Self-Employment Taxes Explained
Many Self-Employed Business Owners Must Pay These Taxes
If you own your own business and you haven't incorporated, you're self-employed, and this means you must pay self-employment taxes. These are taxes payable to the Social Security Administration for Social Security and Medicare. You must pay them on your net self-employment income each year.
Does My Business Type Affect My Self-Employment Taxes?
Self-employment tax is due on the income of small businesses including sole proprietors and independent contractors, partners in partnerships, and LLC owners. These businesses are pass-through entities because the profits and losses of the business pass through to the owners on their personal tax returns. These payments to owners don't have income tax or Social Security/Medicare taxes withheld, so they must be paid with the person's tax return.
You don't have to pay self-employment taxes if you own a corporation because payments you receive from the corporation as a shareholder come not in the form of dividends, which are taxed separately. If you are paid as an employee of the corporation, you pay Social Security and Medicare taxes in the form of FICA taxes.
How Do Self-employment Taxes Differ from "Employment Taxes"?
Everyone who earns income in the U.S. must pay Social Security and Medicare taxes. For employees, these are called FICA taxes. FICA stands for the “Federal Insurance Contributions Act" and it has two parts. The first is Social Security, and the second component is Medicare. These taxes are actually called Old Age, Survivor, and Disability Insurance or OASDI.
The Social Security portion of the tax is 12.4 percent on incomes up to $128,400 as of 2018, and the Medicare portion is 2.9 percent. Employees pay half this tax and their employers pay or match the other half, and this is sometimes called an "employment tax."
Employees have Social Security and Medicare taxes deducted from their gross income before income tax is calculated. The Social Security deduction is 6.2 percent—half of 12.4 percent—and Medicare is 1.45 percent or half of 2.9 percent, for total FICA taxes payable by the employee of 7.65 percent.
If you're self-employed, you must pay the entire 15.3 percent based on the profits of your business. Self-employed individuals must pay the entire amount because the employee and the employer are effectively the same entity.
How Is the Self-Employment Tax Calculated?
When it comes time to complete your personal income tax return, you'll first calculate your net income from self-employment by completing Schedule C. This form begins with your total earnings then deducts various allowable ordinary and necessary business expenses. The resulting number is your taxable or net income from self-employment.
This income is then used to calculate the amount of self-employment tax you owe for the year using Schedule SE. The calculation is somewhat complicated, and there are several ways to run it. Schedule SE walks you through the steps to some extent so you can do it yourself, but you might feel more comfortable asking a tax professional to do it for you or using a tax preparation program.
The total amount of the tax is then carried over from Schedule SE to line 57 of your Form 1040. Any amount you owe for self-employment tax is added to your personal tax liability for the current year to be paid to the IRS. But the Internal Revenue Service is willing to give you a break.
The Self-Employment Tax Adjustment to Income
You'll notice a section titled "Adjusted Gross Income" at the bottom of the first page of Form 1040. You can claim a tax deduction here on line 27 for anywhere from one half to 57 percent of your self-employment tax. When you complete Schedule SE, it will tell you the exact amount you're able to deduct.
In a respect, the IRS is giving that 50 percent contribution your employer would have made right back to you as what's sometimes called an "above the line" deduction. It might not be cold, hard cash, but it does reduce the amount of your income that's subject to income tax.