Self-employment taxes are to individual business owners what payroll taxesare to employers and employees. They fund Social Security and Medicare.
All individuals with self-employment income must pay self-employmenttaxes, regardless of their age. When business owners reach retirement age,they’ll be able to collect Social Security and Medicare A (hospital insurance)benefits if they paid self-employment taxes for at least 10 years (40quarters).
You pay self-employment taxes on your net earnings from self-employment,not your entire business income.
In this article, we will discuss:
- How Much Are Self-Employment Taxes?
- Individuals Subject to Self-Employment Taxes
- Net Earnings from Self-Employment
- Income Not Subject to Self-Employment Taxes
How Much Are Self-Employment Taxes?
Self-employment taxes are not insubstantial: indeed, many businessowners pay more in self-employment taxes than income taxes.
Two Components
The self-employment tax has two components:
- a 12.4 percent Social Security tax up to an annual incomeceiling adjusted for inflation each year ($147,000 for 2022),and
- a 2.9 percent Medicare tax on all net earnings from self-employment.
You pay the 12.4 percent Social Security tax on the first $147,000 of netearnings from self-employment. You pay the 2.9 percent Medicare tax on allnet earnings from self-employment.
Possible Third Component
If your net earnings from self-employment are over $200,000 if you’resingle, or $250,000 if you’re married filing jointly, you must pay a 0.9 percentadditional Medicare tax on net earnings from self-employment over the$200,000 threshold, for a total 3.8 percent Medicare tax.
Compare to the Employer and Employee
Excluding the additional Medicare tax that’s levied solely on employees, theself-employment tax rate is the same as the combined Social Security andMedicare payroll tax paid by employees and employers. But withemployment, employers pay half of the taxes while withholding the otherhalf from their employees’ wages.
Observation. At first glance, it looks as if W-2 employees personally payhalf as much as the self-employed. But that’s not so.
The tax code allows the self-employed to make up for some of thisunfairness by allowing them to
- reduce net income subject to self-employment taxes by 7.65percent, and
- deduct on their Form 1040 half of their self-employment taxes.
Example. Your 2022 net profit on Schedule C of your Form 1040 is$200,000. On Schedule SE, you multiply the $200,000 by 92.35 percent(100 – 7.65 percent) and you have $184,700 in net earnings subject to self-employment taxes. Your total self-employment tax is $23,584 [($147,000 x12.4 percent) + (184,700 x .029 percent)].
You deduct $11,792 (half of $23,584) on Schedule 1 of your Form 1040. Ifyou are in the 24 percent tax bracket, the deduction saves you $2,830 intaxes. In this example, your net self-employment taxes are $20,754($23,584 – $2,830). This does not get you even with the combinedemployer and employee, but it helps.
Had you operated as a C corporation and paid yourself $200,000 in wages,the combined employer and employee Social Security and Medicare costwould be $17,689 (versus $20,754 with self-employment).
Have Both W-2 Wages and Self-EmploymentIncome?
If you earn both W-2 wages and self-employment income, you count yourW-2 first as if you had no self-employment income.
If your W-2 wages exceed the annual ceiling ($147,000 in 2022), no SocialSecurity taxes are due on any of your self-employment income.
In this case, you pay less in taxes under the ordering rule because it allowsyou to use all or part of the Social Security wage ceiling with your employeeincome (taxed at 6.2 percent) before applying the formula above.
You report your self-employment taxes on Form SE and pay them alongwith your income taxes. You must include them in your quarterly estimatedtaxes.
Individuals Subject to the Self-Employment Tax
You pay self-employment tax if you
- earn income on a 1099,
- operate as a single-member LLC,
- do business as a sole proprietor,
- are a general partner in a partnership,
- are an LLC member in a multi-member LLC, or
- are a co-owner of any other business entity taxed as apartnership. (There is an exemption for limited partners—see
When Partners and LLC Members Do or Don’t Pay Self-Employment Taxes.)
You determine if your activity is a business under the same rules you usefor deducting business expenses.
The general rule is that a business is an activity you engage in regularly andcontinuously to earn a profit. You don’t have to work at a business full-time,but it can’t be a sporadic activity.
You don’t pay self-employment taxes on personal investment income orhobby income. For example, you don’t pay self-employment taxes on profitsyou earn from selling stock, your home, or an occasional item on eBay.
Net Earnings from Self-Employment
The self-employment tax is not a progressive tax. It starts immediately—ondollar one, once you have over $433 in Schedule C, E, or F net incomefrom a business ($433 x 92.35 percent = $400, the trigger number forSchedule SE).
Example. Nancy earns $1,000 in Schedule C profits. Her net earnings fromself-employment are $935 ($1,000 x 92.35 percent). Her self-employmenttax is $143 ($935 x 15.3 percent).
Your net earnings from self-employment start with the gross income fromyour trade or business minus deductions attributable to the business
Key point. This makes business deductions doubly valuable since theyreduce both your income and self-employment taxes. In contrast, personalitemized deductions and “above-the-line” adjustments to income don’tdecrease net earnings from self-employment.
- If you have more than one business (say two Schedule Cs), you combinethe net income or loss to determine your net earnings from self-employment. Thus, a loss from one business offsets the income fromanother profitable business.
But all is not roses: when calculating net earnings from self-employment,you may not deduct:
net operating loss carryovers from past years,
- the deduction for health insurance premiums for the self-employed,
- contributions to a self-employed retirement plan such as anIRA, SEP-IRA, or 401(k),
- the Section 199A qualified business income deduction, or
- the deduction for one-half of your self-employment taxes.
Rental Income Is Not Self-Employment Income (WithTwo Exceptions)
In general, rental income is not considered self-employment income and isnot subject to self-employment taxes unless it is received as part of a realestate dealer’s trade or business. Rents from personal property leasedwith rental real estate, such as kitchen appliances, are also not self-employment income.
Exception 1
Rental income from equipment leasing is subject to self-employment taxes.
Example. John owns a medical equipment leasing business as a soleproprietor. He also is an LLC member in a real estate partnership that ownsa commercial building.
- John’s income from his equipment leasing business is subject toself-employment taxes,
- but his distributive share of rental income from his LLCmembership in the real estate partnership does not createearnings subject to self-employment taxes.
Exception 2
Services for tenants can trigger self-employment taxes. The IRS explainsthis well in Regulation 1.402(a)-4 as follows:
Services rendered for occupants. Payments for the use or occupancy ofrooms or other space where services are also rendered to the occupant,such as for the use or occupancy of rooms or other quarters in hotels,boarding houses, or apartment houses furnishing hotel services, or in touristcamps or tourist homes, or payments for the use or occupancy of space inparking lots, warehouses, or storage garages, do not constitute rentals fromreal estate; consequently, such payments are included in determining netearnings from self-employment.
Generally, services are considered rendered to the occupant if they areprimarily for his convenience and are other than those usually orcustomarily rendered in connection with the rental of rooms or other spacefor occupancy only.
The supplying of maid service, for example, constitutes such service;whereas the furnishing of heat and light, the cleaning of public entrances,exits, stairways and lobbies, the collection of trash, and so forth, are notconsidered as services rendered to the occupant.
IRS Chief Counsel Advice 202151005 noted that some services may nottrigger the self-employment tax, but that advice gives little guidance as towhat those services may be.
Most Interest Income Is Not Self-EmploymentIncome
In general, interest income is not subject to self-employment taxes.
But interest received in the course of a trade or business is subject to suchtaxes.
For example, interest received by merchants on their accounts issubject to self-employment taxes because they receive the interest in thecourse of their businesses.
Most Dividends Are Not Self-Employment Income
Like interest income, dividends on stock are not included in net earningsfrom self-employment unless the recipient is a dealer in securities whoreceives the dividends in the course of the dealer’s business.
Gain or Loss from Business Property Is Not Self-Employment Income
- You don’t include in net earnings from self-employment gain or loss from
the sale or exchange of a capital asset, or
- the sale, exchange, involuntary conversion, or other disposition of property unless it is inventory.
Example. Arthur owns a retail jewelry store as a sole proprietor. He earns a$200,000 net profit from the sale of jewelry and has a $1,000 gain from thesale of a jewelry display case. He also sustains a $10,000 loss from a fire tohis store building.
Arthur excludes the $1,000 gain and $10,000 loss from his net earningsfrom self-employment. His net earnings from self-employment are only the$200,000 profit from the sale of jewelry.
S Corporation Distributions
The income earned by an S corporation passes through the business to theindividual shareholders as dividends or distributions. Such pass-through Scorporation income is not trade or business income to the shareholders andis not subject to self-employment taxes.
Key point. The S corporation is the one business form that can save itsowners substantial self-employment taxes, which is why it is so popular.
Example Jason owns a landscaping business that generates $100,000 in net profit. Ifhe operates as a sole proprietor, 92.35 percent of his $100,000 netbusiness income is net earnings from self-employment subject to self-employment taxes.
Instead, he incorporates his business with him as the sole shareholder andworks full-time in the business as the corporation’s employee. Jason has hiscorporation pay him $60,000 as employee salary, on which payroll taxesmust be paid.
In addition, the corporation distributes $40,000 to Jason during the year asa distribution. The $40,000 is not subject to self-employment taxes, saving$5,652 in taxes ($40,000 x 92.35 percent x 15.3 percent).
The Salary
But, as the example illustrates, if an S corporation shareholder also works inthe corporation’s business, he or she must ordinarily be classified as anemployee and paid a salary for the services rendered. S corporation salarypayments to shareholders are subject to payroll taxes just like salarypayments to any other employee.
What constitutes a reasonable salary for an S corporation shareholder-employee is a contentious issue that has been on the IRS’s radar for manyyears.
Suppose a shareholder-employee is paid an unreasonably low salary toavoid payroll taxes. In that case, the IRS can reclassify the dividends ordistributions paid to the shareholder as employee wages upon which payrolltaxes must be paid.
Unfortunately, there are no concrete guidelines. For a detailed analysis onhow to avoid IRS problems on the salary, see
Avoid Trouble: Don’t Let theIRS Set Your S Corporation Salary
Takeaways
Here are four things to know from this article:
- The self-employed must pay a 12.4 percent Social Security taxand a 2.9 to 3.8 percent Medicare tax on their net earningsfrom self-employment. The 12.4 percent Social Security tax issubject to an annual income ceiling ($147,000 for 2022).
- You must pay self-employment taxes if you earn income from abusiness that you report on Schedule C or F, co-own as ageneral partner in a partnership, or own as a member in amulti-member LLC, or if you co-own any other business entitytaxed as a partnership.
- Net earnings from self-employment do not include real estaterental income (unless you provide services to tenants), dividendor interest income, or gain or loss from business property otherthan inventory.
- Distributions from S corporations are not subject to self-employment taxes. S corporations must ordinarily treatshareholders who work in the corporate business as employeesand pay them a reasonable W-2 salary.
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