Self-employed small businesses—or sole proprietorships—must pay federal income tax, self-employment tax, and sometimes, additional Medicare tax on their Schedule C income. By studying various combinations of self-employment income and other income reported on the same return, we find that most small businesses have an effective tax rate between 14.13% and 37.00%. Self-employed taxpayers with wages from other sources face particularly high effective tax rates on their business income.
The effective tax rate is total tax divided by total income. Since Schedule C income is reported on the individual return, we calculate the total tax on the business income as the increase in tax when the business income is added to the return. For instance, if $10,000 of income results in an additional $1,200 of tax, the effective tax rate is 12%. Effective tax rates are useful in determining the “fairness” or overall effectiveness of tax policy.
Key Takeaways
- There are three income-based taxes that a self-employed business might pay on the owner’s individual income tax return:
- Self-employment
- Income
- Additional Medicare
- A single self-employed taxpayer earning up to $14,903 with no other sources of income will pay an effective tax rate on that income of 14.13% or $2,106. This amount is comprised entirely of self-employment tax.
- A single taxpayer with self-employed business income of $100,000 and no wages will pay tax on their business income of $21,502, or an effective rate of 21.50%.
- A single taxpayer with self-employed business income of $100,000 but with $150,000 in wages from an employer will pay tax on their business income of $32,122, for an effective tax rate of 32.12%.
- High non-self-employment income, such as the wages, can increase the effective tax rate on self-employment income by as much as 20% by eliminating the QBID.
1. Self-employment Tax
Let’s start our discussion with self-employment tax. It’s 15.3% of the net income from your self-employed business, but there are a number of complications that can make the computation messy. To understand the complications, you first need to learn the two components of the self-employment tax:
- Social Security tax of 12.4%
- Medicare tax of 2.9%
These taxes might look familiar because they are the same taxes withheld from employee’s paychecks. The difference is that employees and employers split the total cost by paying 7.65% each, while self-employed individuals must pay the whole 15.3%.
Social Security Tax
For 2023, you only have to pay Social Security tax on the first $160,200 of combined wages and self-employed income. So, if you have wages of:
- $100,000, you’ll only have to pay the Social Security portion of self-employment tax on a $60,200 of business income; or
- over $160,200, you won’t have to pay any of the Social Security portion of self-employment tax, but you’ll still need to pay the Medicare portion.
Medicare Tax
There is no ceiling on the Medicare tax, so you need to pay the full 2.9% of self-employment income.
Self-employment Income
Income subject to the self-employment tax is reduced only by the direct business expenses reported on Form 1040, Schedule C. Other deductions available through Form 1040 that reduce taxable income—but do not reduce self-employment tax—include:
- Standard or itemized deductions
- Qualified business income deduction (QBID)
- Self-employed retirement savings
- Self-employed health insurance
Before calculating the self-employment tax, self-employment income is reduced by 7.65%, which represents the employer’s portion of the tax if the income were wages instead of self-employment income.
Expert tip: I know this seems weird, but the idea is that since corporations get to deduct their share (50%) of FICA taxes, then self-employed taxpayers should also get to deduct 50% of self-employment taxes.
Sharon spends all her time in her self-employed business and reported net income on her Schedule C of $100,000. Here is the calculation of her self-employment tax:
Total Self-employment Tax | |
|---|---|
Schedule C Income | $100,000 |
Reduce by 7.65% | × 92.35% |
Net Self-employment Income | $92,350 |
Self-employment Tax Rate | × 15.3% |
Self-employment Tax | $14,130 |
Self-employment Income | ÷ $100,000 |
Effective Self-employment Tax Rate | 14.13% |
Self-employment Tax Wrap-up
The amount of wages the self-employed person earns aside from their self-employment income has a drastic effect on the effective tax rate of the self-employment tax. A self-employed person with no wages pays an effective rate of 14.13% (example 1), while a self-employed person with over $160,200 in wages pays an effective self-employment tax rate of only 2.68% (example 3).
Statutory Rate | Effective Rate | |
|---|---|---|
Self-employment Tax | 15.3% | 2.68% to 14.13% |
2. Federal Income Tax
The federal income tax rate on your small business depends on your other sources of income. If you don’t have any other sources of income, then your small business income will be taxed at an initial rate of 0% since it can be partially offset with your standard deduction. On the other extreme, if your other taxable income exceeds about $700,000, then all of your small business income will be subject to 37% federal income tax.
Federal Income Tax Adjustments for Self-employed Businesses
1. Standard or Itemized Deductions
Your self-employment income subject to income tax can be reduced by the standard or itemized deductions reported on your income tax return. However, if you have additional sources of income, these deductions may already be used to offset that income and thereby be unavailable for your business income.
2. 50% of Self-employment Tax
Self-employed persons can reduce their taxable income by 50% of the self-employment tax calculated above. So, if you pay the minimum 2.68% in self-employment tax, you can reduce your federal income tax by 1.34%. Similarly, if you pay the maximum effective rate of 14.13%, you’ll reduce your income tax by 7.065%.
3. 20% QBID
Most self-employed individuals qualify to reduce their federal income tax by 20% with the QBID, sometimes referred to as the 20% pass-through deduction. If joint taxpayers have over $340,100 of taxable income ($170,050 single taxpayers), then they may not qualify for any deduction or a reduced QBID, especially if they are a professional service business, like doctors, lawyers, and accountants.
The QBID will reduce federal income tax by as much as 20% or as little as 0%—depending on the total income reported on the return. Thus, other high sources of income, like wages of a spouse, can increase the effective tax rate on self-employment income by 20%.
4. Income Tax Adjustments Ignored
Self-employed taxpayers can reduce their taxable income by health insurance premiums paid and retirement contributions made to specific types of self-employed retirement plans. These adjustments are being ignored in our calculation of the effective tax rate as they are very difficult to estimate the amount. For instance, the health insurance deduction varies based on whether the spouse has employer-provided insurance, a tax credit is available, the taxpayer is eligible for Medicare, and the actual amount of premiums.
The effective tax rate on small businesses will be lower than we estimate for self-employed taxpayers who qualify for a health insurance or retirement deduction.
Federal Income Tax Statutory Rates
For 2023, federal income tax rates for individuals vary from 10% to 37%. In addition, a taxpayer will pay no tax, or a 0% rate, if their income is below the standard deduction for the year. Here are the full federal income tax brackets for 2023:
2023 Federal Income Tax Rates | ||||||||
|---|---|---|---|---|---|---|---|---|
Filing Status | Single | Head of Household | Married Filing Jointly | Married Filing Separately | ||||
Tax Rate | From | To | From | To | From | To | From | To |
10% | $0 | $11,000 | $0 | $15,700 | $0 | $22,000 | $0 | $11,000 |
12% | $11,001 | $44,725 | $15,701 | $59,850 | $22,001 | $89,450 | $11,001 | $44,725 |
22% | $44,726 | $95,375 | $59,851 | $95,350 | $89,451 | $190,750 | $44,726 | $95,375 |
24% | $95,376 | $182,100 | $95,351 | $182,100 | $190,751 | $364,200 | $93,376 | $182,100 |
32% | $182,101 | $231,250 | $182,101 | $231,250 | $364,201 | $462,500 | $182,101 | $231,250 |
35% | $231,251 | $578,125 | $231,251 | $578,100 | $462,501 | $693,750 | $231,251 | $346,875 |
37% | $578,126 | ― | $523,601 | ― | $693,751 | ― | $346,875 | ― |
Federal Income Tax Wrap-up
Statutory federal income tax rates range from 0% to 37%. However, the effective income tax rate for self-employed taxpayers is less than that because they can reduce their taxable income from Schedule C by the standard or itemized deductions, 50% of the self-employment tax, and 20% of QBI. We’ll look at various scenarios in a later section to estimate how these items help determine the effective income tax rate of small businesses.
3. Additional Medicare Tax
An additional Medicare tax of 0.9% is assessed on wages and self-employment income when the total exceeds $250,000 for married taxpayers and $200,000 for single taxpayers. So, this is another area where non-business income will result in an increase in the effective tax rate paid by small businesses.
As with the self-employment tax, net self-employment income is Schedule C income multiplied by 92.35%.
Estimating the Total Effective Tax Rate on Small Businesses
Let’s look at the variations in the effective tax rate on a single taxpayer who works as a self-employed tax consultant. We’ll look at the variation of the effective tax rate as the Schedule C income increases, as well as what happens when our taxpayer has wages in addition to their Schedule C Income.
Schedule C Income | Wages | QBID | Self-employment Tax | Schedule C Income Tax | Additional Medicare Tax | Total Tax on Schedule C | Effective Tax Rate on Schedule C |
|---|---|---|---|---|---|---|---|
$14,903 | None | None | $2,106 | $0 | $0 | $2,106 | 14.13% |
$50,000 | None | $6,524 | $7,065 | $2,911 | $0 | $9,976 | 19.95% |
$50,000 | $50,000 | $9,294 | $7,065 | $4,461 | $0 | $11,526 | 23.05% |
$100,000 | None | $15,817 | $14,130 | $7,372 | $0 | $21,502 | 21.50% |
$100,000 | $50,000 | $18,587 | $14,130 | $15,801 | $0 | $29,931 | 29.93% |
$100,000 | $150,000 | $0 | $3,963 | $27,777 | $381 | $32,122 | 32.12% |
$150,000 | $100,000 | $0 | $11,602 | $38,283 | $347 | $50,232 | 33.49% |
$250,000 | None | $0 | $26,881 | $50,099 | $278 | $77,257 | 30.90% |
$400,000 | None | $0 | $30,898 | $101,640 | $1,525 | $134,063 | 33.52% |
$1,000,000 | None | $0 | $46,967 | $316,518 | $6,512 | $369,997 | 37.00% |
How To Calculate the Effective Tax Rate on Small Businesses
To illustrate the calculations in the table, let’s look at a couple of scenarios. You can calculate the effective tax rate on your Schedule C business by following the steps below.
Scenario 1: $50,000 of Schedule C Income and $50,000 of Wages
Step 1: Calculate your self-employment tax
Schedule C Income | $50,000 |
× 92.35% | |
Net Self-employment Income | $46,175 |
× 15.3% | |
Self-employment Tax | $7,065 |
Remember, if your combined net self-employment income and wages exceed the maximum Social Security threshold, you’ll need to compute the Social Security and Medicare portions of the self-employment tax separately.
Step 2: Figure the tax on Schedule C income
The tax on Schedule C income is calculated as the total tax on the return, less the total tax calculated without the Schedule C income.
Total | With No Schedule C | Schedule C Tax Columns 1 to 2 | |
|---|---|---|---|
Wages | $50,000 | $50,000 | |
Schedule C | $50,000 | ||
½ of SE Tax | – $3,532 | ||
QBID $[50,000 - $1,316) X 20%] | – $9,294 | ||
Standard Deduction | – $13,850 | – $13,850 | |
Taxable Income | $73,324 | $36,150 | |
Income Tax | $8,579 | $4,118 | $4,461 |
Self-employment Tax | $7,065 | $0 | $7,065 |
Additional Medicare Tax | $0 | $0 | $0 |
Total Tax Liability | $15,644 | $4,118 | $11,526 |
Step 3: Compute the effective tax rate on Schedule C Income
The effective tax rate is the tax on Schedule C income divided by the Schedule C income:
$11,526 ÷ $50,000 = 23.05%
Scenario 2: $150,000 of Schedule C Income and $100,000 of wages
Step 1: Figure your self-employment tax
Since the wages and net self-employment income combined exceed the total maximum Social Security base of $160,200, we need to calculate the Social Security and Medicare portions of the self-employment tax separately.
Social Security | Medicare | ||
|---|---|---|---|
Schedule C Income | $150,000 | $150,000 | |
× 92.35% | × 92.35% | ||
Net Self-employment Income | $138,525 | $138,525 | |
Maximum Social Security | $160,200 | ||
Wages | $100,000 | ||
Remaining Social Security Base | $60,200 | ||
× 12.6% | × 2.9% | ||
Self=employment Tax | $7,585 | $4,017 |
Step 2: Calculate the additional Medicare tax
Net Self-employment Income | $138,525 |
Wages | 100,000 |
Total | $238,525 |
Threshold | – $200,000 |
Tax Base | $38,525 |
× 0.9% | |
Additional Medicare Tax | $347 |
Step 3: Compute the Tax on Schedule C Income
The tax on Schedule C income is calculated as the total tax on the return, less the total tax calculated without the Schedule C income.
Total | With No Schedule C | Schedule C Tax Columns 1 to 2 | |
|---|---|---|---|
Wages | 100,000 | 100,000 | |
Schedule C | $150,000 | ||
Half of Self-employment Tax | – $5,968 | ||
QBID (Phased-out for High Income) | $0 | ||
Standard Deduction | – $13,850 | – $13,850 | |
Taxable Income | $230,349 | $86,150 | |
Income Tax | $52,544 | $14,261 | $38,283 |
Self-employment Tax | $11,602 | $0 | $11,602 |
Additional Medicare Tax | $347 | $0 | $347 |
Total Tax Liability | $64,493 | $14,261 | $50,232 |
Step 4: Figure the effective tax rate on Schedule C income
The effective tax rate is the tax on Schedule C income divided by the Schedule C income:
$50,232 ÷ $150,000 = 33.49%
Other Small Business Taxes
Self-employed businesses are subject to other taxes excluded from the estimated effective tax rate in this article.
1. State income: Most states have an income tax rate that applies to the income from self-employed taxpayers. Because of the wide range of tax rates, this article didn’t attempt to include them in our effective tax rate.
2. Payroll: Schedule C businesses must pay payroll tax if they have employees. The owner is not considered an employee and cannot be paid through payroll.
3. Sales: Self-employed businesses must pay sales tax on many items purchased. They must also collect sales tax from customers and remit those taxes to the proper authorities.
4. Excise: Small businesses within certain industries must pay excise tax. The tobacco, alcohol, and fuel industries are a few burdened with excise taxes.
Bottom Line
Small businesses organized as sole proprietorships—often referred to as self-employed businesses—must pay self-employment tax, income tax, and sometimes, additional Medicare tax. Together, these three taxes can create an effective tax rate of up to nearly 38%. Unlike C corporations (C-corps), other income of the business owners has a substantial effect on the tax rate paid on business income.
