How is self-employment tax deferral for 2020 reported on Schedule SE and Schedule 3?
A self-employed client wants to take advantage of the self-employment tax deferral under the CARES Act. How is that accomplished on his tax return?
Q: Can a self-employed taxpayer defer SE tax as part of the social security payroll tax deferral?
My client Etan is a self-employed hair stylist who files a Schedule C. During the lockdown last spring he had to close his salon for nearly two months. He leases his shop location, which is in a large retail space. He reduced his first and second quarter estimated tax payments because of the self-employment tax deferral he heard about.
As it turned out, his business picked up over the summer and fall and now he expects to do as well or even better than he did in 2019. He is estimating his net earnings to be about $50,000. He increased his third quarter estimate and is wondering about the final estimate and the deferred SE tax. He expects that he’ll pay in between $7,000 and $8,500 in total.
How will the deferral of self-employment taxes work when Etan files his 2020 tax return? Will he be penalized if his estimated tax payments don’t cover his 2020 self-employment tax liability?
A: Yes, a self-employed person may defer one-half of the social security tax portion of SE tax.
Self-employed taxpayers can take advantage of a CARES Act provision that allows them to defer one-half of the social security portion of self-employment tax attributable to net earnings from self-employment for the period March 27, 2020 through December 31, 2020. In anticipation of the deferral, taxpayers can reduce their estimated tax payments accordingly without penalty.
Taxpayers who plan to defer a portion of self-employment taxes must complete four steps:
- Determine the maximum SE tax deferral amount
- Determine the allowed SE tax deferral amount
- Elect how much of the allowed SE tax deferral they wish to use
- Determine how much to repay in 2021 and 2022
Maximum SE tax deferral amount (Schedule SE, Part III)
When Etan files his 2020 tax return he’ll compute self-employment tax, including the adjustment for one-half of SE tax in the usual manner. He will then complete new Part III of Schedule SE to calculate the maximum deferral amount.
He can use any reasonable method to allocate net earnings to the period March 27 through December 31. Schedule SE instructions state that in most cases, a proportional division of amounts based on the number of days in each period is reasonable. The SE instructions provide an illustration using a 22.5% and 77.5% split.
To illustrate, let’s assume that Etan’s net earnings from self-employment are $50,000 and he reasonably allocates 77%, or $38,500 to the deferral period. His maximum deferral amount is therefore $2,204 ($38,500 × 0.9235 × 0.062). Here, the 6.2% represents one-half of the social security portion (12.4%) of SE tax.
The $2,204 is the maximum deferral amount but not necessarily the amount that Etan will defer. Etan must also determine his allowed deferral and, of that amount, how much he elects to defer.
Allowed SE tax deferral amount (worksheet to Schedule 3, line 12e)
In general, the amount that a taxpayer is allowed to defer is the smaller of:
- The maximum deferral amount, or
- The tax underpayment, i.e. the difference between total taxes due and total taxes paid in.
The allowed deferral amount is calculated on the deferral worksheet to Schedule 3, line 12e, which is on page 101 of the 2020 draft instructions to Form 1040.
Continuing with the illustration, suppose Etan’s tax liability for 2020 is $10,000 and he pays $7,000 through estimated tax payments so that he has a tax underpayment of $3,000 ($10,000 - $7,000) for the year. Since the underpayment is more than the maximum deferral, Etan can defer up to $2,204. If so, he reduces his underpayment to $796 ($3,000 - $2,204).
In the alternative, suppose Etan instead pays in $8,500 through estimated tax payments, resulting in an underpayment of only $1,500 ($10,000 - $8,500). In that case, his allowed deferral would be limited to $1,500.
Electing the SE tax deferral amount (Schedule 3, Additional Credits and Payments)
The third step is to for Etan to decide how much of the allowed amount he wishes to defer. The elected deferral is reported on Schedule 3, line 12e, and carries to line 31 of Form 1040. As explained above, the deferral serves to lower Etan’s balance due.
Note: Regardless of his decision, the full amount of self-employment tax is included in his total tax liability and one-half of the tax is claimed as an adjustment to income on Form 1040.
Repayment amounts in 2021 and 2022
The maximum deferral amount is split equally between 2021 and 2022. If the maximum amount is allowed and elected, Etan would repay $1,102 by December 31, 2021 and $1,102 by December 31, 2022.
If Etan is deferring something less than the maximum deferral amount, then the 2022 repayment is the smaller of $1,102 (one half of the maximum deferral) or the elected deferral amount. Any remaining deferral amount must be repaid in 2021. For example, if the deferral amount is $1,500, Etan would have to repay $1,102 in 2022 by December 31 and $398 ($1,500 - $1,102) in 2021.
The Schedule 3 worksheet is also used to calculate the two repayments depending on the maximum deferral, the allowed deferral, and the elected deferral.
See FAQs 21-24 in IRS’s Deferral of employment tax deposits and payments through December 31, 2020.