When Your Income Is Subject to Self-Employment Taxes?

When Your Income Is Subject to Self-Employment Taxes?

There are many types of taxes assessed by many different types of government entities.

Sales tax assessed on items you purchase from a store (virtual or brick and mortar) and is usually collected by the State through the counties or cities in which you reside.

Property tax on a home or even a vehicle which is usually collected by the county or the state respectively.

Income tax assessed on your earnings (both employee as a W-2 and self employed as a business owner or independent contractor).

Income tax is assessed by the Federal, State, and sometimes city in some parts of the country if the locality has an income tax.

This all seems simple right.

But it’s important to understand the “self-employment” taxes that small business owners pay. 

Self-employment taxes are to individual business owners what payroll taxes are to employers and employees.

Simply put, if you have ever been a W-2 employee you may have noticed the deductions on your paystub of social security and Medicare taxes.

These are to fund the Social Security and Medicare systems.

All individuals with self-employment income must pay self-employment taxes, regardless of their age.

When business owners reach retirement age, they’ll be able to collect Social Security and Medicare “A” (hospital insurance benefits if they paid self-employment taxes for at least 10 years (40 quarters).

There’s a lot more to unpack with this but those are deeper topics for another time.

How much are self-employment taxes? 

Self-employment taxes are not a small amount.

In fact many business owners pay more in self-employment taxes than income taxes.

The self-employment tax has two components:

• A 12.4% Social Security tax up to an annual ceiling adjusted for inflation each year (147,000 for 2022), and
• A 2.9% Medicare tax on all net earnings from self-employment. 

That’s a combined 15.3% tax ON TOP of your income tax.

 Possible Third Component

If your net earnings from self-employment are over $200,000 if you are single, or $250,000 if you are married filing jointly, you must pay an additional 0.9% Medicare tax on net earnings from self-employment over the $200,000 threshold, for a total of 3.8% Medicare tax.

Compare to the Employer and Employee

Excluding the additional Medicare tax that is levied solely on employees, the self-employment tax rate is the same as the COMBINED Social Security and Medicare payroll tax paid by employees and employers. 

But with employee situations, the employers pay one half of the taxes while withholding the other half from their employees’ wages.

So, it appears that W-2 employees personally pay half as much as the “self-employed.” But that’s just smoke and mirrors.

The tax code allows self-employed business owners to make up for this perceived “unfairness” by allowing them to reduce net income subject to self-employment taxes by 7.65% and deduct on their Form 1040 one half of their self-employment taxes.

For example:

Your 2022 net profit on a Schedule C of the form 1040 is $200,000.

On Schedule SE, you multiply the $200,000 by 92.35% (100% - 7.65%) and you have $184,700 in net earnings subject to self-employment taxes.

Your total self-employment tax is $23,584

That equates to:

$147,000 x 12.4% = $18,228

Plus $184,700 x 0.29% = $5,356

For a combined $23,584 (OUCH!)

You deduct $11,792 (half of $23,584) on Schedule 1 of your Form 1040.

If you are in the 24% tax bracket, the deduction saves you $2,380 in taxes.

In this example, your net self-employment taxes are $20,754 ($23,584 - $2,830).

This doesn’t quite level the playing field to the combined employer and employee situation, but it helps.

What if you have BOTH W-2 earnings and Self Employment Income?

If you earn both W-2 wages and self-employment income, you count your W-2 wages first as if you had no self-employment income.

If your W-2 wages exceed the annual ceiling on Social Security taxes ($147,000 for 2022), then no Social Security taxes are due on any of your self-employment income.

In this case, you pay less in taxes under the “ordering rule” because it allows you to use all or part of the Social Security wage ceiling with your employee income (taxed at 6.2%) before applying the formula above.

You report self-employment taxes on Form SE and pay them along with your INCOME taxes.

You must include your self-employment taxes in your quarterly estimated taxes.

Who pays Self Employment Tax?

If you:

• Earn income on a 1099,
• Operate as a single member LLC,
• Do business as a sole proprietor,
• Are a general partner in a partnership,
• Are an LLC member in a multi-member LLC, or
• Are a co-owner of any other business taxed as a partnership

The IRS has rules that govern what is determined to be business activity and they are the same rules for determining what is a business activity.

The general rule is that a business is an activity that you engage in regularly and continuously to earn a profit. You don’t have to work at a business full time for it to qualify as business activity.

You don’t pay self-employment taxes on personal investment income or hobby income. For example, you don’t pay self-employment taxes on profits you earn from selling stock, your home, or an occasional item on eBay or Facebook Marketplace.

Stay tuned for more information about the Self Employment tax in Part 2 of the Self Employment Tax Explained…