Many people start their own company because they have a passion and want to pursue it their way. They’re tired of reporting to someone else, or maybe they’re even tired of how they get paid. Self-employed payroll gives entrepreneurs greater control over their compensation, though there are some limitations depending on how their business is structured.
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What does being self-employed mean?
Self-employed, or entrepreneur, is defined as someone working independently to earn an income without being employed by another person or business. These individuals often wear many hats – marketing, sales, accounting, human resources, etc. As business grows, they may lighten the workload by hiring employees, though doing so makes payroll that much more important.
Payroll options for self-employed individuals
Business owners cannot always pay themselves the same way they pay their employees. Employees may receive a salary, an hourly wage or, in some cases, straight commission. Owners, however, must choose from the payment options that are acceptable according to their business structure:
| Business Type | Acceptable Payments |
|---|---|
| Sole proprietorship | Owner’s draw |
| Partnership | Owner’s draw, guaranteed payment |
| Single-member limited liability corporation (LLC)* | Owner’s draw |
| Multi-member LLC* | Owner’s draw, guaranteed payment |
| S corporation | Salary, distribution |
| C corporation | Salary, dividend |
*Single-member and multi-member LLCs can elect to be taxed as corporations. In such cases, the members who actively work for the company may be considered employees and can earn a salary.
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Compare PackagesSelf-employed payroll steps
The following basic steps apply to self-employed individuals who have employees or earn a salary as an owner of an S corporation or C corporation:
- Determine a payment frequency that meets state requirements.
- Track the hours of any employees who are nonexempt under the Fair Labor Standards Act or applicable state law and may be eligible for overtime.
- Calculate gross wages by multiplying the hourly rate by the hours worked or dividing the annual salary by the number of pay periods in the payroll calendar.
- Withhold income taxes, payroll taxes and all other applicable payroll deductions.
- Remit tax payments to government agencies. The IRS uses the Electronic Federal Tax Payment System (EFTPS); state and local methods will vary.
- Pay employees or business owners their net wages via a method that meets state requirements. Examples include paychecks, direct deposit and paycards.
Looking at these steps, one might think that business owners who don’t earn a salary can escape payroll taxes, but that’s not the case. They may be subject to self-employment tax.
What is self-employment tax?
Self-employment tax is designed to ensure that entrepreneurs who receive owner’s draws, distributions and guaranteed payments still pay their share in taxes. It’s equal to the combined total that employees and employers pay for Federal Insurance Contribution Act (FICA) taxes, also known as Medicare and Social Security taxes.
Who must pay self-employment tax?
Sole proprietors, including independent contractors and partners in a partnership, generally pay self-employment tax if they earn $400 net or more each year. Depending on the circumstances, caregivers who are paid for providing in-home services to family members who are elderly or have disabilities may also have to pay self-employment tax. This rule generally only applies to individuals who, besides caring for a family member, own a business that provides caregiving services.
How to calculate self-employment tax
The self-employment tax rate is 15.3%, of which 12.4% is for Social Security and 2.9% is for Medicare. Similar to FICA, there is an annual limit to the amount of earnings subject to the Social Security tax, but the Medicare tax applies to all taxable, self-employment income. What’s more, any self-employment income that exceeds a certain threshold is subject to Additional Medicare tax.
So, just how much income is taxable? Self-employment tax applies to 92.35% of net earnings from self-employment. Net earnings are calculated by subtracting ordinary and necessary business expenses from the gross income generated by the business.
Self-employment tax deductions
Self-employment tax accounts for the combined total that an employer and an employee pay towards FICA. As such, the IRS allows self-employed individuals to deduct the employer portion of the tax, e.g., 7.65%, from their gross income. This deduction only impacts income tax, not net earnings from self-employment or the self-employment tax.
Self-employment health insurance tax deduction
Some self-employed individuals may be eligible to deduct the cost of health benefits from their gross income. This deduction is an adjustment to income, not an itemized deduction.
How to pay self-employment tax
Self-employed individuals who expect to owe $1,000 or more when filing taxes must estimate their income tax and self-employment tax using IRS Form 1040-ES. They pay the estimated taxes quarterly using the online EFTPS service or by mail. A completed Form 1040-ES should be included with the payment. Those who don’t estimate and report their taxes correctly could be penalized by the IRS.
Frequently asked questions about self-employed payroll
How do I qualify for a self-employed 401(k)?
Self-employed individuals may qualify for a solo 401(k) as long as they don’t have any employees other than a spouse who works for the business.
What is a solo 401(k)?
A solo 401(k) is a retirement savings plan designed for self-employed individuals. It has rules and regulations similar to other types of 401(k) plans, except it is not subject to discrimination testing since no employees are enrolled in the plan.
What percentage should a self-employed person pay themselves?
Self-employed people who structure their business as an S corp may have to pay themselves a reasonable salary, i.e., it’s comparable to what similar companies pay their employees for the same type of work. Compensation analysis reports and information from the Bureau of Labor Statistics can help with this determination.
Should LLC members be on a payroll?
LLC members may be considered employees and, thus, eligible for a salary if the LLC elects to be taxed as a corporation. The member must also actively work for the company, and the salary must be reasonable.
Can I do my own payroll for S corp?
S corp owners who perform more than just minor work for their business must earn a salary, which means they have to run payroll. Small business payroll software is usually the best option because it automates the process, saving time and helping prevent costly errors.
This article is intended to be used as a starting point in analyzing self-employed payroll and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
