Entrepreneurs and others who work for themselves are often on the hook for significant federal self-employment (SE) tax, in addition to federal and state income taxes. Here are the answers to some common questions about this tax.
SE tax is the combined Social Security and Medicare taxes that individuals who work for themselves must pay. It generally mirrors the Social Security and Medicare taxes that employed individuals have withheld from their pay by their employers — known as the Federal Insurance Contributions Act (FICA) tax — but self-employed individuals pay more than employees.
Employees split the FICA tax responsibility with their employer. For Social Security, in 2023, the employer and employee each pay FICA tax at a rate of 6.2% of the first $160,200 of income. The amount of income subject to FICA tax is adjusted annually for inflation. In addition, both the employee and employer pay Medicare tax at a rate of 1.45% of income, with no cap.
The IRS essentially treats self-employed individuals as both employers and employees. As a result, for 2023, they must pay 12.4% on the first $160,2000 of income for Social Security and 2.9% of income for Medicare. That results in a combined SE tax rate of 15.3%.
Self-employed individuals — like employees — also are liable for an additional 0.9% Medicare tax if, for 2023, their wages, compensation and SE income are more than $200,000 ($250,000 for married couples filing jointly).
The IRS allows taxpayers to deduct 50% of their SE tax when determining their adjusted gross income for income tax purposes. The deduction affects neither your SE earnings nor your SE tax. However, SE tax isn't applied to your entire net earnings (that is, gross income less ordinary and necessary business expenses). Rather, it's applied to 92.35% of the net earnings from self-employment.
Self-employed individuals also can deduct health insurance costs. This deduction is taken into account when calculating net earnings from self-employment.
The tax generally applies to those who carry on a full- or part-time trade or business and don't otherwise pay withholding taxes. For example, SE tax may apply to:
These individuals must pay the SE tax when they have net SE earnings of $400 or more in a tax year. SE tax rules apply regardless of age or whether you're already receiving Social Security or Medicare.
When determining whether an individual is an employee or independent contractor, the IRS evaluates the facts and circumstances of each situation. The primary focus is the degree of control the employer has over the individual. The IRS considers behavioral and financial factors, as well as the type of relationship between the worker and company.
Important: If you have a loss or minimal SE income, you can use an optional method to calculate your taxable net earnings. It can give you credit toward your Social Security coverage. Self-employed individuals who aren't involved in qualified farming activities may use the optional method if: 1) their profits were less than $6,540 and less than 72.189% of their gross income, and 2) their net SE earnings were at least $400 in two of the prior three years. A taxpayer can use the optional method no more than five times.
For tax purposes, a trade or business generally is an activity carried on for a livelihood or in good faith to make a profit. You needn't earn a profit to be carrying on a trade or business, but you must have a profit motive. In contrast, a hobby is engaged in for sport or recreation.
The facts and circumstances of each case will determine whether an activity is a trade or business. Some of the important factors the IRS considers when making this determination include:
Remember that you still must report any income from a legitimate hobby — you just don't need to pay SE tax on it. The same applies to sporadic or one-time gigs and passive investments. It's worth noting that you can have a full-time job and a part-time trade or business that subjects you to SE tax.
Employees have their share of FICA taxes withheld from their paychecks throughout the year. Similarly, self-employed individuals must make estimated quarterly payments of their SE taxes. They also must file Schedule SE, "Self-Employment Tax," with their annual tax returns.
SE tax can be a major expense for small business owners — and many self-employed individuals are blindsided by this tax when they file their first tax return with SE income. If you have additional questions or want a more detailed explanation, contact your tax advisor.
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