On December 23, Congress passed H.R. 3765, the “Temporary Payroll Tax Cut Continuation Act of 2011” (the TTCA). The bill was signed into law by President Obama shortly thereafter. The tax provisions of the TTCA consist of a two-month temporary extension of the payroll tax cut that’s in place for 2011, plus a parallel extension of a lower Self Employment Contributions Act (SECA) tax rate on self-employment income.

Overview. The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax).

Before passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act, P.L. 111-312), the FICA tax rate for employees and employers was 7.65% each—6.2% for OASDI and 1.45% for HI. Under the SECA tax, self-employment income of self-employed taxpayers was subject to a tax of 15.3%—12.4% for OASDI and 2.9% for HI. There is a maximum amount of compensation subject to the OASDI tax (the wage base), but no maximum for HI. (The wage base is $106,800 for 2011 and $110,100 for 2012.) Similar rules apply under the Railroad Retirement Tax Act (RRTA).

Under pre-2010 Tax Relief Act law, for computing the income tax of an individual, Code Sec. 164(f) allowed an above-the-line deduction equal to 50% of the amount of the SECA tax imposed on the individual’s self-employment income for the tax year.

Under Code Sec. 1402(a)(12), a taxpayer is allowed a deduction in computing net earnings from self-employment equal to: (1) net earnings from self-employment as determined before taking the Code Sec. 1402(a)(12) deduction into account, multiplied by (2) one-half the sum of the OASDI tax rate and the HI tax rate. This deduction is allowed in computing net earnings from self-employment in lieu of the Code Sec. 164(f) above-the-line deduction of one-half of the self-employment tax. Thus, the Code Sec. 164(f) deduction can’t be taken in computing self-employment tax liability. The Code Sec. 1402(a)(12) deduction is designed to put the self-employed in the same position as employees in that they don’t have to pay self-employment tax on about half of the amount of the tax itself.

Temporary tax cut for 2011. For remuneration received during 2011, the 2010 Tax Relief Act reduced the employee OASDI tax rate under the FICA tax by two percentage points to 4.2%. Similarly, for self-employment income for tax years beginning in 2011, the Act reduced the OASDI tax rate under the SECA tax by two percentage points to 10.4% percent. As a result, for 2011, employees pay only 4.2% Social Security tax on wages up to $106,800 and self-employed individuals pay only 10.4% Social Security self-employment taxes on self-employment income up to $106,800.

The 2010 Tax Relief Act provided rules for coordination with deductions for employment taxes, as follows.

The Code Sec. 164(f) income tax deduction allowed for tax years beginning in 2011 is computed at the rate of 59.6% of the OASDI tax paid, plus one half of the HI tax paid.

A new percentage (59.6%) replaces the rate of one half (50%) allowed under pre-2010 Tax Relief Act law for this portion of the deduction. The new percentage is necessary to continue to allow the self-employed taxpayer to deduct the full amount of the employer portion of SECA taxes. The employer OASDI tax rate remains at 6.2%, while the employee portion falls to 4.2%. Thus, the employer share of total OASDI taxes is 6.2 divided by 10.4, or 59.6% of the OASDI portion of SECA taxes.

However, the two-percentage-point reduction is not taken into account in determining the Code Sec. 1402 SECA tax deduction allowed for determining the amount of the net earnings from self-employment for the tax year.

New law. Under the TTCA, the reduced employee OASDI tax rate of 4.2% under the FICA tax, and the equivalent employee portion of the RRTA tax, is extended to apply to covered wages paid in the first two months of 2012. (Sec. 601(c) of the 2010 Tax Relief Act (P.L. 111-312), as amended by TTCA Sec. 101)

The TTCA also provides for a recapture of any benefit a taxpayer may have received from the reduction in the OASDI tax rate, and the equivalent employee portion of the RRTA tax, for remuneration received during the first two months of 2012 in excess of $18,350 (i.e., two-twelfths of the 2012 wage base of $110,100). (Sec. 601(g) of the 2010 Tax Relief Act (P.L. 111-312), as amended by TTCA Sec. 101) The recapture is accomplished by a tax equal to 2% of the amount of wages (and railroad compensation) received during the first two months of 2012 that exceed $18,350.

M&Q observation: A highlight of the TTCA issued by the House Ways & Means Committee on December 22, indicates that the recapture provision would apply only if the temporary payroll tax cut ends on Feb. 29, 2012. A House-Senate Conference will convene soon to consider extending the temporary payroll tax cut for the remainder of 2012.

For tax years beginning in 2012, the TTCA provides that the OASDI rate for a self-employed individual remains at 10.4%, for self-employment income of up to $18,350 (reduced by wages subject to the lower OASDI rate for 2012). (Sec. 601(f) of the 2010 Tax Relief Act (P.L. 111-312), as amended by TTCA Sec. 101) Related rules for 2011 concerning coordination of a self-employed individual’s deductions in determining net earnings from self-employment and income tax also apply for 2012, except that the income tax deduction allowed for the OASDI portion of SECA tax paid for tax years beginning in 2012 is computed at the rate of 59.6% of the OASDI tax paid on self-employment income of up to $18,350. For self-employment income in excess of this amount, the deduction is equal to half of the OASDI portion of the SECA tax paid. The Joint Committee on Taxation explanation of the TTCA says that the 59.6% used for the first $18,350 of self-employment income is necessary to continue to allow the self-employed taxpayer to deduct the full amount of the employer portion of SECA taxes. The employer OASDI tax rate remains at 6.2%, while the employee portion falls to a 4.2% rate for the first $18,350 of self-employment income. Thus, the employer share of total OASDI taxes is 6.2% divided by 10.4, or 59.6% of the OASDI portion of SECA taxes, for the first $18,350 of self-employment income.

Effective date. The above TTCA changes are effective for remuneration received during the months of January and February in 2012 and for self-employment income for tax years beginning in 2012. (TTCA Sec. 101(c)).