SE on their individual income tax return, but they pay both the employee and employer amount. This is an incredible burden on a small business taxpayer. It is especially bad because they don’t see it coming, and it absolutely hampers expansion exactly at a time when a successful small business needs cash to grow.

It doesn’t need to be this way. In 1951, you could buy a car for $400. $400 also happens to be the exemption from self-employment tax on a 1951 Schedule C. This means that if you earned less than $400 in 1951, you paid $0 in self-employment tax. In 1951, the maximum amount of income that was subject to self-employment tax was $3,600. This means that if you earned more than $3,600, you didn’t pay tax on anything above that amount. At the rate of 2.25% in 1951, that means the maximum tax due was $81.

Congress has authorized the IRS to make cost of living adjustments to certain values to properly reflect how inflation affects the cost of living. For example, the standard deduction and personal exemption amounts change upward every year. In 1951, these amounts were a $1,000 standard deduction and $600 for each exemption. It makes sense that in 2012 a married filing joint standard deduction would be $11,900 and a personal exemption would be $3,800. In 2012, the minimum threshold for self-employment tax still is $400. For 61 years, this vital threshold has never been indexed for inflation, and it means that more and more people are caught with this tax every year. Underage teenagers working a side job are caught in it. Seniors working to supplement their retirement are caught with it.  We should absolutely stop destroying small businesses by indexing this number to a current 2014 value.

If you have been caught in the self-employment trap, there are options. If you owe back taxes due to self-employment, we can help. Our firm has worked with many small business taxpayers in negotiating payment plans with the IRS that are affordable. We can also review your returns to make sure you properly took every deduction you are allowed. Don’t ignore another bill from the IRS. Contact Dallo Law Group by clicking here, or call us at 619.795.8000.