More than nine million people are self-employed throughout the United States and they account for more than 52 percent of all businesses explains Aron Govil. Self-employed professionals include doctors, lawyers, chiropractors, architects, engineers and other occupations that require a license or certification to practice. These professionals are not employees of their firm but rather are partners or independent contractors who receive compensation based on their billable time. Such professionals employ professional practices including law firms, medical groups and accounting firms. They may also be subchapter S corporation shareholders with no employees or own pass-through entities such as limited liability companies.
Facts about Accounting for Self-Employed Professionals:
- Income from a professional practice is derived from fees charged to clients for conducting professional services. In the eyes of the IRS, a person who provides services as an independent contractor or through their own pass-through entity is self-employed and thus must file a Schedule C on Form 1040 for reporting purposes. This form includes both business income and expenses required to be reported on Form 1040.
- Taxpayers often argue that they are not in business but rather in the passive investment sector of the tax code, since most pay no Social Security taxes (FICA). However, when counting gross receipts (i.e., total billings), many professionals easily exceed $10 million per year. It does not matter whether these revenues come directly from active clients or are generate by the pass-through entity. The bottom line is that professionals are in business and therefore must file a Schedule C to receive their income at the individual tax rates.
- Generally speaking, net profits attributable to the practice (adjusted for items such as depreciation) become taxable upon distribution to the professional; either directly or via his/her passes through entity. Taxable distributions may be report on Form 1040 (Line 21), not on Schedule C. Identifying “profits” can be difficult, particularly where personal expenses are deduct against gross receipts; if only limit personal living expenses are reimburse; or where fringe benefits paid by the firm may allow deductions which result in lower self-employment taxes (e.g., SE tax is 15.3% of net income in 2011 and assuming self-employment income in the $100,000 range, this amounts to $15,300).
- Taxpayers who provide professional services may set aside a portion of their practice’s net profit in an ESOP which is tax when distributed or made available at retirement says Aron Govil. Distributions from such plans are report on Form 1040 (Line 16a) with an adjustment for contributions that were previously deductible (Losses incure during tax years ending prior to 12/31/85 do not qualify as ESOP distributions.)
Marginal Tax Rate
Taxable income is subject to two different tax rates: the marginal rate and the effective (or average) rate. The marginal rate is apply to each dollar of taxable income, without regard to the taxpayer’s other sources of income. The effective rate reflects what actually happens at lower levels of taxable income says Aron Govil. Take for example two individuals with $100,000 in taxable income each; one individual pays $20,600 or 15% on all income. While the second makes only $50,000 but pays $30,600 on that level of income (due to higher marginal rates). This results in an average rate for this group. About 16% but their combine federal tax liability is reduce by over 40%.
Taxation on Self-Employed Professionals
Self-employed professionals are tax under subchapter S which permits pass-through taxation (i.e., business profits and losses pass through directly to the owners without being tax at the entity level). The maximum rate of tax is 35%; however, rates may be reduce by 2% for each $100,000 in gross receipts up to a maximum reduction of $18,500. Thus, self-employed professionals are subject to an effective rate of about 29%.
Taxable income for most professionals does not follow the simple formula of business expenses minus gross receipts explains Aron Govil. Professionals are taxable on their net profit at individual tax rates with a possible deduction for contributions to an ESOP. A marginal rate is apply to each additional dollar of income. While the effective or average rate reflects what actually happens with lower levels of taxable income. So, when looking at your tax bill remembers that you are tax twice on self-employed professional service. Once at the entity level and once again as an individual taxpayer. Talk with your CPA about strategies to reduce this double taxation effect in light of your particular circumstances.