Self Employment Tax Explained... part 2

Self Employment Tax Explained-  Part 2

This is part two of the Self Employment tax explained.

If you missed part 1 or want a refresh, you can find part 1 here. 

The self-employment tax is not a progressive tax.

The self employment tax is 15.3% total but as a self employed individual you receive a reduction of 7.65%. 

So, if you earn $1,000 of self employment income you would calculate the self employment tax on 92.35% of those earnings and multiply that number by the 15.3% to determine the amount of self employment tax.

Remember, self employment tax is effectively Social Security (12.4%) and Medicare tax (2.9%) that is added to your marginal income tax.

The self-employment tax starts immediately once you have over $433 in Schedule C, Schedule E, or Schedule F net income from a business.

Your net earnings from self-employment starts with the gross income from your trade of business minus the deductions related to your business.

Deductions are even more valuable when you realize that the deductions or write offs for your business reduce BOTH your income tax and your self employment tax.

If you have more than one business you combine the net income or loss from each of them to determine your net earnings from self employment.

Thus, a loss from one business offsets the income from another profitable business.

It’s worth noting that business losses can be a possible trigger point for an audit for this reason. 

Certain items do not reduce self-employment taxes.

Some of those are:

• Net operating loss carryovers from prior years,
• Deductions for health insurance premiums for self-employed individuals,
• Contributions to self employed retirement plans. 

What is considered Self Employment Income?

The general rule is that passive income (rents, capital gains, dividends) is NOT considered to be Self Employment income.

Income from a partnership can be considered self-employment income.

However, income earned by an S-corporation that passes through from the business to the individual shareholder as dividends or “distribution of profit” is NOT subject to self employment tax.

This is one key reason why S-corporations are so popular as a tax savings tool.

For example, Patty is a solo entrepreneur operating her business as a sole proprietor on the Schedule C and makes $125,000 gross income as a consultant. She has $25,000 in deductions leaving her with $100,000 net profit.

92.35% of her net earnings from self-employment is assessed the self-employment tax.

The total Self Employment tax on Patty would be $14,130. Ouch!

If, instead, Patty chose to operate her business as a Corporation and makes the “election” to be taxed as an S-corporation as Patty being the sole shareholder and working full time for the corporation as an employee, she could to the following:

• Her corporation could pay her a reasonable salary for performing her duties for the business
• That salary or W-2 wage would be subject to the payroll taxes (both the employee and the employer portions of the Social Security and Medicare taxes)

Let’s say that a “reasonable salary” for Patty is $60,000. 

The corporation distributes $40,000 to Patty during the year as an owners draw or distribution. 

The $40,000 is NOT subject to the self-employment tax. 

This gives Patty $5,652 in tax savings ($40,000 x 92.35% x 15.3%).

SUPER CRITICAL POINT HERE

The distribution of $40,000 is called many things by folks. Distribution, owner draw, dividend… 

It’s key to remember this… in this case the net profit of the business is $100,000. The $40,000 distribution is really a distribution to the owner of the profits of the business.

Another ultra critical point is that the $60,000 used in this example is exactly that… an example for the illustration of how self-employment taxes work.

The salary paid to the shareholder who works for the corporation must be a reasonable salary. There are several methodologies to arrive at what is “reasonable salary” but to say a simple percentage of your income is NOT one of them. 

The bottom line is that a reasonable salary must be paid where the Social Security and Medicare taxes must be paid on.

The topic of “Reasonable Compensation” for a S-Corporation owner is a whole different ball of wax to dive into for another article.

Key takeaways about the Self Employment tax

There are really several key things to know about the Self Employment tax:

1. Self Employment tax is comprised of 12.4% Social Security tax and 2.9% Medicare tax
2. There is an additional 0.9% Medicare tax that can be assessed if total net income crosses certain thresholds.
3. The 12.4% Social Security tax has a ceiling annually ($147,000 for 2022)
4. You must pay self-employment tax if you earn income from a business that you report on Schedule C or F, co-own as a general partner in a partnership, or own as a member of a multi-member LLC, or if you co-own any other business entity taxes as a partnership.
5. Net earnings from Self-Employment generally do NOT include real estate rental income, dividend or interest income, or capital gain or loss.
6. Distributions from S-Corporations are not subject to self-employment taxes. S-Corporations generally must treat shareholders who work in the corporation as employees and pay a reasonable salary on which the Social Security and Medicare taxes are paid.

You see, the government has a system to take our money! Fight back with a system to save money and STOP wasting money on taxes!