(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)
The self-employment tax is a tax that gets added to your normal income tax. The tax is calculated by multiplying your earnings from self-employment by approximately 15%.
Why the Self-Employment Tax Exists
At first glance, it seems unfair that entrepreneurs — the most important driving force behind our economy — would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.
If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the fact that part of your income was withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the Social Security and Medicare taxes.
The way these taxes are structured, the burden is shared equally between the employee and the employer. The employee’s share is calculated as 6.2% of the employee’s wages for Social Security tax and 1.45% for the Medicare tax. At the same time, the employer also pays both taxes, calculated at the same rate. As a result, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for Social Security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for the Medicare tax.
Given that you are self-employed, there is no employer with whom you can split the burden. You are therefore responsible for paying both halves of the Social Security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the self-employment tax.
How to Calculate Your Self-Employment Tax
As long as your “net earnings from self-employment” are $400 or more, you will be responsible for paying the self-employment tax — calculated as 15.3% of your net earnings from self-employment.
To calculate your net earnings from self-employment, subtract your business expenses from your business revenues, then multiply the difference by 92.35%. (This odd multiplication figure is the result of the fact that you’re allowed to deduct 50% of your self-employment tax when calculating the income upon which the tax will be charged.)
It’s important to note that the Social Security portion of the self-employment tax only applies to the first $117,000 of self-employment earnings. (This number is updated annually, so be sure to check what the most recent limit is.) For any self-employment earnings beyond $117,000 the self-employment tax is only 2.9% rather than the usual 15.3%.
(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)
The Importance of Business Expenses (Schedule C Deductions)
Now that you’re self-employed, you have an additional, extra-valuable level of deductions: business deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and thus your regular income tax), but also your earnings from self-employment, thus reducing your self-employment tax as well.
From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thereby saving you even more money.
In order for an expense to be deductible for your business, it must be both “ordinary” and “necessary.” The IRS considers an ordinary expense to be one that is both common and accepted in your field. A necessary expense is one that is helpful and appropriate for your business. (Note that this means that an expense does not have to be absolutely indispensable for it to be considered necessary.)
Deduction for One-Half of SE Tax
One small piece of good news relating to the self-employment tax is that you get a little bit of it back in the form of an above the line deduction. After using Schedule SE to calculate your self-employment tax, you’ll enter an amount equal to one-half of your self-employment tax on line 27 of your Form 1040 as a deduction to arrive at adjusted gross income.
- The self-employment tax exists simply to take the place of the Social Security and Medicare taxes that you and your employer would be paying if you had a job as an employee.
- The tax is calculated as 15.3% of your net earnings from self-employment (or 2.9% for amounts beyond the annual maximum amount subject to Social Security tax).
- Business deductions (sometimes called Schedule C deductions) are more valuable than either above the line or below the line deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your self-employment tax.
- You will get a little bit of the money you pay for self-employment tax back when you file your taxes for the year. This is because you are allowed an above the line deduction equal to 50% of the amount you pay for self-employment tax.