There are many differences between being self-employed and working for someone else. However, the taxes you owe the federal government aren’t one of them.
If you’re self-employed, you’ll still pay the same income tax as people who earn a living in the form of a paycheck or wage paid by an employer. You’ll still owe Social Security and Medicare taxes to boot (possibly at a higher rate), along with potential state income taxes depending on where you live.
As a self-employed individual, the difference lies not in the amount of taxes you pay (Social Security and Medicare aside). Rather, the difference lies in the mechanics of how you pay and file your taxes.
When you’re self employed, no employer withholds money from your paycheck and sends it to the IRS on your behalf throughout the year. Instead, the responsibility for sending in your taxes falls squarely on your own two shoulders.
What Is Considered Self Employment Income?
If you’re a sole proprietor, an independent contractor, or you’re part of a partnership, the money you earn operating a trade, business, or profession may be considered self-employment income. Should your net earnings exceed $400 in a year, then you must report your self-employment income to the IRS and pay taxes
How to Calculate Self-Employment Income
According to the IRS, if you earn more than $400 in self-employment income throughout the year, you must file a tax return. This requirement holds true regardless of any other W-2 income you bring in or your tax filing status.
Depending on how you earn money, you can calculate self-employment income in a few different ways.
- 1099s: Do you earn at least some of your self-employment income as an independent contractor? If so, you should receive 1099s from the companies you contract to do work for throughout the year, assuming you earned $600 or more. Be sure to keep detailed records because even if you don’t receive a 1099, you still need to report the income. Add up the total amount listed on each 1099 form plus any additional earnings from contract work and add it (or have your tax preparer add it) to your tax return.
- Gross Income: Does your business sell goods or services directly to others? If so, you will need to calculate your gross income and include it on your tax return. Gross income is the revenue you earn minus the cost of goods sold. Be sure to keep detailed records throughout the year of both your sales and expenses.
The Self-Employment Tax
In addition to income taxes, self-employed people also must pay self-employment tax. Self-employment (or SE) tax includes both Social Security and Medicare. The current tax rate totals 15.3% — 12.4% for Social Security and 2.9% for Medicare.
For W-2 employees, the taxes due are split in half. The employee pays 7.65%, and the employer takes care of the remaining, equal portion.
The Self-Employed Contributions Act (SECA) of 1954 requires most self-employed people to pay the full 15.3% in Social Security and Medicare taxes on their own.
Breaking Down the Self-Employment Tax
The current 12.4% Social Security tax (6.2% X 2) is due on the first $137,700 you earn per year. This threshold is known as the Social Security wage base.
For the Medicare tax, self-employed filers pay a 2.9% tax (1.45% X 2) on all earnings with no cap. If you earn more than $200,000 ($250,000 for married couples filing jointly), you’ll owe an additional 0.9% Medicare surtax on top of your other obligations.
Self Employed Tax Breaks
As a self-employed worker, you’re not taxed on the gross income your business brings in throughout the year. Rather, your tax liability is based on your net earnings.
Net earnings are your gross business income minus deductions the IRS allows you to claim.
Here are some of the self-employment tax deductions you may be able to claim, potentially lowering your net income and thus reducing your tax liability.
- Self-Employment Tax Deductions: You may reduce your net earnings by half the amount you paid in Social Security taxes. Half of your Social Security tax may also be deducted on IRS Form 1040.
- Qualified Business Income Deduction: Do you have a “pass-through” business (e.g., sole proprietorship, partnership, S corporation, or limited liability company)? If so, you may be able to deduct up to 20% of your qualified business income (QBI) on your taxes. QBI is your company’s profit, minus non-qualified income like dividends, capital gains or losses, income earned outside of the U.S., etc. Income caps also apply. So, you may not qualify for a QBI deduction if you earn more than $160,700 (single filers) or $321,400 (joint filers).
- Miscellaneous Self-Employment Deductions: Self-employed people may also qualify for other valuable tax deductions, depending on the circumstances. For example, if you work from home, you might be able to enjoy a home office tax break for a portion of your mortgage, utilities, repairs, and maintenance. Health insurance and continuing education might be tax-deductible as well. You might even be able to take advantage of tax deductions for car mileage and retirement savings.
How to Report Self Employment Income
No matter how you earn your self-employment income, if it totals more than $400 in a year, you have to report it to the IRS. The form you use to report self-employment income (or loss) may vary based on the structure of your business.
Choosing the Right Form
- Sole proprietors may use Schedule C (Form 1040).
- Farmers use Schedule F.
- If your self-employment income comes from an S corporation, LLC, or partnership, you may need to fill out a Schedule K-1 before you file your personal taxes.
Have questions about the specific forms you need to file with the IRS? It’s best to talk to a tax professional for personalized advice.
Self-Employment Taxes vs. Employee Taxes
As mentioned, self-employed people usually have to pay higher Social Security and Medicare taxes. While employees pay these taxes as well, their employers split the cost with them.
Yet some potential workarounds might help you save money on self-employment tax. It all comes down to how your business is structured.
- S Corporation: When you elect to be taxed as an S corp, you can collect money from your business in two ways — salary and income distributions. You’ll still owe self-employment taxes on the salary portion of your income. But if you take shareholder distributions, those funds aren’t subject to SE taxes. Be aware: You have to give yourself a “reasonable” wage or you might trigger an IRS audit along with other consequences. The cost of establishing and running an S corp may be higher as well.
- C Corporation: Unlike S corporations, LLCs, and sole proprietorships, a C corporation isn’t a pass-through entity. You can avoid self-employment tax with a C corp, but your business will be subject to a corporate tax rate and possible double taxation on any shareholder dividends. You can choose to set your business up legally as C Corp, yet be taxed as an S corporation.
- Limited Liability Company (LLC): Your entire income is subject to self-employment tax when you form an LLC. On the positive side, LLCs require less record keeping than corporations. You can choose to set your business up legally as an LLC, yet be taxed as an S corporation.
- Sole Proprietorship: Operating your business as a sole proprietorship is likely the easiest option available. Yet that doesn’t mean it’s the best choice. As a sole proprietor, you will undoubtedly be subject to self-employment taxes. In addition to the SE tax you must pay, a sole proprietorship doesn’t shield you from personal liability if your business is ever sued. To add insult to injury, establishing business credit scores as a sole proprietor is typically impossible.
Talk to a Tax Specialist
The article above breaks down some of the basics about self employment income and taxes. However, it’s not tax advice and shouldn’t be taken that way. If you have questions about taxes or the best way to structure your business, it’s worth making the investment to speak with a tax specialist.
Trying to choose the right business structure and tax designation for your company can be a daunting task. You’ll need to weigh important choices like S corp vs C corp or LLC vs Sole Proprietorship. In the end, your decision will have a big impact on not just the taxes you pay, but on many other factors that affect your business as well (like business credit).
It’s also critical to calculate your self-employment earnings and taxes correctly. Figure your self-employment income too low, and the mistake could get you into some serious hot water. Calculate your earnings too high or fail to claim all of your available deductions, and you might pay more than your fair share when tax time arrives. Good tax professionals who can guide you through this process are worth their weight in gold.