Self Employment Taxes

Sections within this essay:

Background

Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. Social Security benefits are available to self-employed persons just as they are to wage earners. Most people who pay into Social Security work for someone else. Their employer deducts Social Security taxes from their paycheck, matches that contribution, and sends wage reports and taxes to the Internal Revenue Service (IRS ) and Social Security. But self-employed people must report their earnings and pay the taxes directly to the IRS.

The main source of Social Security income is the taxes that employees, employers, and the self-employed pay. This is the primary method of financing Social Security. Both benefit amounts and Social Security taxes are based on the worker's earnings under the program.

Social Security

The Social Security program is a system of social insurance under which workers (and their employers) contribute a part of their earnings in order to provide protection for themselves and their families if certain events occur. Since each worker pays Social Security taxes, each worker earns the right to receive Social Security benefits without regard to need. The fact that Social Security benefits go to some people who have high incomes has been a source of criticism. However, these persons pay into the program and play an important role in its financial base. Moreover, benefits of higher earners are subject to the income tax as a result of the 1983 Social Security amendments. Social Security taxes and benefit amounts are related to a person's level of earnings during working years. As people earn more money and pay more in Social Security taxes, they are earning a right to higher benefits. There is, however, a limit on the amount of yearly earnings on which Social Security taxes must be paid and on which program benefit payments are figured.

Self-Employment

According to the IRS, an individual is selfemployed if that person operates a trade, business, or profession, either alone or with partners. Yearly earnings in excess of $400 must be reported on Schedule SE for Social Security purposes.

Trade or Business

A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements; however, making a profit is not essential to being in a trade or business as long as the business has a profit motive. The business does not have to be full-time in order for an individual to be self-employed. Having a parttime business in addition to a regular job may be sufficient for self-employment for IRS purposes.

Independent Contractors

Independent contractors often include doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession offering specific services. Generally, an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to SE tax.

Religious Workers

For income tax purposes, a licensed, commissioned, or ordained minister is generally treated as a common law employee of his or her church, denomination, or sect. There are, however, some exceptions such as traveling evangelists who may be treated as independent contractors. The gross income of a licensed, commissioned or ordained minister does not include the fair rental value of a home (a parsonage provided), or a housing allowance paid, as part of the minister's compensation for services performed that are ordinarily the duties of the minister. The fair rental value of a parsonage or the housing allowance can be excluded from income only for income tax purposes. No exclusion applies for self-employment tax purposes. For Social Security purposes, a duly ordained, licensed, or commissioned minister is self-employed. Religious workers can request an exemption from self-employment tax, if they can prove they are conscientiously opposed to public insurance for religious reasons. The exemption is not permitted solely for economic reasons. A previously elected exemption from Social Security coverage and self-employment tax can be revoked; however, once it is revoked, it cannot be elected again.

Income for Self-Employment Tax

Self-employment tax is based solely on the business income reported on Schedule C of an individual's tax return. It is 15.3 percent of the individual's net earnings from self-employment as reported on Schedule SE and consists of two portions: 12.4 percent is for Social Security, and 2.9 percent is for Medicare. The Social Security portion of the self-employment tax is satisfied once the self-employed earner has at least $80,400 of income; however, the Medicare portion of the self-employment tax is unlimited. For an individual who has wages and is also self-employed, the tax on the wages is paid first. This rule is only relevant when the individual has total earnings over $84,900.

Deductions

Income tax deductions can reduce the self-employment tax liability. These deductions are intended to make sure self-employed people are treated in much the same way as employers and employees for Social Security and income tax purposes. Net earnings from self-employment are reduced by an amount equal to half of the individual's total Social Security tax. This is similar to the way employees are treated under the tax laws because the employer's share of the Social Security tax is not considered income to the employee. Also, half of a self-employed individual's Social Security tax can be deducted on the face of the IRS Form 1040. This means the deduction is taken from gross income in determining adjusted gross income. It cannot, however, also be an itemized deduction and must not be listed on Schedule C.

Along with these deductions self-employed persons may deduct numerous business expenses including the cost of computers and computer-related equipment, furniture, office supplies, postage costs, and telephone bills. If the individual works from home, a home-office deduction may be advantageous. Additional potential deductions include business use of a car, health insurance, certain travel and entertainment expenses, 50 percent of meals and entertainment, and attorney and accounting fees that are directly related to the business.

Social Security Credits

Social Security in the United States is designed to act as a safety net for all citizens of the United States. In addition to retirement benefits, those that are disabled, dependent for support upon someone who receives Social Security income, and those who are a widow, widower, or child of someone who has died may be eligible for benefits. When an individual works and pays Social Security taxes, called FICA (Federal Insurance Contributions Act) on some pay stubs, that worker earns Social Security credits. Most people earn the maximum of four credits per year. The number of credits required to earn retirement benefits depends on the date of birth. Those born after 1929 need 40 credits. Social Security taxes pay for Retirement Benefits, Disability Insurance, Family Insurance, Survivors Benefits, and Medicare Insurance. Net earnings of $3,480 or more earns an individual four credits—one for each $870 of earnings. Net earnings for Social Security are gross earnings from a trade or business, minus the allowable business deductions and depreciation.

Correcting Social Security Earnings

Workers 25 and older are mailed Social Security Statements each year. The Statement shows the earnings that appear for each year of work on the individual worker's Social Security record. It is important Social Security earnings records be correct so that workers can get all of the credits earned. Every year, Social Security receives reports of earnings that cannot be credited to anyone because the name and number on the reports do not match the name and number on its records. These records can, however, be claimed by the worker contacting Social Security.

Family Business Arrangements

Family members may operate a business together. A husband and a wife may be partners or be running a joint venture. Each member of a couple who has such a business should report a share of the business profits as net earnings on separate self-employment returns (Schedule SE), even if they file a joint income tax return. The partners must decide the amount of net earnings each should report (for example 50 percent and 50 percent). Each spouse should include his or her respective share of self-employment income on a separate Form 1040 Schedule SE. Self-employment income belongs to the person who is the member of the partnership and cannot be treated as self-employment income by the nonmember spouse, even in community property states. This generally does not increase the total tax on the return, but it does give each spouse credit for Social Security earnings on which retirement benefits are based. However, this may not be true if either spouse exceeds the Social Security tax limitation.

Estimated Tax

Estimated tax is the method used to pay tax (including SE tax) on income not subject to withholding. An individual must make estimated tax payments if the individual expects to owe tax, including self-employment tax, of $1,000 or more for the year. A person who is both self-employed and an employee, can avoid paying estimated tax by having the employer increase the income tax taken out of wages using Form W-4, Employee's Withholding Allowance Certificate. There are penalties for underpayment of estimated taxes.

Additional Resources

Mercer Guide to Social Security and Medicare Treanor, Robert J. and Dale Mercer Myers, Mercer, 2002.

Smart Tax Write-Offs: Hundreds of Tax Deduction Ideas for Home-Based Businesses, Independent Contractors, All Entrepreneurs Ray, Norm, Rayve Productions, Incorporated, 2000

Taxes Made Easy for Your Home-Based Business Carter, Gary, Wiley, John & Sons, 2000.

Organizations

National Association for the Self-Employed

P.O. Box 612067
Dallas, TX 75261-2067 USA
Phone: (800) 232-NASE
URL: http://www.nase.org

The Social Security Administration

6401 Security Blvd.
Baltimore, MD 21235-0001 USA
Phone: (800) 772-1213
URL: http://www.ssa.gov