Self Employment Tax Explained
How Do You Calculate Self-Employment Tax?
In the US, whether you have a W-2 job or not, if you earn income as an independent contractor or through informal side gigs, your profit is generally subject to self-employment tax.
The self employment tax rate consists of 15.3% of your adjusted gross income.
You’re essentially responsible for paying the FICA portion of your tax that an employer would have witheld had you been an employee. The FICA tax consists of Social Security and Medicare.
You pay a rate of 12.4% on the first 137,700 of earnings(2020) for Social Security and 2.9% on all of your earnings for the Medicare portion.
You pay an additional 0.9% Medicare tax on the amount that your annual income exceeds $200,000 for single filers, $250,000 for married filing jointly, and $125,000 married filing separate.
You calculate your net income by subtracting deductions like business expenses from your total income on a Schedule C form.
Learn more about deductible business expenses by reading the Schedule C instructions and reading the IRS’ Publication 535 Business Expenses.
You then take 92.35% of your Schedule C net profit you calculated and use that to determine your self employment tax on your Schedule SE, so read the instructions for more information.
How Do You Pay Self-Employment Tax?
You should not wait till the end of the tax season to start calculating your self employment tax because the government requires that you pay your taxes in four installments (in most cases).
This is called estimated tax and it includes all of your tax liabilities–federal, state, and self-employmenty tax.
To calculate estimated taxes, you estimate your total tax liability for the year and multiply the amount by 90%.
Then, you ideally pay 22.5% of that total amount (90%/4) for each installment. You can input the calculations on form 1040-ES.
The statutory due dates according to the Internal Revenue Code are:
- April 15 (22.5%)
- June 15 (45%)
- September 15 (67.5%)
- January 15 of the following taxable year (90%)
You can usually use your tax amount for the previous year as a good baseline for an estimate. However, self-employed workers often don’t see a predictable stream of income.
That’s where things get messy.
If you suddenly receive a windfall near the end of your tax year that throws off your estimate, you are still required to file an amended return. See Steiner v. C. I. R..
To amend an estimation, you can use Worksheet 2-10 from Publication 505.
Additionally, if your gig is seasonal(you make more in certain periods than in others), you can annualize the payments of a given period rather than cleanly dividing the payments by four.
This method is called an annualized income installment. You first complete the 2021 Estimated Tax Worksheet through line 14b.
Then, you complete the Annualized Estimated Tax Worksheet 2-7 and file the calculations on Form 2210.
What Happens If I Don’t Pay Estimated Taxes?
You will incur a tax penalty for any amount that is underpaid for each period. There are four periods, so paying nothing will likely incur a steep penalty.
However, there are exceptions:
- If your total taxes owed after deducting tax credits is under $1000, you won’t have to sweat too much about not paying estimated taxes, though it’s always a good habit to pay your taxes in installments. For corporations, this number is $500.
- Additionally, if you had no tax liability the previous tax year of 12 months and you were a citizen or a resident of the United States throughout the previous taxable year, you do not have to pay estimated taxes for the current taxable year.
- Further, if you are a newly retired (62 or older) or a newly disabled individual who became disabled within the taxable year or previous taxable year and had a reasonable cause for missing estimated taxes, you will not incur penalties.
Why Do You Have To Pay Self Employment Tax?
Oftentimes, the federal government creates tax policies to generate revenue for programs. In this case, self employment tax ensures that those who do not work (or do not solely work) the normal 9-5, W-2 job pay taxes to fund social security benefits.
In other words, the government is not just trying to tax your business but is also trying to make sure you also contribute to the welfare of the American people. See U.S. v. Cain.
This obligation is a mandatory one, even if you don’t ever plan to take advantage of social benefits. See Eanes v. C.I.R., U.S.Tax Ct.2000, 2000 WL 1131904.
Who is Considered Self-Employed?
According to the federal government, self-employment generally means “. . . any trade or business carried on by . . . an individual.” The phrase “trade or business” is broad.
One is engaged in a “trade or business” if they engage with “the activity with continuity and regularity and … the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”
A full time gambler was once considered engaged in a trade or business. So she would have been self-employed and her earnings would have been subject to self-employment taxes. The 1982 amendments to the Tax Code put gamblers on par with investers, who are not considered self-employed.
Generally, self-employed people fall into several catogeries that include but are not limited to independent contractors, practitioners in a sole proprietorship, partners in a venture, partners in a limited partnership/ partnership, officials of religious institutions, farmers and several others.
Though many self-employed workers can be categorized, the law is not that simple.
Take the gig economy, for example. As the gig economy continues to change, it may become difficult to classify who is an employee of the company or an independent contractor. Luckily, courts have developed factors for determining who is an independent contractor for the purpose of levying self employment tax. See Weber v. C.I.R.
These factors are:
1. The degree of control exercised by the principal
More control by the principal means the worker is likely an employee. The principal does not necessarily have to hover over the worker like a hawk. See Gen. Inv. Corp. v. United States.
For example, workers that set their own hours and clock in and out whenever they want can still be considered employees. This factor is a crucial factor, one that can swing the balance, which makes sense since what separates employees from independent contractors is independence.
2. Which party invests in work facilities used by the individual
If the principal primarily invests in work facilities, then the worker is more likely an employee. But if the worker provides his or her own tools, then it strongly indicates independent contractor status. See Breaux & Daigle, Inc. v. United States.
3. The opportunity of the individual for profit or loss
The ability to make or lose money based on factors within the control of the worker would lean towards independence.
4. Whether the principal can discharge the individual
Work that only allows discharge if the worker doesn’t meet certain specification or rules points to independent contractor status. Work like this is more contractual in nature.
For example, a freelance writer working for a tech company may make an agreement to write three 500-word articles a week for X amount of pay for X amount of weeks.
A specific performance of this contract is required where the worker must meet the target of three 500-word articles a week. Not meeting this goal would be grounds for discharge.
5. Whether the work is part of the principal’s regular business
Work that is part of the principal’s regular business suggests that the person undertaking that work is an employee, but this is just one factor and must be viewed within the context of other factors.
For example, a construction business that hires independent contractors is said to have construction as its principal business, with independent contractors who participate in construction. However, other factors like independent investment, permanence, control, etc. determine status.
6. The permanency of the relationship
Transitory work generally points to independent contractor status, but transients can also be employees.
Conversely, independent contractors can work for long periods. This factor does not weigh heavily in determining whether someone is an independant contractor. See Herman v. Express Sixty–Minutes Delivery Serv., Inc.
7. The relationship the parties believed they were creating.
The intended relationship can be viewed objectively by looking at the regular practise of the principal and whether or not the principal issued a Form 1099-MISC. Or whether the worker requested a W-2 or W-4.
The above factors are weighed in a balancing test to see whether the facts show that the worker is an employee or independent contractor for the purpose of self-employment tax. If you have any questions about where you stand, contact a tax professional.
What Types of Income Can Be Taxed Under The Self Employment Tax?
The IRS, for the purposes of levying tax, places liability on those who receive net “income” greater than $400. See 1401(b). Net income is determined by subtracting your gross income (total income) from your losses.
Importantly, self-employment income, subject to self-employment tax, is determined by the source of the income, not the taxpayer’s status at the time income is realized.
For example, you can’t take a job as a freelancer, quit the job, receive your last freelance check while working at McDonalds and decide to forgo self employment tax since you are now a W-2 worker. The source of the income must be a “trade or business” as described above. Below is a list of some unconventional income sources that can be taxed based on case law:
- Income obtained from religious work if Form 4361 is not filed in a timely manner. Gardner v. C.I.R., U.S.Tax Ct.2013, 2013 WL 892963.
- Income gained from selling capital like real estate if your business makes it a primary means of generating income. Si Boo, LLC v. C.I.R., U.S.Tax Ct.2015, 2015 WL 468165.
- Income earned from Real Estate commissions. Jondahl v. C.I.R., U.S.Tax Ct.2005, 2005 WL 675444.
- Value-added income earned from cooperatives. Fultz v. C.I.R., U.S.Tax Ct.2005, 2005 WL 555269.
- Income earned running a business entity, including a solo law practice.
- Receiving profits from shares of caught fish with less than 10 crew members. Anderson v. C.I.R., T.C.M. (RIA) 2010-001 (Tax 2010).
Who is Exempt From the Self Employment Tax?
Not everyone who would otherwise be considered self employed has to pay self-employment tax. Those who are exempt from self-employment tax include but are not limited to:
- “a duly ordained, commissioned, or licensed minister of a church or a member of a religious order . . .”,
- Christian Science practitioners,
- those who earn money from trading stocks or receiving dividends as long as they are not dealers in stocks and securities
- landlords who earn money from rentals and/or personal property leased with real estate,
- partners of a firm who earn stipend without working in the course of business, and
- limited partners who earn distributed shares.
What Can You Deduct As A Self-Employed Worker?
Self-Employment Tax Deduction
Reduce your taxes by taking advantage of deductions and tax credits. Right off the bat, you can deduct half of your self-employment tax. This means that a self-employment tax bill of $3000 will result in a $1,500 deduction that you can take.
Qualified Business Income Tax Deduction
Another deduction that may be immediately available to certain self-emplyed workers is the qualified business income deduction(QBI). Those eligible for the deduction can deduct up to 20% percent of their taxable business income.
The QBI is complex in that it benefits smaller businesses, but becomes increasingly difficult to take advantage of depending on the type of business and the amount of income the business generates.
First off, one’s total taxable income–including personal income(like W-2 income) and business income–must be less than $164,900 for single-filers and $329,800 for joint-filers to receive the full benefit of the deduction. This is called a phaseout and specified service businesses are subject to it. These businesses include:
- actuarial science,
- brokerage services,
- financial services,
- health, and
- the performing arts.
If you have a solo practise in any of the above fields and your “taxable income” or net income is less than the phaseout mark, you can take 20% of your net business income and deduct it from your taxable income. Once you start to pass the phaseout mark, the percent you can take diminshes.
At $213,300 in total taxable income for single filers and $426,600 total taxable income for joint-filers, the deduction is no longer available.
The phaseout does not apply to “nonspecified service buesiness,” but the hard threshold listed above still applies. Speak to a tax professional to find out where your business stands.
Even if your income falls under the phaseout levels, depending on the structure of your business (number of employees on salary, for example), you may receive less than the 20% deduction. The 2017 Tax Act created the complications found in this type of deduction. But, if you can take advantage of the qualified business income deduction, you should do so because the Tax Act and the deduction it provides expires in 2025.
QBI deductions do not go on Schedule C, but go on Form 1040 or 1040-SR.
The Standard and Itemized Deductions
Besides the self-employment tax deduction and the QBI deduction, there are two main deductions. The standard deduction and the itemized deduction. You can only choose one of these deductions.
So, taking a standard deduction will exempt you from the itemized deductions listed below, but not from the self employment tax deduction or the qualified business income deduction.
The standard deduction is a fixed amount and presents much less of a hassle. For 2021, single filers and married filing seperately get a $12,550 deduction; $25,100 for joint filers; and $18,880 for head of household. However, if you have substantial deductible business expenses, then you may want to take advantage of itemized deductions. The itemized deductions will be outlined later.
Additionally, you can take tax credits. Credits work differently from deductions because you subtract the credit from your total tax liability instead of subtracting from your gross income. Combining itemized deductions with tax credits can greatly reduce your tax liability.
However, make sure you have proper documentation at hand to prove that you are eligible for deductions and credits in the event of an IRS audit.
Itemized deductions for 2021
As a sole proprietor, you are in business for yourself and can deduct expenses from your gross income to get your total taxable income. This information is filed on Schedule C, Profit or Loss from Business, which attaches to your 1040 income tax return.
Remember that your self employment work has to be conducted with a “reasonable degree of regularity” to be considered a business rather than a hobby. If your work is considered a hobby, you will not be able to take full advantage of the deductions listed below.
If you have doubts about whether your work is actually a business, talk to an experienced accountant.
As a general rule, if you don’t show profit for at least three out of five consecutive years, the IRS can decide that your work is a hobby if they are not otherwise convinced you are operating a legitimate business.
The IRS is doing a great job of catching up with the gig economy and, as recently as 2019, has created a gig economy knowledge center.
Below are some itemizable deductions you can use to reduce your total tax liability.
The 2017 Tax Act exluded both business-related entertainment expenses and meal expenses from deduction.
You’re actually allowed to deduct accountant fees from your income. This includes but is not limited to accounting, bookkeeping, tax return preparation, and tax advice. You can even deduct the subscription cost of accounting and tax software used to determine your tax liability.
When you set up a home office, there are various items that can be deducted. You can add up the total expenses and deduct them from your gross income. You don’t have to have a home-based business to set up a home office deduction.
The space can be a traditional office, workshop, studio, warehouse, store, or showroom. “Home” is not limited to a house but also includes apartments, lofts, trailers, mobile homes, and detached structures that are part of your residence like garages, sheds, or other buildings.
The tax deductions relate to expenses associated with the space, like: rent or depreciation, utilities, insurance, property taxes, maintenance, home repairs, remodeling, air conditioning, alarm systems, answering machines, telephone answering service fees, internet services, and much more.
Before you take a home office deduction, speak to a tax professional to see whether your office space qualifies. Generally, the space needs to be your “principal place of business” and it needs to be used “regularly and exclusively”(with few exceptions).
Like many rules, the definitions for some of the terms create complexities that are best handled by a tax professional. See IRS Publication 587, Business Use of Your Home.
A percentage of cell phone cost expense related to business can be deducted. Other deductible offense expenses include greeting cards and holiday cards
Additionally, you can deduct business assets like tools, furniture, and vehicles. It’s important to know that there are two modes of deduction when it comes to assets.
One is the Safe Harbor rule for anything $2,500 or less. The IRS doesn’t care if you fully deduct the cost of the asset.
But for anything over $2,500, Section 179 applies and things get a bit more complex. For example, if you want to deduct expenses from a vehicle, you are subject to a maximum amount you can deduct. The deduction itself cannot exceed your gross income.
Importantly, if you converted the car previously used for leisure into a car for business, you cannot deduct the price of the car under Section 179. You can only calculate depreciation.
Talk to your accountant to learn how much you can deduct from your expensive business assets. See IRS Publication 535 to learn about general business expenses.
If you work as a freelancer and you advertise your services on Google or Facebook ads, you can deduct the cost of advertising your business from your income. Advertising includes promotional devices like giveaways.
For example, you might give away pens with the name of your business on them and then be able to deduct the cost of those pens.
Many YouTubers hold contests and the costs of operating these contests can be deductible. Also, when a YouTuber gives away money to random strangers, they may take a deduction for promotion since the act of giving increases goodwill(you can’t deduct under charity if you’re not a corporation).
Prizes are included as long as there is an incentive to generate sales. Unfortunately, the recipient of a prize has to pay taxes on the value of the prize if that prize’s value is over $600.
So, if you win an iPhone from an influencer, know that you owe taxes on that phone and that they likely received a nice tax deduction.
If you want to get into the YouTube game or if you use a drone to advertise your business, you can deduct the cost of the drone. Keep in mind that the price of the drown can effect how much you can deduct in a year.
Clothing with your company’s logo or uniforms worn exclusively for your work are deductible. But that doesn’t mean you can’t wear them outside of work as well.
For example, YouTubers who create merch can deduct the costs of articles of clothing including hats, shirts, jackets, if their logo appears on them. The cost of cleaning them is also deductible!
The reasoning behind this is that clothing with logos on them can be considered a form of promotion, and promotions are deductible. This type of expense category is still considered under supplies.
Those in the gig economy can deduct the cost of their vehicle if purchased for business or they can deduct the Standard Mileage Rate, a method used to calculate depreciation.
The policy is that your car goes down in value the more you use it, so by continually using your vehicle, you’re losing money. Read IRS Publication 946, How to Depreciate Property for more information. You can also deduct the cost of fuel when using your vehicle.
You can actually deduct the cost of a bike if it was purchased in the tax year, or you can deduct the depreciating value of the bike.
You can hire your own children and get a deduction for their wages. The children themselves are not liable for federal income tax or payroll tax.
The children must be under 18 and make a maximum of $6, 350(maximum subject to change from year to year) to exempt them from paying taxes.
The children of course have to actually be doing work related to your business. If you pay the children above the maximum, the children would have to file W-4s and you will have to file W-2 and W-3 payroll forms at the end of the year.
However, the children do not need to pay the Social Security and Medicare tax and you don’t have to pay payroll tax.
See IRS Publication 15, Employer’s Tax Guide for more information.
Bank charges, services, ATM fees, penalties, check writing fees, check printing fees, and credit card fees are deductible.
Specifically, you can deduct the interest cost of credit cards For any purchases made using the ATM, you can deduct the ATM fees from your gross income.
If you hired a freelance web developer to build a website for you, you can deduct that fee from your gross income under commission and fees.
This applies to other freelancers and independent contractors.
This section may be most beneficial to freelance web developers who may be paying a subscription fee for various types of software, like development environments.
But this also applies to other freelancers who use enterprise software to increase their productivity. You can deduct the amount paid in cash for the tax year from your gross income. Software also includes paid apps used in the course of business.
When you do freelance work long enough, you’re bound to encounter a customer that refuses to pay you for your services. This is called “bad debt.”
Unfortunately, you can’t take a bad debt deduction for the time you spent working on that website or copy. But if the customer pays you with a check that bounces, you can deduct the expense from your net income.
Note: If you’re a drop ship seller on Shopify, you can take a bad debt deduction even if the customer does not pay. That’s because inventory is deductible at the end of the year as costs of goods sold.
Because of Amazon, Ebay, and Shopify, there are a lot of resellers making money as sole proprietors. Did you know the cost of packaging is considered part of inventory and so is deductible?
Even if you’re a drop shipper who doesn’t physically hold inventory, goods you have drop-shipped are still considered inventory, so you’re entitled to include warehousing and shipping fees to costs of goods sold. Additionally, weekly delivery service charges are deductible
You can actually deduct the cost of learning new skills while you are self-employed if what you are learning improves your skill in your business. For example, a freelance web developer who already knows how to program can pay for an advanced programming course and deduct the cost of that course.
But a freelance programmer cannot deduct money spent on a cooking course because it doesn’t improve his programming skills.
Also, you can’t decide to learn how to program before starting your web design business, and then deduct the cost of learning from your gross income once you do start the business. Learning must take place while you are in business for you to deduct expenses.
And you cannot deduct education if that education is required to meet minimum requirements for the employment; a wannabe Uber driver can’t deduct cost of driving school, because you need to know how to drive to be self-employed in that field.
You can deduct as part of education expenses: tuition,registration fees, course fees, instructional material, textbooks, supplies, laboratory fees, and commuting fees to the education center.
Self employment tax can get complex because of the way it interacts with other forms of taxes. You are forced to withold taxes yourself and pay quarterly (estimated taxes), which triggers potential issues since self-employment is not the most reliable field when it comes to steady income.
This is on top of the federal and state taxes you must pay. Things can get pretty hectic. For this reason, the information presented here is not mean to represent legal or accounting advise. The purpose of this article is to make the ordinary self-employed person or would-be self-employed person aware of the potential tax liability they may face.
- Kamoroff, Bernard C.P.A. 475 Tax Deductions For Businesses And Self-Employed Individuals : An A-To-Z Guide To Hundreds Of Tax Write-Offs. Guilford, Connecticut, Lyons Press, 2019.
- TAX ALERT—THE IMPACT OF THE 2017 TAX ACT ON BUSINESS ENTITIES, CD MA-CLE I-1
- IRS Publication 946
- IRS Publication 15
- IRS Publication 578