The self-employment tax seems to lend itself to an intuitive definition. What is the self-employment tax? It’s a tax on the self-employed. Who pays the self-employment tax? The self-employed pay, clearly. However, there’s more to this than meets the eye due to the nuance associated with the nexus of real life and arbitrary rules. This article will tackle that nuance, and explain what it is about the self-employment tax that differentiates it from the income tax in general.
While it’s certainly true that one needs to be self-employed to pay the self-employment tax, you need to understand who is self-employed as defined by the IRS. At the most basic level, there are those that have sole proprietorships, which can be thought of as unincorporated businesses that are not partnerships, corporations, or limited liability companies. Think of a kid with a lemonade stand or your nice elderly neighbor that sells cakes to everyone in town. This income qualifies as self-employment income. Also, income paid to you through a contracting job, even if it’s paid to you in your name with no accompanying business or company structure, is considered self-employment income for the purposes of the self-employment tax. Furthermore, if you are a general partner in a partnership or a member of a limited liability company that has not elected to be classified as a corporation for tax purposes, then you most likely have self-employment income.
It basically comes down to this – whether you own a sole proprietorship, are a member of a limited liability company, or are a general partner in a partnership, you have self-employment income if you work for that enterprise and derive income from that work. Work in this context means that you manage or perform labor for that enterprise. Note that being a silent investor and therefore not managing or working for the company means that any income derived is not subject to the self-employment tax because it would be passively derived income.
A couple more notes on this, while it’s true that most business income that you work for in the context of your own company qualifies as self-employment income, there is some grey area. One of them is real estate. Rental income from your residential rental real estate is most likely not self-employment income largely because the IRS has classified this type of income as passive income regardless of your level of involvement in management or labor. However, if you owned 100 rental homes under the umbrella of a limited liability company for which you are the managing member, then your income derived from your LLC would be self-employment income subject to the self-employment tax. It’s therefore a matter of degree. If you have one rental house, then that does not a company make, at least by IRS standards, but if you have a litany of rental homes and that’s the primary way you make money, then you’ll be paying the self-employment tax on that income.
Under the same foregoing analysis, this principal of degree also works for investments in capital assets, such as equities and real estate. If you are a real estate investor that “flips” one home a year, then your income is probably capital in nature and not subject to the self-employment tax. However, if your main gig is flipping houses, or you are a managing partner in a partnership that flips 10 houses a year, then you have to pay self-employment tax on that income. In fact, in this example, the IRS actually classifies the houses that you flip as inventory for sale to the public. Similarly, if you own stock as an individual investor, then the income derived from the sale of that stock is classified as a capital gain. However, if you are the principal of a hedge fund that invests in distressed assets, then your gains are not capital, and you would be subject to the self-employment tax. Again, this is a matter of degree.
What is it?
The short answer is that the self-employment tax is the payroll tax, aka FICA, aka social security and Medicare. In terms of numbers, social security stands at an employer/employee contribution of 6.2% each, for a total of 12.4% on an employee’s gross income, and Medicare is 1.45% each from employer/employee for a total contribution of 2.9%. Therefore, because the self-employment tax is really just social security and Medicare taxes, the total combined rate is 15.3%.
Here’s why this tax sucks. If you are employed by a company that you don’t own, there’s an outside source that contributes a total of 7.65% to FICA. However, if you’re self-employed there is no outside source, so you contribute the full 15.3%. This hits people hard, especially when they first start to work for themselves. They’ve never experienced a tax like this really. For one reason, after profit from the business is figured, typically using Schedule C, Profit or Loss from Business, that entire amount is subject to the self-employment tax, so there really is no standard deduction, exemptions, or credits. There is a deduction for one half of the self-employment tax, but I’m sort of getting ahead of myself.
How is it figured and reported?
You figure the self-employment tax using Schedule SE, Self-Employment Tax. If you look on the form itself, you’ll notice that there are two versions, the short form and long form. Basically, the short form applies if your household income is below the threshold for the maximum amount subject to the social security tax, which is currently $137,700 (2020). Notice that this all earned income within your household, and remember, earned income is what you work for, so it’s from wages, salaries, tips, contracting income, and any business that you own that you also work in. For example, if you and your spouse both have jobs and you make a combined $150,000 from corporate employment and then you have a side business consulting, and you make $30,000 profit, then your gross earned income is $180,000, and you would have to use the long form Schedule SE. Therefore, the primary difference between the short form and long form Schedule SE is that the long form is used when some or all of your self-employment income is not subject to the social security tax, due to your total household income already reaching the $137,700 limit. By corollary, the short form is used when your total household income has not reached the limit for the social security tax, and you therefore still owe that component of the self-employment tax on your business’s profits.
Regardless of whether you use the short or long form, Schedule SE itself is pretty simple and self-explanatory. Using the short form really only involves tallying the amount of self-employment income, then multiplying that income by 92.35% (.9235), and then multiplying the product by 15.3% (.153) to get the total amount of self-employment tax owed. Using the long form, you’ll tally the amount of self-employment income that is taxed for social security and the amount that is taxed for Medicare and then multiply those by 92.35% (.9235) and then multiply by 12.4% (.124) and 2.9% (.029), respectively. After you find the total amount of self-employment tax, multiply that amount by 50% (.5) to figure the deductible part of self-employment tax. Carry the amount of your self-employment tax to Schedule 2, line 4 and the deductible part of self-employment tax to Schedule 1, line 14. This is a slight oversimplification, but not by much, and you therefore most likely won’t find the form itself particularly challenging.
Here’s my suggestion. Whether you have contractor’s income, small business income, limited liability company income, or partnership income, these are all types of self-employment income, assuming you do work and earn income from any one or more of these sources. As a result, you’ll most likely owe the self-employment tax. If you are subject to it, then it’s your responsibility to withhold and remit to the IRS directly. In this vein, do yourself a favor and pay these taxes quarterly, every three months, using IRS Direct Pay. It’s pretty simple to use and gets the job done so you aren’t left flat footed, owing thousands to the IRS.
If you are having issues with calculating your self-employment tax, or you have any tax issues or questions whatsoever, call Dino Tax Co at (713) 397-4678 or email firstname.lastname@example.org. The first phone consultation is always free. Also, if you’d be so kind, please like us Facebook here.