What every entrepreneur needs to know about self-employment tax
When you’re starting a business, you’re likely to encounter a whole host of new tax concepts. One of them is self-employment tax. Read on to learn exactly what this tax is, who needs to pay it, and how it’s calculated.
What is self-employment tax?
Self-employment tax refers specifically to Social Security and Medicare taxes.
It’s called “self-employment tax” because typically the employer and employee split the burden of these taxes. If you’re working for a paycheck, half of your Social Security and Medicare taxes will be withheld from your paycheck, while your employer will pay the remainder.
When you earn income through self-employment, however (even if it’s a side-gig), you’re responsible for paying the full sum of your Social Security and Medicare tax on that income.
Who is subject to self-employment tax?
According to the IRS—the definitive source on the subject—you generally must pay self-employment tax if you earn $400 or more through self-employment.
That seems clear enough, but what qualifies as “self-employment”? The answer might not be exactly what you’d expect. In general, freelancers and contract workers are considered to be self-employed even though they are working for someone else. On the other hand, business owners may not be considered self-employed (at least, not for tax purposes).
The determining factor is your business’s tax structure:
- If your business is a sole proprietorship or partnership, you will be subject to self-employment tax.
- If your business is taxed as a corporation, you’re required to put yourself on payroll and you’ll have a salary. This means you won’t need to pay self-employment tax.
You might have noticed that we haven’t covered LLCs yet; this is because LLCs are a state-designated legal structure that can be taxed in a variety of ways. If your business is an LLC, it will have a default tax structure that you can change by filing a form with the IRS.
Corporations and employment taxes
Corporations are not subject to self-employment tax, but that doesn’t mean you’re able to avoid paying Social Security and Medicare taxes. If your business is taxed as a corporation, you are required to put yourself on payroll—meaning that you’ll need to withhold estimated taxes from your salary and send them to the IRS. At that point, the business (as your employer) will pay half your Social Security and Medicare taxes and the remaining sum will be withheld from your paychecks.
One question that often comes up is “Can I save on Social Security and Medicare taxes if I choose a different tax structure?” The answer is, naturally, “It depends.” If you’re taxed as a corporation, you are required to pay yourself a fair salary (which is subject to Social Security and Medicare taxes) but you may be able to take additional earnings as a shareholder distribution (which is taxed differently). If this is something you’re interested in doing, it’s a good idea to consult a tax professional to make sure the compensation strategy you’re considering is appropriate.
How it’s calculated
Self-employment tax generally applies to your net earnings (your total income from self-employment minus any deductible business expenses). This means taking all the appropriate deductions can substantially reduce your total self-employment tax liability. Fun fact: you can deduct one-half of your Social Security and Medicare taxes. This deduction is intended to make up for the fact that you don’t have an employer to split the tax burden with you.
Once you’ve determined your net earnings, you’ll typically multiply that number by the self-employment tax rate (in 2019, this rate is 15.3%) to determine your total tax due. However, there are variables that could affect this calculation. For example, the Social Security portion of self-employment income only applies to income up to a specific threshold that changs from year to year.
Since the calculation varies based on the year, your total income, and potentially other factors as well, the best way to determine the amount of tax you owe is to use the appropriate IRS form (Form 1040, Schedule SE) or use tax preparation software.
How to file and pay self-employment tax
If you’re wondering how to file and pay self-employment tax, the answer is deceptively simple: you’ll file and pay these taxes just like any other tax.
It’s more complicated in practice, however, because newly self-employed people often have to deal with a variety of different tax changes all at once. When you become self-employed, you will probably have to fill out new tax forms, and you may need to start making quarterly estimated tax payments.
The good news is that you don’t have to track due dates or payment methods for self-employment taxes specifically, however. Your self-employment tax will be calculated on your annual tax return, and you will pay all your federal taxes the same way (whether you make payments annually or quarterly).
Hi there! This post exists to offer you (hopefully) useful information but it cannot take the place of personalized professional advice. Please consult a qualified expert if you have questions about your business. Also, Azlo doesn’t endorse any third-party sites that are linked here.
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