For most people, being self-employed is no bed of roses. One thing that can make it difficult for a self-employed person to earn a living is the tax burden imposed on individual business owners. When you're self-employed you have to pay both income taxes and self-employment taxes on your net self-employment income.
Self-employment taxes are the taxes self-employed people must pay to support the Social Security and Medicare systems. Employees have their Social Security and Medicare taxes directly deducted from their paychecks by their employers, who must make matching contributions. Such taxes are usually referred to as FICA taxes. But if you’re self-employed, your clients or customers will not pay or withhold your Social Security and Medicare taxes. You must pay them to the IRS yourself.
Who Must Pay Self-Employment Taxes
Sole proprietors, partners in partnerships and members of limited liability companies must all pay SE taxes if their net income for the year is $400 or more.
Corporations do not pay SE taxes. However, if you’re incorporated and work in your business, you are an employee of your corporation and will ordinarily be paid a salary. Instead of paying SE taxes, you must pay FICA taxes on your salary just like any other employee. Half of your Social Security and Medicare taxes must be withheld from your salary and half paid by your corporation.
Self-Employment Tax Rates
There are different tax rates and income ceilings for Social Security and Medicare taxes.
Social Security Tax
The Social Security tax consists of a flat 12.4% tax up to an annual income ceiling. (During 2011 and 2012 the tax rate was reduced to 10.4%). If the ceiling didn’t exist, people with higher incomes would end up paying far more than they could ever get back as Social Security benefits. The Social Security tax ceiling is adjusted annually for inflation. You can find the current ceiling amount at the Social Security Administration website.
The basic Medicare tax rate is 2.9% and there is no income ceiling. This means that the self-employed must pay the tax on all their net self-employment income, no matter how high. Moreover, an additional 0.9% Medicare tax took effect on January 1, 2013 in order to fund "Obamacare." The tax only applies to self-employed taxpayers whose income exceeds $250,000 if married and filing jointly, or $200,000 if single. Once a taxpayer's income exceeds the applicable threshold, the effective Medicare tax rate will be 3.8%--the standard 2.9% rate plus an extra 0.9% The additional tax is only paid on that portion of net self-employment income that exceeds the threshold.
Earnings Subject to Self-Employment Tax
You pay self-employment taxes on your net self-employment income, not your entire income. To determine your net self-employment income, you first figure the net income you’ve earned from your business. Your net business income includes all your income from your business, minus all business deductions allowed for income tax purposes. However, you can’t deduct retirement contributions you make for yourself to a Keogh or SEP plan or the self-employed health insurance deduction. If you’re a sole proprietor, as are most self-employed people, use IRS Schedule C, Profit or Loss From Business, to determine your net business income.
If you have more than one business, combine the net income or loss from them all. If you have a job in addition to your business, your employee income is not included in your self-employment income. Nor do you include investment income, such as interest you earn on your savings.
The fact that you can deduct business expenses from your SE income makes them doubly valuable: They will not only reduce your income taxes, but your SE taxes as well.
How to Pay Self-Employment Taxes
You pay SE taxes directly to the IRS four times per year as part of your estimated taxes. When you file your annual tax return, you must include IRS Form SE, Self-Employment Tax, along with your income tax return. This form shows the IRS how much SE tax you were required to pay for the year. You file only one Form SE no matter how many unincorporated businesses you own. Add the SE tax to your income taxes on your income tax return, Form 1040, to determine your total tax.
Even if you do not owe any income tax, you must still complete Form 1040 and Schedule SE if you owe $400 or more in SE taxes.