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Self-employment tax can easily sneak up on unsuspecting taxpayers (and even some unsuspecting accountants). Sole proprietors are not the only ones subject to self-employment tax; partners in partnerships and individuals with side hustles may also be liable. You should understand not only what self-employment taxes are, but also how they affect your tax liability. And if you have a quality income tax planning software, you can take it one step further by determining how these taxes play into your long-term goals.
The 15.3% self-employment tax rate is applied on a taxpayer’s net earnings from self-employment. This tax is in addition to income tax. Yes, this means that taxpayers may be paying both income and self-employment tax on the same income.
Although an additional 15.3% tax seems excessive, it makes sense once you understand why it exists.
Employed persons split the cost of Medicare and Social Security taxes with their employers. Each party pays 1.45% to Medicare and 6.2% to Social Security. Employees’ taxes, which are collectively referred to as payroll taxes, are withheld from their paychecks. The employer combines the employee’s portion of payroll taxes with their own portion and remits the full 15.3% to the Federal government on a regular basis.
Self-employed individuals are also liable for payroll taxes, but since they have no employer, they are required to pay both the employer’s portion and the employee’s portion. This amount – 15.3% – is what we call self-employment tax.
In other words, self-employment tax is the Federal government’s mechanism to ensure self-employed persons pay into Medicare and Social Security.
Individuals with net earnings of at least $400 are liable for self-employment taxes. One category of taxpayer subject to self-employment tax is sole proprietors. This includes:
Partners in partnerships are also liable for self-employment taxes. This includes owners of legal partnerships and owners of LLCs that choose to be taxed as partnerships. Each partner’s share of partnership earnings is considered self-employment earnings, including any guaranteed payments they may receive.
S corporation shareholders do not owe self-employment taxes, but S corporation shareholders who are also employees of the business will be liable for payroll taxes just as any other employee would be. But the distributions they receive as a shareholder are not considered self-employment earnings, even if those shareholder-employees are actively involved in making business decisions.
There are a few other special rules and exceptions.
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The self-employment tax rate is only assessed on an individual’s net earnings from self-employment. Net earnings are considered all revenues of the business less associated expenses. Deductible expenses might include office supplies, asset purchases, travel costs, inventory, materials, depreciation, equipment leases, and other costs that are necessary to run a business.
If you earned $10,000 from their side gig but had $2,200 of deductible business expenses, only your net earnings of $7,800 would be included in the self-employment tax calculation.
However, not all an individual’s net earnings are taxable. Only 92.35% of self-employed net earnings are subject to tax. On the self-employment tax form, Schedule SE, taxpayers multiply their net earnings by .9235 to determine their taxable earnings.
You reported $7,800 of net earnings from your business. Only 92.35% of that amount – or $7,203 – would be taxable.
Self-employment tax is calculated on Schedule SE and eventually flows to an individual’s Form 1040. In general, the rough calculation is as follows:
Net Earnings from Self-Employment
X 92.35%
Taxable Net Earnings Self-Employment
X 15.3%
Self-Employment Tax
There are a few caveats to this calculation, though.
In 2020, Social Security tax is only assessed on the first $137,700 of an individual’s taxable earnings. This includes earnings from self-employment and W-2 wages. Schedule SE asks for you to report all earnings subject to Social Security – self-employed earnings or otherwise – so that only $137,700 of earnings get taxed.
Just as employers are permitted to deduct the employer’s portion of payroll taxes, self-employed persons can deduct half of their self-employment tax. This deduction is calculated on Line 13 of Schedule SE and flows to the individual’s Form 1040.
You may be required to pay additional Medicare Tax. The Additional Medicare Tax of .9% is due on all Medicare-eligible wages that exceed a certain threshold. For 2020, the threshold for married taxpayers and single taxpayers is $250,000 and $200,000, respectively. Keep in mind that if your W-2 wages exceed these thresholds, your employer may already be withholding excess Medicare. Use Form 8959 to calculate the liability.
Self-employment tax is calculated for each individual. If both married couples are self-employed, you should file one Schedule SE for each spouse.
In the end, self-employment taxes get reported on an individual’s Form 1040 alongside their income tax. Like income tax, they are required to pay their self-employment tax equally throughout the year. When calculating your quarterly estimated tax payments, don’t forget to include self-employment tax in the calculation.
A good tax preparation software will calculate self-employment tax for you, but even the best tax preparation software is unable to predict what role self-employment taxes will play in an individual’s long-term strategy. That’s why you need to invest in a good tax planning software. A good tax planning software like Corvee’s allows you to change multiple inputs and assumptions at once. This lets shows you how different decisions play off each other and how their self-employment tax will change as a result.
See how Corvee allows your firm to break free of the tax prep cycle and begin making the profits you deserve.
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