Being your own boss can be fun and rewarding. But, whether you own a small business, run a custom quilting operation from your home or write editorial articles for fun, taxpayers need to be aware of the self-employment (SE) tax.
The SE tax is imposed on taxpayers that report SE income on their individual Form 1040. The purpose of the SE tax is to recoup Social Security (FICA) and Medicare taxes from taxpayers that do not pay these through paycheck withholding. When a taxpayer is an employee, it is their employer's responsibility to withhold these taxes from their paycheck and remit them to the government. But, since self-employed taxpayers do not receive a "paycheck" per se, they must pay these taxes when they file their individual Form 1040.
What types of income are subject to the SE tax?
Before calculating SE tax, the taxpayer must first determine how much SE income they have. Common types of SE income include:
- Rental income
- Net profit from sole-proprietorship or single-member LLC (reported on Schedule C)
- Nonemployee compensation received and reported on Form 1099-MISC, such as contract labor, commissions, or bonuses.
Note that rental income is included above. If rental income is passed through to the taxpayer on a Schedule K-1, then the K-1 should indicate whether the activity is passive. If it is passive, then it is subject to the SE tax.
How much is it?
As mentioned above, the purpose of the SE tax is to recoup Social Security and Medicare taxes. The Social Security rate is 12.4% on all SE income up to $113,700, and the Medicare rate is 2.9% with no upper income limit. The total amount of tax will be reported in the "Other Taxes" section of the Form 1040, but 50% of the amount reduces the taxpayer's AGI as an adjustment to income on page 1 of the Form 1040. Here's an example:
Marty makes and sells custom coffee cups at his home. He is not incorporated, and his net profit for the year was $75,000. He will pay total SE tax of $11,475, made up of $9,300 in FICA (75,000 x 12.4%) and $2,175 in Medicare (75,000 x 2.9%). He will get an adjustment to income in the amount of $5,738 ($11,475 x 50%)
But what if Marty makes really awesome coffee cups?
Marty had the most successful year of his coffee cup career, showing net profits of $200,000. Marty will pay total SE tax of $19,899, made up of $14,099 in FICA (113,700 x 12.4%) and $5,800 in Medicare (200,000 x 2.9%). Notice how the FICA taxes are capped at $113,700, but Medicare is charged on the full amount.
Options to reduce or eliminate SE tax
Taxpayers can reduce their SE tax burden in various ways. One way is through business structure. Taxpayers that have substantial business income, such as Marty above, can consider incorporating and filing an S election. As an S-corp, Marty could pay himself a reasonable salary for the year which would have the required payroll taxes withheld, and the remaining profit would be passed through to him on a Schedule K-1 as ordinary income not subject to SE tax. If his salary was $100,000 and the other $100,000 was passed through to him on a K-1, Marty would save almost $10,000 in SE taxes. Marty could also elect to be a normal C corporation, and all the profits from the business would be taxed at the corporate level. Although this would eliminate the SE tax for Marty, corporate rates are not as favorable as individual rates and the taxpayer could end up paying more in corporate taxes.
Taxpayers that generate SE income from their home should consider the Home Office Deduction. The IRS now offers a simplified calculation for smaller operations, but taxpayers with a significant home office should go through the full calculation to reduce their SE income.
Taxpayers can also reduce their regular tax burden associated with SE income by making contributions to retirement plans. A traditional IRA is the easy way to go, but taxpayers with higher amounts of income and cash flow should consider a SEP (simplified employee pension). The SEP will allow contributions up to 25% of SE income, with a maximum of $51,000. However, the retirement contributions reduce the amount of taxable income, but not the amount of SE income. In Marty's case above, he would have regular taxable income of $50,000 less after making a SEP contribution, but his SE tax would not change.