How self-employment taxes work
Self-employment taxes (sometimes called SECA tax, for the "Self-employed Contributions Act"), are the taxes self-employed business owners pay for Social Security and Medicare. Yes, they are the same taxes employees and their employers pay as FICA taxes.
Owners of sole proprietorships, LLCs, partnerships, and S corporations are owners; corporate owners are shareholders and employees. First, make sure you are clear about whether you are an owner or an employee.
We'll have this discussion primarily from the standpoint of Social Security benefits since Medicare benefits aren't affected by the amount of your business income. (Medicare tax eligibility is affected by the credits you accumulate from self-employment income; see below).
How Self-employed Business Owners Pay Taxes
Employees pay their half of FICA taxes through withholding from paychecks, then the employer kicks in the other half of these taxes. Employees get the benefit of being able to count the tax payments toward their Social Security and Medicare eligibility and the amount of their benefits.
But business owners don't get a paycheck. So, they qualify for SECA tax based on the profits of their business. These profits get reported for sole proprietors on Schedule C - Business income or loss - as part of the owner's personal 1040. Partners and LLC owners report their business income on Schedule K-1.
How Self-Employment Income Affects Social Security Credit
To get Social Security (and Medicare) credit, the business owner must:
- Report the income on Schedule C or Schedule K-1 and on your personal tax return. If you don't report, you don't get the credit, and
- You must have a profit for the year. No profit, no credit.
Social Security credits add up quarterly. Because businesses report income annually, based on their Schedule C net profit, your business profit must be at least $1200 for the year to receive 4 quarters of credit (based on 2014 income).
Your self-employment income affects your Social Security credit in two ways:
- First, you must meet the minimum number of quarterly credits over your working life to qualify to receive the Social Security benefit.
- Then, the amount of your benefit is determined by your earnings from all sources (including your self-employment income), up to the annual maximum ($118,500 for 2015).
The business owner who has no profit can't count his or her business activity for that year for SECA purposes. That means, no quarters of eligibility for Social Security, in particular. While it sounds like good news not have to pay the SECA tax, it's bad news in that the owner worked a year for nothing, for Social Security purposes.
If the business owner can show a bigger profit, he or she can get a greater Social Security benefit, based on the amount of the profit. But, don't forget that the profit also means higher income taxes. See what I mean about this being a good-new/bad-news thing?
So, if a business owner is diligent and he or she takes all available and legitimate business tax deductions to get to a lower business income for income tax purposes, he or she is also lowering the amount of credit for SECA purposes.
The higher the profits, the higher the income tax, the higher the SECA tax, and the greater the SECA credit. But the lower the profits, the less the income tax bill, and the less the SECA tax bill, but the lower the SECA tax credits for Social Security and Medicare eligibility.
So what's a business owner supposed to do? This dilemma is one every business owner faces, even without Social Security in the mix. You want to maximize your profits to increase your income, but you don't want to pay too much income tax. There may be other ways to legally avoid income taxes while still maintaining your business profit numbers; by funding or contributing to a self-employed IRA, for example.
Disclaimer: The purpose of this discussion was to provide general information on the correlation between business income and self-employment taxes. Nothing in this article, or on this site, is intended as tax or legal advice. Every business situation is unique, and taxes and laws are always changing. Before you make any decisions that may affect your income taxes or your Social Security benefits, discuss the issue with your tax advisor.