Thanks to the continuing advancements of technology, self-employment and entrepreneurship are more popular than ever, as all it takes to work from home these days is a strong internet connection.
If you’re going to be self-employed, it’s important to know how your self-employment tax obligations will affect your bottom line, but there’s quite a few potential areas for confusion in this regard.
Who needs to pay self-employment tax? Which business entity owners are considered to be self-employed? How much does self-employment tax cost, and what does it cover? How and when do you need to pay it?
In this article, we’ll take aim at answering all of these questions and many more, as we help you improve your understanding of this important aspect of the American business ownership landscape.
What Is Self-Employment Tax?
Self-employment tax is applicable to all people who work for themselves in America, and it consists of each individual’s Social Security and Medicare tax responsibilities. Unlike people who have typical jobs with an employer, self-employed individuals are required to pay both the employer and employee portions of Social Security and Medicare.
The self-employment tax rate currently sits at 15.3%, which combines the 12.4% Social Security tax and the 2.9% Medicare tax. It’s important to note that this tax is in addition to any income tax responsibilities you may have, and is not a substitute or replacement for any of your income tax obligations.
Another area that can be a bit confusing is that depending on your income, you may not need to pay self-employment tax on all of your earnings. You are required to pay the full 15.3% on your entire net income up to $128,400, but if you make more than that amount, you only need to pay the 2.9% for Medicare on your income over that threshold.
Who Pays Self-Employment Tax?
It’s often an unpleasant surprise to recently self-employed people when they pay taxes for their first year, because many of them don’t know that this rate applies to them. In general, if you operate any of the following business entities, or you pursue any of these business activities, you will be required to pay the 15.3% self-employment tax on your net income.
- Sole proprietorship
- General partnership
- Limited partnership
- Only a general partner pays self-employment tax, while a limited partner does not
- Limited liability company (LLC)
- Independent contractor
- Dealing commodities and options
While all of the above roles require self-employment tax payments, we’ll note that owners of S corporations also need to pay self-employment tax on the salary they pay themselves, but not on the rest of their business profits. For example, if your S corp has $100,000 in profits for the year, and you pay yourself a salary of $50,000, you need to pay self-employment tax on your $50,000 salary, but not on the other $50,000 of your company’s profits
In addition, church employees are required to pay self-employment taxes, but only if the church or church-operated organization you work for elects to be exempt from Social Security and Medicare taxes (as most American religious institutions do). If you make more than $108.28 as an employee of a religious institution or an organization run by a church, you need to pay self-employment tax on that income.
How Is Self-Employment Tax Paid?
To be able to pay your self-employment taxes, you will need either a Social Security number (SSN) or an individual taxpayer identification number (ITIN). Once you have that number, you can report your business income on the Schedule C form, and then file your taxes for this income on a Form 1040.
One important aspect of self-employment is that you need to make quarterly estimated tax payments to the Internal Revenue Service. Estimated taxes aren’t just for self-employed individuals, as you will also be required to make estimated payments if your employer doesn’t withhold enough money from your salary, or if you receive income from interest, dividends, alimony, capital gains, prizes, or awards.
The exact due dates for self-employment tax vary from year to year, typically because the IRS avoids having payments due on weekends or holidays. For example, the 2019 payment dates are April 15, June 17, and September 16 of 2019, along with January 15 of 2020. It’s a bit odd that the second “quarter” only includes two months’ worth of earnings, while the fourth “quarter” encompasses four months, but that’s how the IRS structures it, and who are we to challenge that notion?
If you don’t make enough payments through the estimated tax program throughout the year, the IRS can charge you an underpayment penalty. You can avoid this penalty if you owe $1,000 or less after your estimated payments, or if you’ve paid 90% or more of your total tax obligation.
Self-Employment Tax Deductions and Income Reductions
Self-employed individuals tend to have some rather large deductions available to them, which often revolve around the presence of a home office.
If you do your self-employed work from home, and you have an area of your home that is used solely for business purposes, you can deduct your home-office expenses as a percentage of your total home expenses.
For example, if your home office occupies 15% of your home, you can deduct 15% of your rent or mortgage, along with 15% of your homeowner’s or renter’s insurance, property taxes, utility bills, etc. Most self-employed people can also deduct their health insurance premiums, along with those of their spouses and/or dependents.
As a self-employed person, you are also allowed to claim half of your total self-employment tax burden as a deduction for your income taxes. So, if you pay $3,000 in Social Security and Medicare self-employment taxes, you can reduce your taxable income for income tax purposes by $1,500.
This means that if you’re in the 25% individual tax bracket, you can save $375 on your income taxes due to the payments you’ve made for your self-employment taxes.
A vitally important addition to the self-employment tax landscape is the new 20% deduction on self-employed income that was introduced for the 2018 tax year. With this new deduction, you are allowed to deduct ⅕ of your net business income before paying taxes, meaning that you are only required to pay taxes on 80% of your total income from self-employment.
The issue of self-employment tax might seem simple enough on the surface, but as you can see, there are some interesting wrinkles that complicate matters a bit. There are software products like TurboTax that can simplify a self-employed person’s annual tax return, but this doesn’t help all that much with your ongoing quarterly estimated tax payments.
All told, if you’re a self-employed individual of any kind, you should keep a close eye on your tax commitments at all times, to ensure that you don’t fall behind on your tax obligations.
After all, it’s always advisable to do everything you can to avoid paying the IRS any underpayment penalties on your estimated tax payments. If you want to be absolutely certain that you’re following every rule and regulation to the letter, it might not be a bad idea to enlist the services of an accountant who has experience working with self-employed taxpayers.
We hope this article helped you improve your understanding of self-employment taxes, and whether you need to pay them or not.