Article - Self-Employment Taxes

Self-Employment Taxes

One of those unpleasant little surprises that new business owners learn about when they start their business is the concept known as the Self-Employment Tax. As an employee, you were probably familiar with this tax, but knew it by another name: Social Security taxes, OASD, or FICA. These taxes are your contributions to the Social Security payments that you will (hopefully) get when you retire. What you may not have been aware of is that when your employer deducted 7.65% of your earnings and sent it off to the Social Security Administration for you, he also matched that amount from his own money and sent that along too, both portions going into the social security pot under your name.

As far as the Social Security Administration is concerned, they don't really care that you are now the EMPLOYER as well as the EMPLOYEE; they still want the full 15.3% of what you earn. The good news is, you get to deduct half of your self-employment taxes on your tax return.

This article will explain some of the basics regarding self-employment taxes, how they are computed, and how to handle them as a small business owner.

Who has to pay self-employment tax?

If you receive income from carrying on a business as a sole-proprietor (or independent contractor), or as a member of a partnership, it is generally considered self-employment income, and therefore subject to self-employment tax. You are considered a sole-proprietor by the IRS if you own an unincorporated business by yourself. Your business can be full-time or part-time, you can be an employee for someone else as well as having your own business, you can even have more than one sole-proprietorship. But as long as you are not a corporation, your business income will be subject to self-employment tax.

Tax Rates and Limits

If your net self-employment income (business income minus business expenses) is less than $400, you will not owe any self-employment taxes. If your net business income is $400 or more, you will pay self-employment tax on the full amount of your net business income. For example, if you made $600 in your yard maintenance business, and had $350 worth of business expenses, your net business income would be $250, and you would not have to pay any self-employment tax. If, however, you made $600 in your yardwork business, and only had $100 in business expenses, you would pay self-employment income on your $500 net business income.

The self-employment tax rate of 15.3% is actually the combined rate of two taxes:

12.4% is for Social Security (old-age, survivors, and disability insurance), which has a top limit of $84,900 for the year 2002. This means that you you pay the 12.4% tax on income UP TO this amount, but not on any income that EXCEEDS this amount for the year 2002. If you receive wages as an employee as well as self-employment income, those wages are included when determining social security wages. For example, if you earn $50,000 as an employee, and have net self-employment income of $45,000, then you would only owe SE income on $34,900 of your business income ($84,900 - 50,000). The top limit generally changes each year.
2.9% is for Medicare (hospital insurance), which has no top limit. You will pay the 2.9% medicare tax on all net self-employment income you make, regardless of how much you make for the year.

Since your business income is figured separately from your other income and personal deductions, it is possible to owe self-employment tax even if you do not owe any income taxes.

Filing and Computing the Tax

If you owe self-employment taxes you will need to fill out a Schedule SE, Self-Employment Tax and file it with your Form 1040, Individual Tax Return, and Schedule C, Profit or Loss from Business. Most people will be able to use the SE short form (the short form is on the first page, and the long form is on the second page). This is a pretty easy form to fill out. When you have computed your SE tax amount, write it on your Form 1040, line 50. Also remember to write half of this amount on line 27 on the front of your Form 1040, to be deducted from your total income.

IRS "Pay As You Go" Policy

Even though you won't know exactly what your tax requirements will be till the end of the year, the IRS wants you to pay your taxes throughout the year. This is done through quarterly estimated tax payments. See the IRS article "Understanding Estimated Taxes" for more information on computing and paying estimated taxes. If you are an employee of someone else in addition to having your own business, you can also choose to increase your withholding on your paycheck to cover the extra taxes you will owe from your business income. You can adjust the amount your employer deducts from your paycheck at any time. You will just need to fill out a new W-4 form (Employees Withholding Allowance Certificate) and give it to your employer. You can either ask for one from your employer, or download one from the IRS website by clicking HERE.

Keep in mind that if you don't make estimated taxes (or adjust your withholding from your employer), and end up owing more than $1,000 in federal income taxes and self-employment taxes at the end of the year, you could end up owing an underpayment penalty as well as the additional taxes.

See Pub. 533 Self-Employment Tax for more information.