SEE Part 1 taxation explained

Taxation is worth 15 of the 85 scored questions on SEE Part 1, about 18%. It covers the taxes that sit on top of ordinary income tax, and the rules for paying them on time: alternative minimum tax, self-employment tax, household employment taxes, net investment income tax, Additional Medicare Tax, underpayment penalties and interest, and special provisions for clergy, the military and decedents. The questions are about structure: who owes the tax, on what base, and on which form.

What the outline covers

Self-employment tax

Self-employment tax is the Social Security and Medicare tax for people who work for themselves, calculated on Schedule SE. Know the mechanics rather than memorising the figures:

• The base is 92.35% of net earnings from self-employment, which reflects the employer-equivalent share.
• The Social Security portion stops at the annual wage base; wages already earned as an employee count toward it first. The Medicare portion has no cap.
• Half of the SE tax is an adjustment to income, not an itemized deduction.
• No SE tax is due when net earnings fall below a small annual minimum.

Alternative minimum tax

AMT is a parallel calculation. Start from regular taxable income, add back preferences and adjustments (the state and local tax deduction and the standard deduction are classic examples), subtract the AMT exemption, which phases out at higher incomes, and apply the AMT rates. The taxpayer pays the higher of regular tax or tentative minimum tax. AMT caused by timing items (such as incentive stock options) generates a minimum tax credit usable in later years on Form 8801; AMT from exclusion items does not.

Paying on time: estimated tax and penalties

Tax is a pay-as-you-go system. A taxpayer generally avoids the underpayment penalty if withholding plus timely estimated payments equal at least:

• 90% of the current year’s tax, or
• 100% of the prior year’s tax (110% for higher-income taxpayers), where the prior year was a full 12-month year with a return filed.

Withholding is treated as paid evenly through the year unless the taxpayer elects otherwise, which makes extra withholding late in the year a useful fix. The annualized income method helps taxpayers whose income arrives unevenly. Interest on underpayments is separate from the penalty and runs until the tax is paid.

Taxes on higher incomes

Net investment income tax (NIIT): 3.8% on the lesser of net investment income or the amount by which modified AGI exceeds the threshold for the filing status. Net investment income includes interest, dividends, capital gains, rents and royalties, and passive business income. It excludes wages, self-employment income, and distributions from qualified plans and IRAs.

Additional Medicare Tax: 0.9% on wages and self-employment income above a threshold that depends on filing status. The employer must withhold it once an employee’s wages from that employer pass a fixed level, regardless of filing status, so married couples can end up under-withheld and settle it on Form 8959.

Employment situations

Household employees. A family that pays a nanny, housekeeper or caregiver above the annual threshold owes Social Security and Medicare taxes on those wages, reports them on Schedule H with Form 1040, and gives the worker a Form W-2. Federal unemployment tax can also apply. Workers who are self-employed contractors, and certain family members, are treated differently.

Excess Social Security withholding. If a taxpayer worked for two or more employers and total Social Security withheld exceeds the maximum for the year, the excess is claimed as a credit on the return. If a single employer withheld too much, the employer must refund it; it is not claimed on the return.

Clergy. A minister’s housing allowance is excluded from income tax but included for self-employment tax. Ministers are treated as self-employed for Social Security purposes on their ministerial earnings, unless they have an approved exemption based on conscientious objection (Form 4361).

Military. Combat zone pay is excluded (enlisted members fully, officers up to a limit), and deadlines are extended for service in a combat zone.

Income in respect of a decedent. Income the decedent had earned but not received (a final paycheque, IRA balances, accrued interest) is taxable to whoever receives it, with the same character. If the estate paid estate tax on that item, the recipient may deduct the estate tax attributable to it.

Sample questions

What to practise

For each of AMT, SE tax, NIIT and Additional Medicare Tax, write four lines: the base, the rate or mechanism, the form, and one common trap. Then work two estimated-tax safe harbor scenarios, one that passes and one that fails. Next, advising the individual taxpayer.