Kristie L. Darien, Executive Director of
The National Association for the Self-Employed

House Committee on Small Business

Reforming the Tax Code to Assist Small Businesses

September 21, 2005

On behalf of the National Association for the Self-Employed’s 250,000 member businesses, we would like to thank Chairman Manzullo, Ranking Member Nydia Velazquez and the Members of the House Committee on Small Business for convening this hearing to discuss reforming the tax code to work with rather than hinder micro-businesses. The NASE is a leading resource for the self-employed and micro-businesses, businesses with ten or less employees. Today, this vital segment of the small business population within our nation numbers more than 18 million.

The complexities and inequities within our tax code have long placed a significant burden on the smallest of businesses in our nation. More than ever, America needs micro-businesses to marshal their resources and continue to advance the American economy by doing what they do best - create, innovate, produce, build and grow. Small business-specific tax reform would assist in creating a favorable environment for the growth and success of small firms.

The NASE strongly supports the Small Employer Tax Relief Act of 2005 and feels that the provisions included in the bill would significantly assist micro-business owners and the self-employed. In particular, I would like to highlight two key provisions and their importance to the self-employed: the self-employment tax deduction on health insurance premiums and an annual standard home office deduction of $2,500.

SECA Tax Deduction for Health Insurance Premiums

A chief impediment that micro-businesses and the self-employed are facing is the ever-increasing costs of health coverage. The state of health care among the nation’s micro-businesses is critical. The number of uninsured Americans continues to grow and many are owners or workers in small businesses. The NASE strongly support removing current inequities in the tax code that make the purchase of health coverage more costly and a disincentive for the self-employed.

NASE Member Scott Falnes, owner of a carpentry and construction company located in Lake in the Hills, Illinois pays an additional $336 annually in self-employment tax on health insurance premiums. Scott calls this extra tax on sole proprietors unfair. “Obviously the tax is not fair across the board. The general population is not affected. I have to fight to keep my prices competitive, pay the bills, and hopefully have enough to let my business grow. I don’t mind paying my ‘fair’ share, so long as it’s fair.” Falnes, is of course referring to the fact that he – and 16 million other sole proprietors and partnerships with earned income have to pay the equivalent of payroll taxes on their health insurance premiums.

All employees who receive compensation from employers pay FICA taxes. FICA comprises Social Security (6.2 percent) and Medicare (1.45 percent) taxes. Employers are required to withhold from gross compensation 7.65 percent for FICA. In addition to the FICA withheld from the employee, the employer is required to “match” the FICA withholding. Therefore, the employee and employer contribution for FICA is 15.3 percent of compensation (subject to applicable annual limits).

The self-employed pay into the Social Security Fund at a rate equivalent to employees and employers. FICA tax for the self-employed is called “self-employment tax.” The self-employment tax is computed at the same rates (15.3 percent) as employee/employer FICA and is subject to the same annual limits.

The tax inequity faced by the self-employed when purchasing health insurance lies in the fact that Schedule C filers (sole-proprietors) and Schedule E filers (partners in partnerships with earned income and 2 percent owners in S Corporations) do not receive a “business deduction” for health insurance premiums. The premiums are not deducted for purposes of the self-employment tax and, accordingly, the sole proprietor(s), partners in partnerships and S corporation owners pay self-employment tax (15.3 percent on self-employment income up to $90,000) on the insurance premiums. The self-employed are the only segment of the business population that has to pay this extra tax on health insurance.

C corporations, on the other hand, receive a deduction for health insurance premiums as an ordinary and necessary business expense for all employees including owners. Since the premiums paid for health insurance are not considered compensation to the employee or employee owner, they are not subject to FICA (Social Security and Medicare) taxes for either the employee or the employer.

While 100 percent deductibility of health insurance premiums has phased in, it does not solve this tax inequity. The self-employed are required to pay two types of taxes on their annual tax returns: income tax and self-employment tax. One hundred percent deductibility relates only to income tax and not self-employment tax. Thus, the self-employed still pay the 15.3 percent self-employment tax on their health insurance premiums.

According to the most recent Kaiser Family Foundation study, the self-employed pay on average $10,880 for family health coverage. Because they cannot deduct these premiums as an ordinary business expense, they are required to pay $1,665 in additional taxes that no other business entity must pay. This is money that our members tell us they would use to reinvest into their business, hire part-time assistance, or utilize to offset the rising premium costs they face each year so they may hold on to their coverage a little longer.

NASE Member David Caffrey, an electrical contractor in Rio Rancho, New Mexico pays an additional $715 annually in self-employment tax on his health insurance premiums. He says that this extra cost adds to the already high tax burden for small businesses in New Mexico and increases his health care burden. If David did not have to pay this extra cost, he would help pay for his gasoline expenses. Rob and Laurie Wren, real estate investors in St Louis, Missouri tell us that they would invest the $1,744 tax savings they would on additional advertising in order to increase sales. Laurie says that the additional tax “definitely increases my health care burden-both for my family and my employee whose insurance I pay for as well.”

To achieve tax equity between all forms of business entities, the self-employed must receive exclusion of health insurance premiums from self-employment tax regardless of the entity form under which they choose to operate. Health insurance premiums of the self-employed should be deductible on Schedule C or E as an ordinary and necessary business expense rather than the deduction above the line on Form 1040. This issue is not only one of fairness but, in the current health care climate, the self-employed are disproportionately affected. Removing this extra tax on health insurance premiums would make health coverage slightly more affordable. The NASE is pleased to see this issue addressed in the Small Employer Tax Relief Act of 2005.

Standard Home Office Deduction

Increasingly, entrepreneurs are utilizing their home as a primary place of business. Over 50% of the NASE’s 250,000 members are home-based businesses. According to research commissioned by the SBA Office of Advocacy, home-based businesses represent 52 percent of all firms and provide 10 percent of the total revenue of the economy. Many home-based business owners do not make use of the home office deduction due to the complexity of the deduction and stringent criteria they must meet.

The form for the home office deduction is very complicated. The taxpayer must differentiate between direct and indirect expenses and also between deductible mortgage interest and excess mortgage interest. Some of the expenses are deductible even if the business has a loss and some aren’t. The words “see instructions” appear on this one page form 16 different times. Those instructions say the form will take an average of 1 hour and 15 minutes to complete. A standard deduction for the use of a home office is an excellent step towards tax simplification for the myriad of home-based businesses in our nation.

Conclusion

An overwhelming hardship faced by the self-employed and micro-businesses is the complexity, vagueness, and unfairness of tax regulations. Understanding and then complying with the tax code is extremely difficult and time consuming for a micro-business owner. The inequities within the tax code that this vital segment of the small business community must contend with are unfair and greatly hinder their ability to contribute to our economy.

The introduction, and hopefully eventual passage of the Small Employer Tax Relief Act of 2005, would greatly assist in removing key roadblocks to success and strengthening the competitiveness of our nation’s micro-businesses. Again, the National Association for the Self-Employed is pleased to support this important legislation and we applaud the Committee’s leadership on these crucial issues faced by the self-employed.