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What is Self-Employment Tax?
Self-employment tax is a type of tax payable by individuals such as small business owners who work for themselves. It consists of Social Security and Medicare taxes that the federal government deducts from income of such individuals. Any self-employed individual with a net income of $400 or more per tax year is liable to pay a self-employment tax. Information regarding self-employment tax is available on Schedule SE (Form 1040) of the Internal Revenue Service (IRS).
A Little More on What is Self-Employment Tax
Before we go on to describe self-employment tax, it is important to define the term ‘self-employed’. Any individual can be considered to be self-employed if he works for himself. As such freelancers, sole proprietors and independent contractors, consultants, coaches and trainers can all be considered to be self-employed. The federal government regulations mandate that all such individuals with an annual income of $400 or more are liable to pay a self-employment tax at the rate of 15.3%. The breakup of this tax rate is as follows:
- 12.4% will be collected for social security (old-age, survivors, and disability insurance).
- 2.9% will be collected for Medicare (hospital insurance).
An important point to note here is that any employee who is not self-employed is only required to contribute 6.2% towards social security, while another 6.2% is deducted on his behalf from his employer. However, since a self-employed individual can be considered as both the employer as well as the employee, he is liable to pay both portions of social security (i.e. 6.2% + 6.2% = 12.4%). However, there exists only a single tax bracket for social security tax and that is the first $128,400 of self-employment income earned. Also, the maximum social security tax that can be collected per individual has been set at $15,921.60 for the year 2018. In the event that the annual income of a self-employed individual is subject to either a social security tax or the Tier 1 segment of the railroad retirement tax, or both, he is not required to pay the 12.4% social security part of the self-employment tax on any of his net earnings.
Additionally, although the Medicare tax has been fixed at 2.9%, any individual with an annual income over $200,000 has to pay an additional 0.9% Medicare tax. In case of married couples filing jointly, the tax bracket has been relaxed to $250,000.
It is important to comprehend, at this juncture, that self-employment tax is considered a tax-deductible expense that is chargeable on the individual’s net income from business. The IRS does offer such a taxpayer the option to consider the employer half of the self-employment tax, or 7.65% (which is half of the total SE tax of 15.3%) as a business deduction in order to determine the total tax due. As such, self-employment tax is typically calculated on 92.35% of the net income (100% – 7.65% = 92.35%).
Unlike regular employees who are subject to their employers withholding 7.65% from their paychecks, self-employed individuals are not required to withhold tax. However, such taxpayers are still required to make estimated tax payments on a quarterly basis in order to fulfill their self-employment tax obligations.
How to Pay Self-Employment Tax
Any self-employed individual who has either a Social Security number (SSN) or an individual taxpayer identification number (ITIN) can pay a self-employment tax. All information pertaining to self-employment tax is available on Schedule SE (Form 1040) of the IRS. Form 1040-ES contains details to calculate and pay estimated taxes. As of 2019, a self-employed individual must pay an estimated tax if he is subject to the following conditions:
- The individual is expected to owe at least $1,000 in tax for the year, after subtracting his withholding and refundable credits.
- The individual estimates his withholding and refundable credits to be less than the lesser of:
- 90% of the tax to be shown on the tax return for the tax year.
- 100% of the tax shown on the previous year’s tax return, given that the tax return for the previous year covers all 12 months.
It should be noted that the percentages cited above might differ for farmers, fishermen and taxpayers with higher incomes.
References for Self Employment Tax
Academic Research on Self Employment Tax
Marginal and average tax rates and the incentive for self-employment, Robson, M. T., & Wren, C. (1999). Southern Economic Journal, 757-773. This paper scrutinizes how marginal and average income tax rates influence the motivations of individuals to opt for self-employment, rather than paid employment. The authors construct a model in which an individual is given the option to optimally select the supply of labor effort and also decide on the amount of tax he can evade. The paper concludes that there exists a negative correlation between self-employment and the marginal tax rate. However, self-employment displays a positive relationship with the average rate.
Breaking the Glass Slipper—Reflections on the Self–Employment Tax, Dilley, P. E. (2000). The Tax Lawyer, 54(1), 65-104. The author analogizes the tax legislation drafting process to Prince Charming in pursuit of Cinderella with her glass slipper in hand as his only clue. Such a drafting process clings on to extant tax legislation and thus, fails in introducing any groundbreaking new ideas. However, lawmakers still follow this convention because it is often easier and less time-consuming to amend existing legislation. Besides, such revisions are usually more acceptable to taxpayers. The author recommends ‘breaking the slipper’, that is utilizing an entirely new approach to formulate a payroll tax equivalent for the self-employed.
Flowthrough Entities and the Self–Employment Tax: Is It Time for a Uniform Standard, Fritz, T. E. (1997). Va. Tax Rev., 17, 811. This paper performs an in-depth analysis of the historical background and the policy of the Social Security program as well as the various taxes associated with social security and Medicare. The author discusses current employment-related taxes, including the provisions for self-employment taxation and scrutinizes the underlying rationale behind such policies.
Tax progressivity and self-employment: evidence from Canadian provinces, Ferede, E. (2013). Small Business Economics, 40(1), 141-153. This paper samples data from several Canadian provinces for the period 1979 – 2006, in order to scrutinize the effects of an increasing marginal income tax rate on self-employment. Two factors – taxing success and opportunities for tax evasion determine how income tax progressivity influences self-employment. An analysis of the sampled data reveals that income tax progressivity negatively correlated with self-employment during the sampled period.
Current Status of Limited Liability Companies and the Self-Employment Income Tax, Marquis, J. R. (1998). Mich. BJ, 77, 440. The Internal Revenue Code of 1986 made corporate tax rates higher than individual tax rates. This resulted in a sudden shift to Limited Liability Companies (LLCs) as a way of conducting business. Besides limiting liability, LLCs offered other benefits such as a flexible flow-through tax treatment and relative ease of setting up. However, there are certain drawbacks to an LLC setup, for example, the implications of self-employment tax are still ambiguous as far as LLC members are concerned.
The Application Of Self–Employment Tax To Limited Liability Companies: A Critical Analysis, Koski, T. R. (2007). JOURNAL OF APPLIED BUSINESS RESEARCH, 23(3), 87. This paper studies the issue arising from the application of self-employment tax to members of those limited liability companies (LLCs) that opt for taxation as a partnership. This issue arises from trying to determine the circumstances under which an LLC member’s distributive share of LLC income is subject to self-employment tax. The author scrutinizes the various proposals that have been put forward to address that particular discrepancy.
Delimiting Limited Partners: Self–Employment Tax of Limited Partners, Mayo, D. W., & Freeland, R. C. (2012). Tax Law., 66, 391. This paper describes the ongoing trend of personal service firms opting to register themselves as limited partnerships in order to benefit from the exemption of limited partners from the self-employment tax as described in section 1402(a)(13) of the Internal Revenue Code. However, there exists some ambiguity regarding the application of this tax exemption to newer forms of limited partners.
Self–Employment Tax and Choice of Entity, Chase, B. W. (2005). Colo. Law., 34, 109. Individual businesses often opt for S corporation as the entity of choice, since it exempts the shareholders from the obligation to pay self-employment tax. However, several proposals have been made, of late, to impose self-employment taxes on S corporations. The author scrutinizes the statutory requirements for imposition of self-employment taxes.
Self–Employment Tax and Limited Liability Companies: When are LLC Earnings Subject to Self–Employment Tax, Koski, T. R. (2005). Taxes, 83, 33. Limited Liability Companies (LLCs) provide businesses with an opportunity to opt for taxation as a partnership to benefit from certain federal taxation exemptions. The author studies the impact of the imposition of self-employment taxes on LLCs and scrutinizes the various circumstances under which the distributive share of LLC income of an LLC member becomes subject to self-employment taxation.
Relief from Self–Employment Tax on Farm Rental Income, Vincent, S. E. (2001).J. Mo. B., 57, 92. This paper studies how self-employment tax affects individuals involved in agricultural leasing businesses. The author identifies certain circumstances under which landowners can manipulate leasing situations in such ways as to exempt fair market value rents from self-employment taxes. There have been instances of such landowners successfully exempting their income from self-employment taxes even when they were themselves involved in farming operations pursuant to an unconnected contract.
Self–Employment Tax Issues in LLCs Taxed as Partnerships, Keatinge, R. (2007). This paper scrutinizes the current trends pertaining to how self-employment tax regulations have been treating members of limited liability companies (LLCs). The author bases his observations on the events following the Joint Committee of Taxation recommendations for self-employment taxation policies besides observations of the American Bar Association Section of Taxation.
From the tax adviser: LLC members and self–employment tax, Fiore, N. (1997). Journal of Accountancy, 183(5), 30. The rapid emergence of Limited Liability Companies (LLCs) towards the end of the 20th century in no less than 48 states besides the District of Columbia gave rise to a lot of scrutiny regarding the taxation of such entities as well as their members. Many of these issues were as yet unresolved.