When Your Income Is Subject to Self-Employment Taxes
Self-employment taxes are to individual business owners what payroll taxes are to employers and employees.They fund Social Security and Medicare.
All individuals with self-employment income must pay self-employment taxes, 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 (40 quarters).
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 business owners 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 income ceiling 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 net earnings from self-employment. You pay the 2.9 percent Medicare tax on all net earnings from self-employment.
Possible Third Component
If your net earnings from self-employment are over $200,000 if you’re single, or $250,000 if you’re married filing jointly, you must pay a 0.9 percent additional Medicare tax on net earnings from self-employment over the$200,000 threshold, for a total 3.8 percent Medicare tax.1
Compare to the Employer and Employee
Excluding the additional Medicare tax that’s levied solely on employees, the self-employment tax rate is the same as the combined Social Security and Medicare payroll tax paid by employees and employers. But with employment, employers pay half of the taxes while withholding the other half from their employees’ wages.
Observation. At first glance, it looks as if W-2 employees personally pay half as much as the self-employed. But that’s not so.
The tax code allows the self-employed to make up for some of this unfairness by allowing them to
reduce net income subject to self-employment taxes by 7.65 percent, 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 x 12.4 percent) + (184,700 x .029 percent)].
You deduct $11,792 (half of $23,584) on Schedule 1 of your Form 1040. If you are in the 24 percent tax bracket, the deduction saves you $2,830 in taxes. In this example, your net self-employment taxes are $20,754 ($23,584 –$2,830). This does not get you even with the combined employer and employee, but it helps.
Had you operated as a C corporation and paid yourself $200,000 in wages, the combined employer and employeeSocial Security and Medicare cost would be $17,689 (versus $20,754 with self-employment).4
Have Both W-2 Wages and Self-Employment Income?
If you earn both W-2 wages and self-employment income, you count your W-2 first as if you had no self-employment income.
If your W-2 wages exceed the annual ceiling ($147,000 in 2022), no Social Security taxes are due on any of yourself-employment income.
In this case, you pay less in taxes under the ordering rule because it allows you to use all or part of the SocialSecurity wage ceiling with your employee income (taxed at 6.2 percent) before applying the formula above.
You report your self-employment taxes on Form SE and pay them along with your income taxes. You must include them in your quarterly estimated taxes.
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 a partnership. (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 use for deducting business expenses.
The general rule is that a business is an activity you engage in regularly and continuously 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 or hobby income. For example, you don’t pay self-employment taxes on profits you 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—on dollar one, once you have over $433 inSchedule C, E, or F net income from a business ($433 x 92.35 percent = $400, the trigger number for ScheduleSE).
Example. Nancy earns $1,000 in Schedule C profits. Her net earnings from self-employment are $935 ($1,000 x92.35 percent). Her self-employment tax is $143 ($935 x 15.3 percent).
Your net earnings from self-employment start with the gross income from your trade or business minus deductions attributable to the business.
Key point. This makes business deductions doubly valuable since they reduce both your income and self-employment taxes. In contrast, personal itemized deductions and “above-the-line” adjustments to income don’t decrease net earnings from self-employment.
If you have more than one business (say two Schedule Cs), you combine the net income or loss to determine your net earnings from self-employment. Thus, a loss from one business offsets the income from another 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 an IRA, 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 (With Two Exceptions)
In general, rental income is not considered self-employment income and is not subject to self-employment taxes unless it is received as part of a real estate dealer’s trade or business. Rents from personal property leased with 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 sole proprietor. He also is an LLC member in areal estate partnership that owns a commercial building.
John’s income from his equipment leasing business is subject to self-employment taxes,
but his distributive share of rental income from his LLC membership in the real estate partnership does not create earnings subject to self-employment taxes.
Exception 2
Services for tenants can trigger self-employment taxes. The IRS explains this well in Regulation 1.402(a)-4 as follows:
Services rendered for occupants. Payments for the use or occupancy of rooms 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, boardinghouses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate; consequently, such payments are included in determining net earnings from self-employment.
Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for 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 not considered as services rendered to the occupant.
IRS Chief Counsel Advice 202151005 noted that some services may not trigger the self-employment tax, but that advice gives little guidance as to what those services may be.
Most Interest Income Is Not Self-Employment Income
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 such taxes. For example, interest received by merchants on their accounts is subject to self-employment taxes because they receive the interest in the course of their businesses.
Most Dividends Are Not Self-Employment Income
Like interest income, dividends on stock are not included in net earnings from self-employment unless the recipient is a dealer in securities who receives 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 the sale of a jewelry display case. He also sustains a $10,000 loss from a fire to his store building.
Arthur excludes the $1,000 gain and $10,000 loss from his net earnings from 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 the individual shareholders as dividends or distributions. Such pass-through S corporation income is not trade or business income to the shareholders and is not subject to self-employment taxes.
Key point. The S corporation is the one business form that can save its owners substantial self-employment taxes, which is why it is so popular.
Example
Jason owns a landscaping business that generates $100,000 in net profit. If he operates as a sole proprietor, 92.35percent of his $100,000 net business income is net earnings from self-employment subject to self-employment taxes.
Instead, he incorporates his business with him as the sole shareholder and works full-time in the business as the corporation’s employee. Jason has his corporation pay him $60,000 as employee salary, on which payroll taxes must be paid.
In addition, the corporation distributes $40,000 to Jason during the year as a 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 in the corporation’s business, he or she must ordinarily be classified as an employee and paid a salary for the services rendered. S corporation salary payments to shareholders are subject to payroll taxes just like salary payments 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 many years.
Suppose a shareholder-employee is paid an unreasonably low salary to avoid payroll taxes. In that case, the IRS can reclassify the dividends or distributions paid to the shareholder as employee wages upon which payroll taxes must be paid.
Unfortunately, there are no concrete guidelines, and the burden of responsibility is on the entrepreneur to substantiate their "reasonable wage".
Takeaways
Here are four things to know from this article:
The self-employed must pay a 12.4 percent Social Security tax and a 2.9 to 3.8 percent Medicare tax on their net earnings from self-employment. The 12.4 percent Social Security tax is subject to an annual income ceiling ($147,000 for 2022).
You must pay self-employment taxes if you earn income from a business that you report onSchedule C or F, co-own as a general partner in a partnership, or own as a member in a multi-member LLC, or if you co-own any other business entity taxed as a partnership.
Net earnings from self-employment do not include real estate rental income (unless you provide services to tenants), dividend or interest income, or gain or loss from business property other than inventory.
Distributions from S corporations are not subject to self-employment taxes. S corporations must ordinarily treat shareholders who work in the corporate business as employees and pay them a reasonable W-2 salary.
References
1 IRC Section 1401.
2 Form 1040, Schedule SE, Self-Employment Tax (2021), line 4a.
3 IRC Section 164(f); Form 1040, Schedule SE, Self-Employment Tax (2021), line 13.
4 $9,882 on employee, plus $7,807 net taxes on the C corporation after its tax deduction equals $17,689. Employee: [($147,000 x 6.2 percent = $9,114) + ($53,000x 1.45 percent = $768) = $9,882]. C corporation employer: [$9,882 - ($9,882 x 21 percent = $2,075 taxes benefit) = $7,807.
5 Reg. Section 1.1402(c)-1.
6 Commr. v Groetzinger, 480 U.S. 23.
7 Reg. Section 1.1402(a)-1(a).
8 Reg. Section 1.1402(a)-2(c).
9 IRC Section 1402(a); Form SE Instructions, p. 5 (2021).
10 IRC Section 1402(a)(1).
11 Reg. Section 1.1402(a)-4(c).
12 CCA 202151005.
13 Reg. Section 1.1402(a)-5.
14 Ibid.
15 IRC Section 1402(a).
16 Rev. Rul. 59-221.
17 Rev. Rul. 74-44.
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