Starting an individual business can be liberating for people who are tired of working for someone else. They get to determine their own pay and work whenever and wherever they want. But there’s something from their previous life as an employee that they can’t escape – taxes. One tax particularly significant to entrepreneurs is self-employment tax.
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What is self-employment tax?
When employers hire employees, they share responsibility for Federal Insurance Contribution Act (FICA) tax, also known as Medicare and Social Security taxes. The employer pays half, or 7.65%, of the FICA total and the employee pays the other half. Since entrepreneurs don’t have employees, the IRS requires them to pay both the employer and employee portion of FICA. This requirement is known as self-employment tax.
How much is self-employment tax?
Self-employment tax equals the FICA total for employer and employee, which is 15.3%.
Self-employment tax deductions
At first glance, the self-employment tax rate might seem like a bad deal for entrepreneurs, but there is a silver lining. The IRS allows the self-employed to deduct the employer portion of the tax, e.g., 7.65%, from their gross income. This deduction reduces income tax, but has no bearing on net earnings from self-employment or the self-employment tax itself.
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 a factor when calculating net earnings from self-employment.
Who must pay self-employment tax?
Self-employed individuals generally are subject to self-employment tax if they earn $400 net or more annually. These rules pertain to:
- Sole proprietors
- Independent contractors
- Partners in a partnership
- Single-member limited liability corporation (LLC)
Exemptions may apply to individuals who report earning less than $108.28 per year in church income.
How to pay self-employment tax
Employers withhold FICA and income tax dues when processing payroll, so there’s no action needed on the part of employees. Entrepreneurs don’t have this luxury. If they expect to owe amounts of $1,000 or more when they file their tax returns, self-employed individuals must:
- Estimate their income tax and self-employment tax using IRS Form 1040-ES.
- Pay the estimated taxes quarterly using the online EFTPS service or by mail.
- Provide a completed Form 1040-ES with the payment.
Failure to follow these steps correctly could result in IRS penalties.
How to calculate self-employment tax
The law requires entrepreneurs to pay self-employment tax on 92.35% of their net revenue. Net earnings are the difference between gross income generated by the business and ordinary and necessary business expenses.
Once the personal income subject to self-employment tax is determined, the calculation proceeds as follows:
- Withhold 2.9% for Medicare
- Withhold 12.4% for Social Security (up to the annual wage base limit)
- Withhold 0.9% for Additional Medicare tax if income exceeds a certain threshold
Frequently asked questions about self-employment taxes
Do you pay self-employment tax on passive income?
Self-employment tax generally does not apply to passive income. Examples of passive income include:
- A business owner earns income without participating in the company’s operations.
- A property owner makes money through rentals, but is not a real estate agent.
Please refer to guidance from the IRS and other tax agencies for more information about determining if income is passive.
What kinds of jobs are exempt from paying the self-employment tax?
The federal government charges self-employment tax based on total earnings, not the nature of one’s business. As such, income less than $400 net per year may be exempt from self-employment tax. Church income less than $108.28 may also be exempt.
Do self-employed people pay higher taxes?
The self-employed may pay more taxes than what an employer pays in FICA per employee. The reason is that self-employed individuals pay both the employer and employee portion of FICA tax. However, there are deductions that can help eligible self-employed people reduce their federal and state tax liabilities.
What is the 20% self-employment deduction?
The IRS permits some self-employed individuals to deduct up to 20% of their qualified business income (QBI), as well as 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. Business owners who may be eligible for this deduction include sole proprietorships, partnerships and S corporations.
This article is intended to be used as a starting point in analyzing self-employment tax 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.
