Most self-employed individuals have to pay a self-employment tax in addition to income taxes. The self-employment tax is how self employed individuals pay their share of Social Security and Medicare taxes. In this guide, we’ll tell you the basics of self-employment taxes so that you’re ready at tax time.
Self-employment taxes are primarily regulated by a law called the Self-Employment Contributions Act (or SECA). If you have employees, you must pay half of each employee’s Social Security and Medicare taxes. This is regulated by a different law called the Federal Insurance Contributions Act (or FICA). Learn more about FICA by clicking here.
We recommend TurboTax as the best tax software for self employed individuals. It make it easy to calculate and pay your self-employment taxes so you can focus on running your business.
How Much Self-Employment Tax Do I Owe?
The self-employment tax is designed to ensure that self-employed individuals pay their share of Social Security and Medicare taxes. If you were an ordinary wage earner, half of Social Security and Medicare taxes would be taken out of your salary, and your employer would pay the other half. However, if you’re self employed, you have to pay both the employer and employee portion. Here are the current rates:
Self-Employment Tax Rate for 2015 and 2016
What’s your net self-employment income?
What’s your self-employment tax?
• Under $400
You don’t have to pay self-employment tax
• $400-$200K for single filers
• $400-$250K for married joint filers
• $400-$125K for married separate filers
15.3% of net self-employment income
(This equals 12.4% for Social Security tax + 2.9% for Medicare tax)
• Above $200K for single filers
• Above $250K for married joint filers
• Above $125K for married separate filers
16.2% of net self-employment income
(This equals 12.4 % for Social Security tax + 3.8% for Medicare tax)
Note: If you’re married and file a joint return, you should combine your spouse’s income with your own to determine if you exceed the $250K threshold.
Most people fall into the middle category and pay a 15.3 % tax on their net self-employment income. To calculate your net self employment income, subtract your business expenses from your business revenues. 12.4 % of the self employment tax is comprised of Social Security taxes and is applied to a maximum of $118,500 in income for 2015 and 2016. The other 2.9 % of the tax is for Medicare and is applied to all earnings with no limit.
There’s a small wrinkle at this stage. The self-employment tax isn’t assessed on your entire net self-employment income. It’s assessed on 92.35 % of your net self-employment income. Why? Because you’re allowed to deduct half of your self-employment tax when calculating your net earnings. Don’t worry – this is not something you need to memorize. You should just understand that you first need to multiply your net self-employment income by 92.35 % before calculating the amount of tax you owe.
Example 1: Let’s say that you own a restaurant, and the net earnings for 2015 were $100,000. To figure out your taxable self-employment income, multiply this amount by 92.35 %, which equals $92,350. Then, apply the 15.3% tax rate to this amount. This shows that you owe $14,130 in self-employment taxes.
Example 2: Let’s say you own a booming retail shop, and the net earnings for 2015 were $150,000. Multiplying this by 92.35 % tells you the taxable self employment income, which is $138,525. Only $118,500, however, is subject to Social Security tax, so your Social Security tax is $118,500*12.4% = $14,694. The Medicare portion of the tax applies to the full $138,525, so your Medicare taxes are equal to 138525*3.8% = $4,017. When you add up the Social Security and Medicare taxes, you’ll see that you owe a grand total of $18,711 in self-employment taxes.
This may seem like a lot of money. Indeed, John Scherer, a Certified Financial Planner at Trinity Financial Planning, says that a business owner in the 25% federal and 5% state tax bracket can have a total tax liability equaling 45% of their net profit! (25% fed + 5% state + 15.3% SE). We’ll show you in the next few sections a few ways to potentially reduce your tax liability.
Do I Even Have to Pay Self-Employment Tax?
Before getting to the tax reduction tips, it’s helpful to know if you’re even responsible for self-employment taxes. Anyone who makes more than $400 per year in self-employment income has to pay self-employment taxes, including the following:
- Sole proprietors
- Partners in a partnership
- Members of an LLC (in some cases, if you don’t actively manage the business, you may be exempt).
- Independent contractors and freelancers who receives a 1099-MISC
If you set your business up as corporation, you generally do not have to pay self-employment taxes, says Michael Karu, a CPA at Levine, Jacobs & Company. You would be considered an employee of the corporation and would pay yourself a salary. Half of the social security and medicare tax would be withheld from your salary, and as your employer, the corporation would pay the other half.
For more information, visit the IRS Self Employed Tax Center, or consult a tax professional.
What Forms to Fill Out & Where to Send Payment
Business owners who are subject to the self-employment tax must report the amount due on Schedule SE, which is submitted annually with your income tax return.
In order to help you calculate how much you owe, you can look to your Schedule C (sole proprietorships and LLCs taxed as sole proprietorships) or Schedule K-1 (partnerships) These are income and loss statements for the respective type of business.
If you owe additional self-employment tax for high earners (see table above), you must also file IRS Form 8959 with your return.
When you’re self employed, you don’t have an employer to withhold wages from your income to pay for Social Security and Medicare. As a result, you have to pay your self-employment taxes throughout the year. If you expect to owe more than $1,000 in self-employment taxes (i.e. if your net annual self-employment income is more than $6,500), you will have to pay your estimated taxes in 4 quarterly payments according to the schedule in the table below.
Estimated Payment Due
Jan. 1- March 31
April 1 - May 31
June 1 - Aug. 31
Sept. 1 - Dec. 31
Jan. 15 of following year
You can use IRS Form 1040 ES to estimate your quarterly payments. If your quarterly payments underpay your taxes by more than $1,000, the IRS may charge a penalty when you file your tax return. Form 1040-ES contains blank vouchers you can use to mail your estimated tax payments. However, it’s simpler to make your payments using the Electronic Federal Tax Payment System (EFTPS). This is a free tool offered by the Department of Treasury, and you can use it to schedule payments in advance so that you don’t forget.
According to the EFTPS website, it can take up to 7 business days to receive your PIN, which is required for you to login and make payments. Make sure you apply well in advance of any deadlines.
How to Reduce Your Self-Employment Tax
There are two main ways to reduce your self-employment tax without running into trouble with the IRS:
- Deduct more business expenses.
- Structure your business an an S Corp or an LLC taxed as an S Corp.
Self-employment taxes are calculated based on your net business income. By deducting business expenses on your tax return, you reduce your net income and hence the amount of tax you owe. Karu says that the number one mistake small business owners make when paying their self-employment taxes is not to take advantage of deductions to reduce their taxable income.
Startup costs, business equipment, home office expenses, and business travel are just some of the types of expenses you can lawfully deduct from your income. In general, “ordinary, necessary, and reasonable” business expenses may be deducted. You’ll need to keep records of business expenditures in case the IRS audits you. In addition, some deductions, such as for health insurance, reduce your income tax liability but not your self-employment taxes.
Another way to potentially reduce your self-employment tax is by by creating an S Corp or having your LLC taxed as an S Corp. Why? Because an S Corp lets you earn money in two different ways: as salary and dividends. Only the salary is considered income and is subject to Social Security and Medicare taxes. The catch is that you can’t take all your business revenue in the form of dividends–the IRS requires to pay yourself a “reasonable” salary.
Despite this constraint, this can still potentially save you thousands of dollars in taxes. For example, if your business income was $100,000, you would ordinary pay $14,130 in self-employment taxes. If you form an S Corp or an LLC taxed as one and take $60,000 as a salary, you and the corporation would only pay $9,180 in Social Security and Medicare taxes. That is a tax savings of $4,950!
We recommend that you consult a tax professional or tax attorney for additional information or specific questions.
Use Self-Employment Tax To Reduce Your Income Taxes
While it may seem unfair that you have to pay more in taxes simply because you’re self employed, there is a silver lining. You can deduct half of the amount of self-employment taxes you owe on your income tax return. This can potentially put you in a lower tax bracket, and decrease your income tax bill.
Example: Let’s say you made $80,000 from a home-based business in 2015. Your self-employment tax would be $11,304. For income tax purposes, you would be in the 25 % tax bracket and owe $20,000 in income taxes. You can deduct half the amount of self-employment taxes, $5,652, on your income tax return. This reduces your taxable income to $74,348. That moves you down to the 15 % tax bracket, and you would owe only $11,152 in income taxes. That is a savings of almost $9,000 on your income taxes!
Self-employment taxes are a necessary cost of doing business on your own. While it may seem like you have to pay a large share of your business income in self-employment taxes, there are some ways to ease the pain a little bit. Take advantages of deductions that you permitted to make, and consider setting up your business as an S Corp or having your business taxed as an S Corp. For personalized guidance, we suggest contacting a tax professional.
We recommend using TurboTax for self-employment tax purposes. This greatly simplifies your taxes and enables you to focus on running your business.