What is Self-employment Tax?
Self-employment tax is the tax that self-employed individuals like sole proprietors, independent contractors, and freelancers pay if their net earnings exceed $400. This tax is paid to aid the federal government in funding Social Security and Medicare.
It is similar to the tax withheld from wage-earners remuneration, although the amount paid is higher for self-employed individuals. Professionals earning less than $400 or $108.28 (earned from a tax-exempt church) need not pay the self-employment tax.
Self-employed Tax Obligations
There are certain obligations that self-employed individuals must fulfill as taxpayers that include:
- They must file an annual tax return and pay the federal government every quarter.
- Apart from the self-employment tax obligations paid as Medicare (2.9%) and Social Security (12.4%) taxes, self-employed individuals must also pay income tax based on their profit earnings. As of 2022, the Social Security tax applies to the first $147,000 of one’s self-employment income.
Hence, one must deduct their business expenditures from the net business income to calculate if they can pay this tax.
If your net profit is less than $400, you are not liable to pay taxes. However, you must file a tax return based on the category you fit in. You can check whether you meet any other requirements for tax filing from Form 1040 and 1040-SR instructions. If you have doubts, you can take professional help for tax calculations and determine if you’re eligible for paying self-employed tax.
Example of Self-employment Tax
Self-employment tax is calculated as 92.35% of the net earnings and not on 100% of their total earnings. Let us understand this with the help of an example.
Michael runs a sole proprietorship business whose net earnings amount to $200,000 after deducting the business expenses for 2021. So, the self-employment tax will be calculated on 92.35% of $200,000, which comes to $184,700. Now, this amount is greater than the Social Security tax cap.
Hence, the tax that Michael must pay for Medicare and Social Security is –
(2.9% of $184,700 = $5356.30) + (12.4% of $142,800 = $17,707.20) = $23,063.5.
When filing an income tax return for 2021, Michael will be eligible for claiming an above-the-line deduction for half of their self-employment tax amount is, i.e., ½ of $23,063.5, which equals $11,531.75.
This amounts to the employer portion deduction of the self-employment tax. Thus, the calculation is based on the net income of a self-employed individual in a given year.
Self-employment Tax Rate
According to federal law, the self-employment tax rate stands at 15.3% of the net earnings of a self-employed individual. This rate is combined into a rate that includes –
- 12.4 percent of Social Security tax
- 2.9 percent Medicare tax.
Here is a look into how the year 2021 self-employment tax rate was calculated:
- For the tax year of 2021, the first $142,800 of one’s self-employment earnings marked the Social Security tax portion. However, as mentioned earlier, this amount rose to $147,000 in 2022.
- The Medicare tax must be paid irrespective of one’s earnings.
- An additional tax for Medicare of 0.9% also applies if the net earnings from self-employed jobs exceed $200,000 for sole proprietors/freelancers as a single filer or $250,000 for joint filing.
You should note that the self-employment tax is a tax-deductible expense. While the taxpayer’s income tax is calculated on their business profit, the IRS allows self-employed individuals to calculate half of 15.3% (7.65%) as a part of the business deduction.
How to Calculate Self-employment Tax?
When calculating self-employment tax, you must first determine your net earnings for the particular year. The net earnings indicate the amount left after deducting the various business expenses from the gross income.
- As reiterated above, 92.35% of the taxable amount is the basis for self-employment tax. The tax is levied on this percentage.
- After calculating your net earnings, the next step is to calculate the 15.3% (the standard tax rate as per federal law).
- In case of a loss or less net earnings, make sure to check the IRS Schedule SE that outlines two optional methods for tax calculation for self-employed individuals.
- Before calculating the tax, you can deduct 7.65% of the net earnings as mandated by the IRS.
Who Must Pay Self-employment Tax?
Suppose you are self-employed either as an entrepreneur, a small business owner, or a freelancer, and you fall under any of the following two categories. In that case, you must pay the self-employment tax. The conditions are –
- Your net earnings come to at least $400 (excluding church income).
- If you earned more than 108.28 as an employee of the church.
How to Pay Self-employment Tax?
To pay the self-employment tax, the first thing you must do is to obtain the Social Security Number or SSN. This is also referred to as the Taxpayer Identification Number or ITIN.
So how does one get an SSN and ITIN?
To get an SSN, you must fill the Form SS-5 – the self-employment tax form for applying for a Social Security Card. You can get the form from any of the offices of Social Security or from the SS website.
For non-resident individuals, an ITIN is issued by the IRS. Those who are resident aliens and do not possess SSN must apply for ITIN by filling out Form W-7.
If you are wondering how to file self-employment taxes, it’s recommended to file it quarterly. Once filed, you can refer to the pages on Publication 505, Estimated Taxes and Tax Withholding and Estimated Tax to know more details on how to pay self-employment tax.
Both Schedule SE and the Schedule C forms must be submitted along with the IRS 1040 form, wherein you should fill up the amount due in the ‘Other Taxes’ section. Self-employed individuals can claim 50% of their self-employment tax as Income Tax deductions on this form.
In most cases, the self-employment tax should be paid within that year by filing the Estimated Tax Payments for that year. However, it is advisable not to wait till the next April to pay your taxes as it may cause the IRS to penalize you. For ease of payments online, you can log in to the Electronic Federal Tax Payment System, or opt for voucher submitting available on Form 1040.
When calculating the taxes, it is best to take the help of a qualified tax advisor to ensure that the calculations are correct.
As we stated earlier, it’s best to pay the taxes quarterly throughout the year, especially if:
- You feel you will owe a minimum of $1000 as federal income taxes in the current year, even after calculating the refundable and withholding credits (including the earned income tax credit).
- The refundable and withholding taxes cover less than 90% of the current year’s tax liability or are 100% of the last year’s tax liability. The smaller amount would be considered, with the maximum threshold calculated being 110%, if your gross income after adjustment was more than $150,000 (for married couples) or $75,000 (for single individuals).
What Happens if you Don’t Pay Self-employment Tax?
Failing to pay the self-employment tax on time will attract penalties or notice by the IRS. The IRS may issue a notice or charge a penalty for not paying or delaying tax payments. Therefore, paying the self-employment tax on time will avoid an IRS CP 2000 notice followed by fines for delayed tax payments.
Tax Deductions for Self-employment
Coming to self-employment tax deductions, you can claim half of the self-employment tax as income tax deductions.
Let’s explain this with an example. If you owe $4000 as self-employment tax in the current year, you must pay this amount at the due time during the same year. However, during tax time, only $2000 will be deducted on your form 1040.
As a self-employed individual, you can enjoy many other tax deductions too. One of these is the Qualified Business Income deduction that enables you to claim a tax deduction that is 20% of the net self-employment income. In addition, claims on other tax deductions such as health insurance, home office, etc., are also available for self-employed individuals.
The Tax Cuts and Jobs Acts of 2018 brought about several changes in the self-employment tax deductions. Every year, it is essential to review and look into the areas that allow for a deduction to ensure that you take home maximum profits.
- If you use a vehicle and a home office, there are separate calculating methods to run your business. So, get acquainted with both methods to ensure that you can claim the correct deductions.
- Meals you arrange with customers and clients or for business travel purposes are also liable for tax deductions. However, you must support such expenses with the due receipts to show that these were for business purposes only.
- Whatever business insurance you buy, the premiums on the same are Tax deductible. Thus, while calculating tax deductions, you must factor in costs like advertising, startup costs, retirement plan costs, etc.
You can also check the deductions that have been changed or eliminated under the Tax Cuts and Jobs Act. However, remember that these deduction regulations are dynamic and are liable to change. Some tax deductions are expected to be modified or extended before 2025.
Hence, to ensure that you can claim the correct amount as your self-employed tax deduction, make it a point to review these deductions on the official website annually.
How Can Multiplier Help?
Self-employment tax includes several calculations and considerations. Therefore, it’s best to hire a third-party service provider to make your tax liabilities a smooth and hassle-free affair. In addition, partnering with a global employment solution partner will help you stay abreast of the benefits, tax deductions, and much more.
As you set up your business, you may find it challenging to calculate your tax returns, gather all documents, and adhere to the necessary legal procedures. So why not partner with Multiplier to ease your tax burden when there’s so much to do as a self-employed person?
With Multiplier as your partner, you can focus on your business while our experts handle your tax returns and deductions. Our experts can offer you sound legal advice for running your business smoothly while ensuring full compliance.
Get in touch with our professionals today if you wish to know more!
Frequently Asked Questions
Q. What are some of the tax deduction provisions that are likely to expire by 2025?
Tax deduction laws are constantly changing. According to the Tax Deductions and Jobs Act, the provisions that are likely to expire by 2025 are
- QBI deduction
- SALT deduction cap
- The standard deduction will return to pre-TCJA levels
- Income tax rates will return to pre-TCJA levels
Q. Is travel deduction applicable for Self Employed individuals?
Yes, you may claim travel deductions even if you are self-employed. Make sure to keep all business travel records that show you engaged in actual business activity. This may be meeting clients, communicating with customers, training, etc. The deductible expenses cover your travel cost, round-trip from your home office to the destination, and the transportation costs incurred.
Q. Are there are criteria to apply for ITIN?
To apply for an ITIN or Individual Taxpayer Identification Number, you must prove yourself as a non-resident or alien status. In addition, you must provide a tax return on Form W-7 which mentions specific details as to the application for ITIN. If you have any doubts, you may take the help of ‘acceptance agents,’ which help get ITINs. ITINs are only issued to those self-employed taxpayers who are not eligible to get a Social Security Number.