What is the self-employment tax?

The Self-Employment Tax is the social security and Medicare tax that applies to people who work for themselves, rather than as employees. It is equivalent to the FICA (Federal Insurance Contributions Act) tax withheld from the pay of employees. Self-employed workers are also entitled to social security and Medicare coverage and benefits, but they must calculate this tax themselves, based on their net earnings from self-employment, and pay the tax together with their federal income tax payments.

The social security portion of the tax, which applies up to a maximum amount of net earnings from self-employment each year, covers old-age, survivors and disability insurance; and the Medicare portion, which applies to all net earnings without limit, covers hospital insurance.

Employees have this tax withheld from their paychecks, with a corresponding payment from their employers as a payroll tax. Self-employed workers are responsible for the entire amount of the social security and Medicare tax, but there is a provision in the federal income tax law that allows self-employed individuals to deduct one-half of their self-employment tax as an adjustment to their income for U.S. federal income tax purposes. This reduces net income subject to income tax. It affects only the federal income tax and does not affect net earnings from self-employment or the self-employment tax.

How are social security benefits affected?

Social security coverage is based on obtaining the required number of credits, called quarters of coverage. One credit, up to a maximum of four for the year, is received for a certain quarterly amount of income subject to social security taxes, or self-employment tax, in this case. This amount is subject to change each year. If you have a total of four times the quarterly amount in income subject to social security tax (from self-employment or wages) in a year, you receive the four credits for the year. So, provided that you have earnings from self-employment and you report and pay self-employment tax on these earnings, your social security coverage will be the same as it would have been if you had worked as an employee and had the tax withheld from your pay.

If you have been self-employed but have not reported and paid the self-employment tax, you can still report and pay the tax in order to obtain the corresponding credits for social security coverage. But the Social Security Administration has a 3-year time limit for posting self-employment income. If you file a return for a previous year, you will most likely be assessed a late filing penalty, but you would be able to recover the credits for purposes of determining your future social security benefits.

Who is subject to the self-employment tax?

You are considered to be self-employed, and subject to the self-employment tax, when you:

• Carry on a trade or business as a sole proprietor or an independent contractor,
• Are a member of a partnership that carries on a trade or business, or
• Are otherwise in business for yourself.

If you are carrying on an activity for a livelihood, and your intention is to make a profit, you are in a trade or business. The fact that you do not actually make a profit does not mean that you are not in a trade or business.

You do not have to carry on regular full-time business activities to be self-employed. If you have a part-time business in addition to a regular job, you are still considered to be self-employed in your part-time business.

For self-employment tax purposes, you are an independent contractor if the person or company you work for has the right to control or direct only the results of your work and not how you do it. Independent contractors include professionals and others who provide services to clients and charge for their services on a fee or other basis. They are not contracted as employees and do not have social security and Medicare tax withheld from the pay they receive for their services.

If your earnings from self-employment are low, but you don’t want this to prevent you from obtaining the required number of credits to ensure your social security benefits when you retire, there are optional methods of calculating the self-employment tax, which are discussed below.

Special Cases

Limited Liability Company

If you set up and operate an unincorporated business by yourself, you are a sole proprietor. If you set up a limited liability company (LLC) to operate your business, you are still considered a sole proprietor unless you elect to treat the LLC as a corporation.

Corporation

If you set up your business as a corporation, even if you own most or all of the stock, your income as an employee or officer of the corporation is not subject to SE tax.

S corporation

If you are a shareholder in an S corporation, your share of the corporation’s earnings are not subject to SE tax. If you perform substantial services, you are an employee of the S corporation, and you are subject to withholding of social security and Medicare taxes, and are not subject to the self-employment tax.

Partnerships

If you are a general partner in a partnership that carries on a trade or business, you are considered self-employed. If you are a limited partner; that is, you have an interest in the partnership but do not actively participate in its management and operations, you are generally not considered to be self-employed.

If you and your spouse operate a business as a partnership, you should report your business income and expenses on Form 1065, U.S. Return of Partnership Income, and attach separate Schedules K-1 showing each partner’s share of the earnings. Each spouse must must then report his or her share of the partnership earnings on Form 1040 and file a separate Schedule SE to report self-employment tax.

However, if one spouse is contracted as an employee of the other, rather than being treated as a partner, you must withhold and pay social security and Medicare taxes for him or her.

Rental income

Rental income you receive from real estate and personal property is not subject to self employment tax unless:

• You are a real estate dealer, or
• You provide services for your tenants.

You are a real estate dealer if you are in the business of selling real estate to customers with the purpose of making a profit from those sales. In this case, rent you receive from real estate held for sale to customers is subject to the self-employment tax.

If you operate hotels, boarding houses, and apartments, the rental income you receive is subject to self-employment tax if you provide services for the occupants, such as maid service, and not just the normal services priovided for occupancy, such as utilities.

Church employees

If you are a church employee you may also be subject to self-employment tax if the church elected an exemption from social security and Medicare taxes. In this case, you are subject to self-employment tax if you receive $108.28 or more in wages from the church.

Self-employed retirees

If you are over the normal retirement age and are self-employed, the self-employment taxes still apply, even if you are already receiving social security benefits.

Self-employment tax for U.S. citizens and resident aliens living outside the U.S.

Resident aliens are subject to the same self-employment tax requirements as U.S. citizens. If you are a self-employed U.S. citizen or resident alien living outside the United States, in most cases you must pay self-employment tax. You should not reduce your foreign earnings from self-employment by your foreign earned income exclusion.

There is an exception for self-employment in countries with which the United States has social security agreements to eliminate double taxation. Under these agreements, you generally must only pay social security and Medicare taxes to the country you live in. This country will issue a certificate which serves as proof of exemption from social security tax in the other country.

How to calculate net earnings subject to self-employment tax

The self-employment tax is calculated and reported on Schedule SE. Before completing this schedule you will need to determine your net earnings from self-employment.

• Sole proprietors and independent contractors determine their net earnings on Schedule C or C-EZ.
• Self-employed farmers use Schedule F.
• If you are self-employed as a member of a partnership, you should use information from your Schedule K-1 (Form 1065 or 1065-B) to determine your earnings subject to self-employment tax.
• Church employees use the information on their W-2 statement.

Then you report these earnings on Schedule SE to figure your self-employment tax. Schedule SE is filed with your federal income tax return. If you do not have to file a federal income tax, but need to report and pay your self-employment tax, you can use Form 1040-SS to report your earnings. If you are a resident of Puerto Rico, you can file Form 1040-PR instead of Form 1040-SS.

Most taxpayers can use the Short Schedule in Section A of Schedule SE. If any of the following apply, you will need to complete Long Schedule SE in Section B.

• In addition to earnings from self-employment you also had wages and tips subject to social security, and your total earnings (from wages, tips and self-employment) were more than the maximum amount of income subject to social security tax for the year.
• You received tips subject to social security or Medicare tax that you did not report to your employer.
• You are a chuch employee and received income of $108.28 or more, as reported on your W-2.
• You are a minister, member of a religious order, or Christian Science practitioner who received IRS approval not be be taxed on earnings from these sources, but you owe self-employment tax on other earnings.
• You are using one of the optional methods to figure your net earnings from self-employment.

There are three ways to figure your net earnings from self-employment:

1. The regular method
2. The non-farm optional method
3. The farm optional method

The Regular Method

You must use the regular method unless you are eligible to use one or both of the optional methods.

The optional methods may result in paying more tax, but these methods can be used when you have a low amount of self-employment income and want to receive higher benefits when you retire. These methods are only for purposes of the self-employment tax, not the income tax. Using the optional methods may also qualify you for other tax benefits, such as the Earned Income Credit, the Additional Child Tax Credit, and the Child and Dependent Care Credit.

Nonfarm Optional Method

You can use this optional method for earnings that do not come from farming if you meet all the following tests.

1. You had $400 or more in net earnings from self-employment in at least 2 of the last 3 tax years, before filing for this year.
2. You have used this method less than 5 years. (There is a 5-year lifetime limit.) The years do not have to be consecutive.
3. Your net nonfarm profits were:
   • Less than $1,733, and
   • Less than 72.189% of your gross nonfarm income.

Farm Optional Method

You can use this optional method only for earnings from a farming business if you meet either of the following tests.

• Your gross farm income is $2,400 or less, or
• Your net farm profits are less than $1,733.

Using Both Optional Methods

If you have both farm and nonfarm earnings, you should figure your earnings separately under each method, and then add these amounts together to arrive at your total net earnings from self-employment.

How is the self-employment tax paid?

The self-employment tax is reported on Schedule SE, which is filed with your annual federal income tax return. If you have to pay self-employment tax, you will need to file Form 1040 and attach Schedule SE, even if you don’t otherwise have to file a tax return.

When you are self-employed, you do not have tax withheld from your pay, so you need to make estimated tax payments, including the self-employment tax, during the year. You must make estimated payments if you expect to owe $1,000 or more in taxes, including self-employment tax, when you file your return. If you do not make sufficient estimated payments by the due dates, you may be subject to a penalty for underpayment of taxes when you file your return. Estimated tax payments are due on April 15th, June 15th, September 15th, and January 15th.

If you are self-employed and also work as an employee, you may be able to avoid having to make estimated tax payments by having your employer withhold more tax. You can do this by adjusting your W-4.

Summary

When you are self-employed, whether part-time or full-time, you can ensure that you will be covered by social security and will be entitled to future benefits. You do this by properly keeping track of your self-employment earnings, completing and filing Schedule SE with your annual income tax return, and making the necessary payments. If you have a low level of self-employment earnings, you can use an optional method to meet the requirements for obtaining the necessary credits for social security coverage.