Independent Contractors Must Pay Self-Employment Taxes

If you moonlight (have a second job) as an independent contractor, you'll have to pay self-employment taxes on the income you receive.

Carnell Specks found out about this rule the hard way. Specks, a Houston police officer, moonlighted by providing security services to various private businesses in the Houston area. He earned about $44,000 doing this work one year. He listed this "other income" on his tax return for the year and paid no self-employment tax (Social Security and Medicare taxes) on it.

Unfortunately for Specks, the companies he worked for treated him as an independent contractor and reported all the money they paid him to the IRS on Form 1099-MISC--the form used to report payments to independent contractors. Since these firms regarded Specks as an independent contractor, they did not withhold or pay any Social Security or Medicare taxes for Specks. The IRS computers whirred away and quickly discovered that Specks had self-employment income (reported on the Forms 1099-MISC), but had paid no self-employment taxes on his tax return. The result: He got audited.

Specks tried to claim to the IRS that he was really an employee of the firms he moonlighted for, thus he owed no self-employment tax. This argument just wouldn't fly. The tax court noted that Specks had been issued Forms 1099-MISC by the firms for his services; thus he knew they considered him an independent contractor. If he thought he should have been classified as an employee, he should have told these hiring firms about it. Specks didn't qualify as an independent contractor anyway since it was clear he was running an independent security on the side. Specks had to pay the self-employment taxes he should have paid plus interest and penalties. (Specks v. Comm'r, T.C. Memo 2012-343.)

Here's a simple rule: If you work as an independent contractor, it's up to you to pay income and self-employment taxes (Social Security and Medicare taxes) on the payments you receive. The firms that hire you need not, and will not, do so.

You'll know if you're being treated as an independent contractor instead of an employee if you are not asked to complete an IRS Form W-4, Employee's Withholding Allowance Certificate when you're hired.

You have to pay income taxes and Medicare taxes on all your self-employment income. You must also pay a 12.4% Social Security tax and 2.9% Medicare tax on such income. However, the Social Security tax is subject to an annual income ceiling. Your self-employment income above the ceiling amount is not subject to Social Security tax. There is no income ceiling for the Medicare tax. An additional 0.9% Medicare tax took effect on January 1, 2013 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 is 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.

If you have Social Security taxes withheld from your wages by your employer, you must pay the Social Security tax on your wages first. If your wages are at least equal to the Social Security annual tax ceiling, you won’t have to pay the 12.4% Social Security tax on your self-employment income. But no matter how much you earn from your job, you’ll have to pay the 2.9% Medicare tax on all your self-employment income.

Example: Anne earned $120,000 in employee wages and $10,000 in self-employment income from a business. Her employer paid and withheld Social Security tax on all of her employee wages which were below the Social Security tax threshold for that year. She did not owe any Social Security taxes on her self-employment income because combined with her wages it exceeded the annual Social Security tax threshold. Anne had to pay the 2.9% Medicare portion of the self-employment tax on her $10,000 in self-employment earnings.

However, if your employee wages are lower than the Social Security tax ceiling, you’ll have to pay Social Security taxes on your self-employment income until your wages and self-employment income combined exceed the ceiling amount.

Example: Bill earned $40,000 in employee wages and $80,000 in self-employment income. His wages were lower than the the Security Security annual tax threshold. His employer paid and withheld the Social Security tax on all of his wages. He then had to pay the 12.4% Social Security tax on his self-employment income until it, combined with his employee income, equaled the annual tax ceiling. The remainder of his self-employment income was not subject to Social Security tax, but all of it was subject to the 2.9% Medicare tax.

You pay income tax, Social Security tax, and Medicare tax on your self-employment income four times per year in the form of estimated taxes that you send in to the IRS. If you underpay, you'll have to pay tax on the amount plus interest when you file your return for the year.