How Taxes for Self-Employed Individuals Work

Don’t forget self-employment tax in your business tax planning. The tax for Social Security and Medicare paid by business owners is what self-employment tax is. It is paid in a different way but it is the same tax and rate as taxes paid by employees and employers (called FICA tax).

Based on your income from your business as a self-employed person, you pay self-employment tax each year. If you don’t have a profit in your business for the year, you don’t have to pay this tax. But, if you don't have a profit and pay the tax, you don’t get Social Security/Medicare credit for benefits for the year. 

Tax Rate of the Self-employment

From your net business income, the self-employment calculation is 15.3% and there are two-part to this rate:

• Social Security: 12.4%. Each year, this amount is capped a maximum amount. 
• Medicare: 2.9%. You must pay an additional Medicare tax of 0.9% on that income if your annual income from employment and self-employment is over a certain amount. 

Business types that pay self-employment taxes

On the income of all small businesses, self-employment is due. Since the profits and losses of the business pass through the owners on their personal tax returns, all of these businesses are considered pass-through entities. The business owner calculates from the business for that year their share of net income  (income minus expense deductions) and includes this income on their personal tax return. 

Sole proprietors (like independent contractors and freelancers), partners in partnerships, S corporation owners and limited liability company (LLC) owners are included in pass-through business types. Shareholders are owners of a corporation and since they are not self-employed, they don’t pay self-employment tax. 

How to calculate and pay the self-employment tax

Step 1: Calculate the business net income

Let’s assume on Schedule C of your personal tax returns, you are calculating your business taxes. This form the various allowable ordinary and necessary business expenses will be deducted from your total earnings. The result will be used in your calculation and is your taxable or pass-through net income from self-employment. 

Step 2: On Schedule SE calculate self-employment tax

Using Schedule SE, this net income is then used to calculate the amount of self-employment tax you owe for the year. There are several ways to run the calculation and it can be complicated, using a long version or a short version. 

A deduction for one half of the self-employment tax is what Schedule SE includes. Before calculating your tax bill, you take this deduction to reduce your adjusted gross income (AGI). This deduction helps employees to only need to pay half and it also helps offset the issue of business owners having to pay the entire amount. 

Step 3: On your personal tax return, including your self-employment tax

From Schedule SE to your personal tax return, the amount of the tax (minus the deduction) from Schedule SE is then carried over. For the current year, any amount you owe for the self-employment tax will be added to your personal tax liability to be paid to the IRS. 

Estimated Taxes and Self-Employment Tax

As a business owner, self-employment tax and income taxes are not withheld from your income. Taking money from the profits, you get paid as a business owner. To avoid IRS fines and penalties for underpayment of taxes, you may need to make quarterly estimated tax payments. 

 What if you have both Self-employment income and Employment income?

If you have a pay check, based on your income from your job, you have a Social Security/Medicare taxes (called FICA tax). The Medicare portion is 2.9% and the Social Security portion of the tax is 12.4% on incomes up to the annual maximum. The employee pays half and will be withheld from the employee’s pay check while the employer also pays half. 

If you have both the self-employment and employment income, for several purposes the two are considered together:

• At the maximum for the year, to make sure Social Security is stopped. 
• Additional Medicare Tax begins at the threshold point, and
• For self-employment tax to be calculated. For this purpose, the self-employment income will come after the employment income up to the Social Security maximum. 

In this case, you must use the long form of Schedule SE.