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Does Your Tax Planning Software Take Self-Employment Tax into Account?

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. As your client’s advisor, you need to understand not only what self-employment taxes are, but also how they affect your client’s tax liability. And if you have a quality income tax planning software, you can take it one step further by showing your clients how these taxes play into their long-term goals.

What Is Self-Employment Tax?

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.

Who is Liable for Self-Employment Tax?

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:

  • Proprietors of limited liability companies (LLCs)
  • Members of unincorporated joint ventures
  • Independent contractors and freelancers
  • Individuals earning money from side hustles
  • Owners of other business entities that are disregarded for tax purposes

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.

  • Some churches and church-affiliated organizations can request an exemption from paying payroll taxes. Employees of these organizations are required to pay self-employment tax if they are paid more than $108.28 annually.
  • U.S. citizens are required to pay self-employment tax if they are employed by foreign governments or international organizations, but only if those services were performed in the United States or its territories.
  • Individuals who are actively collecting Social Security are not exempt from paying self-employment tax.

What Are Taxable Self-Employment Earnings?

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.

Example:

If your client earned $10,000 from their side gig but had $2,200 of deductible business expenses, only their 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.

Example:

Your client reported $7,800 of net earnings from their business. Only 92.35% of that amount – or $7,203 – would be taxable.

How is Self-Employment Tax Calculated?

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.

Social Security Tax is Limited

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.

Half of Self-Employment Tax is Deductible

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.

Additional Medicare Tax May be Due

Some of your clients will 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 client’s W-2 wages exceed these thresholds, their employer may already be withholding excess Medicare. Use Form 8959 to calculate the liability.

Each Spouse Files their Own Schedule SE

Self-employment tax is calculated for each individual. If both married couples are self-employed, you should file one Schedule SE for each spouse.

Taxpayers Should Pay Self-Employment Taxes Throughout the Year

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 client’s quarterly estimated tax payments, don’t forget to include self-employment tax in the calculation.

How Can Tax Planning Software Help?

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 ours at Corvee allows you to change multiple inputs and assumptions at once. This lets you show your client how different decisions play off each other and how their self-employment tax will change as a result.

Use Our Tax Planning Software for Individual Clients With One or More Self-Employed Businesses.

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