An Explanation of Self-Employment Taxes
If you own your own business you will want to follow the tax rules for small businesses and incorporate them into your financial planning for the year. One significant consideration for self-employed business owners is the self-employment tax, which is charged to cover Social Security and Medicare expenses that aren’t withheld from a standard W-2 filing. These are taxes payable to the Social Security Administration. As a self-employed business owner, you must pay them from your net self-employment income each year.
Business Type and the Affect on Self-Employment Taxes
Self-employment tax is due on the income of all small businesses. This includes sole proprietors and independent contractors, partners in partnerships, and LLC owners. All of these businesses are considered pass-through entities because the profits and losses of the business pass through to the owners on their personal tax returns. In general, pass-through taxes are what characterize small businesses and make their tax situations unique.
Self-employment Taxes vs "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 referred to as OASDI (old age, survivor, and disability insurance).
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. At corporations, 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 the Self-Employment Tax Is 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 pass-through net income from self-employment that you will report on your 1040.
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 Form 1040. Any amount you owe for self-employment tax will be added to your personal tax liability for the current year to be paid to the IRS.