07 Aug Facing a Large Tax Bill as a New Business Owner: Understanding FICA Taxes
Starting a new business is an exciting venture, but it often comes with unexpected challenges, particularly when it comes to taxes. Many of my clients who start businesses encounter a significant tax bill in their first year of formation, before they have had a chance to do any tax planning. This large tax bill is often due to Social Security and Medicare taxes (also called “FICA Taxes”). These taxes can be a bit overwhelming at first, so I am going to share some knowledge on what they are and why you are responsible for them them as a small business owner.
Note that you can reduce these taxes through tax planning, which is a service that Lipkin CPA PLLC offers.
What Are Social Security and Medicare Taxes?
Social Security and Medicare taxes are part of the self-employment tax, which is designed to cover the social security and medicare program through the federal government. When you contribute to these taxes through employment (either by yourself or another), you build up your future benefits, but you also end up reducing the funds that you have available now. You are required to pay these taxes if you have taxable wages.
When you are employed by someone else, your employer pays half of these taxes, and the other half is deducted from your paycheck and all of the payments and paperwork are taken care of “behind the scenes”. However, as a self-employed individual, you are responsible for making the payments to the IRS both the employer and employee portions, since you are both the employer and employee.
Here is a description of each tax and how it works for the year 2024:
- Social Security Tax: This tax funds the Social Security program, which provides benefits to retirees, disabled individuals, and survivors of deceased workers. For 2024, the Social Security tax rate is 12.4% on the first $168,600 of net earnings for both employee and employer portions. This ceiling for these taxes increases each year for inflation.
- Medicare Tax: This tax funds the Medicare program, which provides health insurance to people over 65 and to certain younger people with disabilities. The Medicare tax rate is 2.9% on all net earnings, with no income limit for both employee and employer portions.
Combined, these taxes comprise a total of 15.3% of your total earnings, before you even pay your income tax.
The Quarterly Payment Obligation
Unlike traditional employees who have these taxes withheld from their paychecks, you must make quarterly estimated tax payments to the IRS. This means you need to estimate your earnings for the year and pay the required taxes in four installments, typically due in April, June, September, and January. Your earnings are the revenue your business brings in less the expenses the business pays out.
Failing to make these payments on time can result in penalties and interest charges, adding to the financial burden.
The Deduction for Self-Employment Taxes
While it may seem daunting to pay both the employer and employee portions of these taxes, there is a little bit of relief. The IRS allows self-employed individuals to deduct half of their self-employment tax as an adjustment to income on their tax return. This means you can reduce my taxable income by 50% of the self-employment tax paid.
However, it’s important to understand that this deduction is not a dollar-for-dollar reduction of the tax owed. Instead, it simply reduces the amount of income that is subject to income tax. For example, if I paid $10,000 in self-employment taxes, I could deduct $5,000 from my taxable income. This deduction lowers my overall tax liability, but I still need to come up with the full $10,000 to make the quarterly payments. The deduction of $5,000 from my taxable income would result in a dollar for dollar reduction of tax of my tax rate multiplied by the deduction amount.
As an example, if my income tax rate is 12%, the $5,000 deduction would reduce my tax bill by $5,000 x 12% = $600, so I would still be paying $9,600 in actual tax (the $10,000 in self employment tax less the $600 effect of the deduction).
Navigating the Financial Challenge
Facing a large tax bill can be intimidating, especially when you’re just getting started. It’s crucial to plan ahead and set aside a portion of your income for these taxes.
Consulting with a tax professional can also help ensure that you’re making accurate estimated payments and taking full advantage of any deductions available to you. If you would like to learn more about these taxes and business taxes in general, our firm can help you.