Often, when taxpayers file a tax return with a balance owed to the IRS, they file it without fully understanding the nature of the taxes they are paying. Some taxpayers fairly believe that they pay a CPA to understand those things for them. However, even a basic understanding of what causes tax to be owed can create a better relationship between farmers and their tax professionals. Those strong relationships create knowledgeable and confident taxpayers, who are better prepared to save money through careful planning.
Farm income, in most cases, is considered “earned income,” which is subject to certain types of tax. The most prominent of those types are Social Security, Medicare, and income taxes. Social Security tax is calculated as 12.4 percent of earned income, and is charged on the first $117,000 (indexed for inflation) earned by an individual. Medicare Tax is calculated as 2.9 percent of earned income, and is charged on all the income earned by an individual (additional Medicare taxes are charged to certain high-income earners, but those taxes are outside the scope of this discussion).
Social Security and Medicare taxes are often discussed together, because employees have these taxes withheld from their paychecks. When paychecks are calculated, employees pay half of the Social Security and Medicare taxes charged on their earnings, and the other half is paid by the employer as a business expense. The two halves add up to 15.3 percent of the employee’s earnings.
But what about individuals who aren’t employees of someone else? Who pays the employer half of these taxes? Self-employed individuals, including farmers, don’t have an employer to pay the other half of the Social Security and Medicare taxes on their earnings – so they are required to pay the entire 15.3 percent themselves. When this 15.3 percent tax is levied on profits from farming or self-employment, it is called Self-Employment Tax, which is one component of the total tax on a farmer’s tax return – income tax is another. Because self-employed individuals must pay both sides of these taxes, Congress has provided a slight break by requiring self-employment tax to be paid on only 92.35 percent of earned income from self-employment.
In a very simplified example, a married couple has $50,000 of taxable income, including a $10,000 farm profit. That couple would pay $1,500 in federal income tax as a result of their farm profit, because they are in the 15 percent tax bracket. In addition, their farm profit would be subject to Self-Employment Tax of $1,413 ($10,000 x 92.35% x 15.3%). That’s a grand total of $2,913 of tax, generated by $10,000 of farm profit. So even though this farm couple is in the 15 percent bracket, their farm profit is subject to nearly 30 percent tax.
Understanding the nature of Self-Employment tax should help farmers understand what taxes they are paying. It can also open the door to constructive conversations with tax preparers about potential ways to reduce taxes.