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Understanding Self Employment Tax: A Comprehensive Guide for Freelancers and Independent Contractors

December 12, 202319 min read

A Comprehensive Guide for Freelancers and Independent Contractors

Self employment taxes are one of the largest issues we see here at Tax Sherpa. Many solopreneurs, freelancers, and independent contractors are caught by surprise when they are considering their tax liabilities as self employment tax is a mostly flat tax assessed in addition to ordinary income tax. When planning for taxes, it is critical to consider the total tax liability and not just one segment of taxes.

Self employment tax (often called SE tax) refers to the tax that self-employed individuals are required to pay on their earnings. It is a crucial aspect of running a business or working as an independent contractor. Understanding self employment tax is of utmost importance for anyone who is self-employed as it directly impacts their financial responsibilities and obligations to the government. Self employment tax also indirectly affects qualifications for certain tax credits and tax deductions like the Earned Income Credit, the Child and Dependent Care credit, self-employed health insurance deductions, home office deductions, and eligible retirement plan contributions among others.

When it comes to self employment tax, there are some key differences compared to regular employment taxes. In traditional employment settings, employers typically withhold taxes, such as Social Security and Medicare taxes, from their employees' paychecks. The employer withholds half of the Social Security and Medicare taxes from the employee's wages and pays the other half directly.  However, in the case of self-employment, individuals are responsible for paying these taxes themselves, since they are both the employer and employee.

The self employment tax consists of two main components: the Social Security tax and the Medicare tax. The Social Security tax helps fund retirement benefits, disability benefits, and survivor benefits, while the Medicare tax provides healthcare coverage for individuals aged 65 and older. These taxes are calculated based on a specific tax rate, which is subject to change each year.

One of the critical reasons why self-employed individuals should have a comprehensive understanding of self employment tax is the potential impact it can have on their financial well-being. On the one hand, the overall tax can be quite high and we generally want to reduce it. On the other hand, failing to pay self employment tax or underestimating the amount owed can result in penalties and unnecessary financial burdens. It is essential to accurately estimate and budget for these taxes to avoid any surprises come tax time.

Additionally, understanding self employment tax allows self-employed individuals to take advantage of tax deductions and credits that can help reduce their overall tax burden. By knowing what expenses are deductible and how to properly document them, self-employed individuals can optimize their tax returns, potentially resulting in significant savings.

Moreover, being knowledgeable about self employment tax enables self-employed individuals to make informed financial decisions and plan for the future. When they have a clear understanding of their tax obligations, they can effectively budget and set aside funds for their tax payments. This helps to avoid the stress of scrambling for money when taxes are due and ensures that they are compliant with the law. At Tax Sherpa, we strongly recommend using a modified Profit First method that takes tax strategy savings into account.

Self employment tax is a critical aspect of being self-employed and should not be overlooked. Understanding the nuances of self employment tax helps individuals fulfill their tax obligations, avoid penalties, and make the most of available deductions and credits. By staying informed and proactive in managing their tax responsibilities, self-employed individuals can maintain financial stability and smoothly operate their businesses.


Understanding Self Employment Tax

Self-employment tax is a crucial aspect of financial responsibility for individuals who work for themselves rather than as traditional employees. It is important to understand who needs to pay self-employment tax, how it applies to different types of self-employment, and the significance of fulfilling these tax obligations.

First and foremost, it is essential to know if you fall under the category of individuals who need to pay self-employment tax. Generally, if your net earnings from self-employment are $400 (as of 2023) or more, you are required to pay self-employment tax. This tax is a combination of Social Security and Medicare taxes, commonly known as the Federal Insurance Contributions Act (FICA) tax.

Entity Effects on Self Employment Tax

Self-employment tax is applicable to various self-employment entities, including sole proprietorships, partnerships, and some limited liability companies (LLCs). Each of these structures has specific self-employment tax obligations:

1. Sole Proprietorships and Disregarded Entities: As a sole proprietor, you have complete control over your business but are personally responsible for its debts and liabilities. When it comes to self-employment tax, sole proprietors are responsible for paying the full FICA tax on their net earnings from self-employment. A sole proprietorship (or a single-member disregarded LLC) files Schedule C attached to the Form 1040 to report the Profit or Loss from Business. The net earnings from the Schedule C is subject to self employment tax.

2. Partnerships and LLCs with Multiple Members: Partnerships and multi-member LLCs distribute their profits among the owners or members. Each individual partner or member is responsible for paying self-employment tax on their share of the net earnings. Partnerships file Form 1065 for their tax returns and the owners receive a Schedule K-1 (1065) reporting their share of the partnership earnings. Box 1 of the K-1 (1065) reports the owner share of total earnings while Box 14 reports the owner share subject to self employment tax. Typically these numbers are the same for active owners. There may also be amounts reported in Box 4 for guaranteed payments which are also subject to self employment tax, depending on how the business operates.

3. S Corporations: S corporations (or S Corps) are a popular choice for small business owners due to the potential tax advantages they offer. For self-employment tax purposes, S corporation owners who also work in the business must pay themselves a reasonable salary and pay payroll tax on that salary. However, any remaining profits are included as ordinary income but are not subject to self-employment tax.

4. C Corporations: C corporations (or C Corps) are stand-alone entities in that they pay their own taxes. When an individual  owner receives money from a C Corp it may be in the form of wages or dividends. Dividends are not subject to self employment tax and have special rates depending on whether they are qualified dividends or ordinary dividends. Wages are subject to the payroll taxes of Social Security and Medicare, but these are assessed at the C Corp level and through Form W-2 rather than through self employment tax and Form SE.

These considerations are why Step 1 of our 4-Step Process is Entity Optimization.

Self Employment Tax Obligations

Understanding and fulfilling self-employment tax obligations is crucial to avoid penalties and minimize audit risks. The Internal Revenue Service (IRS) closely scrutinizes self-employment tax compliance, making it essential to accurately report and pay the correct amount of self-employment tax. Failing to do so can result in additional taxes, interest, and penalties.

Now let's delve into some common types of self-employment income that are subject to self-employment tax. Freelance earnings play a significant role in the self-employment landscape. Individuals who engage in freelance work, such as independent contractors, consultants, or gig economy workers, must include their earnings from these activities when calculating self-employment tax.


Calculating Self Employment Tax

Calculating Self Employment Tax

When it comes to calculating self employment tax, there are a few key factors to consider. Understanding the components of the tax, deductions and credits that can help reduce the tax liability, and the appropriate tax forms for reporting are all essential for self-employed individuals. Let's delve into these points to gain a comprehensive understanding of how self employment tax is calculated.

First and foremost, let's discuss the actual process of calculating self employment tax. The current self employment tax rate is 15.3% of net earnings. It's worth noting that this rate consists of two components: Social Security tax and Medicare tax.

Components of self employment tax

Now, let's break down these two components in detail. The Social Security tax portion of self employment tax is calculated at a rate of 12.4%. This tax is levied on the first $160,200 (as of 2023) of net earnings from self-employment. It is important to keep in mind that this threshold may change from year to year, so staying up to date with the latest figures is crucial. However, it's also essential to remember that Social Security tax is not applied to earnings above this threshold.

Moving on to the second component, Medicare tax. The Medicare tax portion of self employment tax is calculated at a rate of 2.9%. Unlike Social Security tax, there is no income threshold for Medicare tax. All self-employment earnings are subject to this tax rate. 

Additional Medicare Tax

However, it's important to note that self-employed individuals who earn higher incomes may be subject to an Additional Medicare Tax of 0.9% on their earnings over certain thresholds. This tax, implemented as part of the Affordable Care Act, applies to both self-employed individuals and employed individuals who exceed the income thresholds. The threshold for the Additional Medicare Tax is $200,000 for individuals and $250,000 for married couples filing jointly.

The Additional Medicare Tax is calculated based on the individual's total earnings for the year. It applies to the amount that exceeds the threshold, regardless of whether the income is derived from self-employment or other sources. For example, if a self-employed individual earns $300,000 in the tax year, they would be subject to the Additional Medicare Tax on the $100,000 that exceeds the threshold.

It's important for self-employed individuals to be aware of the Additional Medicare Tax and plan accordingly. While the regular Medicare tax rate is 2.9% (split evenly between the employer and employee for those who are employed), the Additional Medicare Tax applies only to the individual's earnings and is not shared with an employer. Therefore, self-employed individuals are responsible for paying the full 0.9% themselves.

Examples

Example 1: Alice is a freelance consultant who files a Schedule C for her disregarded single-member LLC. In 2023 she brought in revenue of $183,400 and had expenses of $31,279 leaving her with a net profit of $152,121.

The entire $152,121 is subject to SE tax. She will owe 15.3% of $152,121 . $152,121 x 0.153 = $23,274.51, which gets rounded to $23,275.

Note: Income tax is assessed in addition to self employment tax and will increase the total tax liability

Example 2: Bob runs a small marketing agency and files a Schedule C for his disregarded single-member LLC. In 2023 he brought in revenue of $526,900 and had expenses of $128,744 leaving him with a net profit of $398,156.

For direct self employment tax Bob has a tax liability of $398,156 x 0.153 = $60,918.

For Additional Medicare Tax, since Bob files married-filing-joint he has additional tax of ( $398,156 - $250,000 ) x 0.009 = $1,333.

His total self employment tax and Additional Medicare Tax will be $60,918 + $1,333 = $62,251

Notes: Income tax is assessed in addition to self employment tax and will increase the total tax liability. Bob may also have other income subject to Additional Medicare Tax. The amounts here are the Additional Medicare Tax stemming from the self employment income.

Filing Quarterly Estimates

To meet their tax obligations, self-employed individuals can make estimated quarterly tax payments throughout the year using From 1040-ES. These payments help ensure that they don't face a large tax bill when they file their annual tax return. It's crucial for self-employed individuals to accurately estimate their income and stay on top of their tax obligations, including any additional taxes like the Medicare Tax.

Additionally, self-employed individuals should keep accurate and thorough records of their income and expenses. This documentation is crucial for accurately reporting their self-employment income and calculating their self-employment tax. It's also advisable to consult with a tax professional who specializes in self-employment tax to ensure compliance and maximize deductions.

While self-employment can offer many benefits, including flexibility and control, it's important for self-employed individuals to be aware of their tax obligations. The Additional Medicare Tax is one such obligation that higher-income earners must consider. By staying informed, making estimated tax payments, and maintaining proper records, self-employed individuals can navigate the complexities of self-employment tax and ensure compliance with the Internal Revenue Service.


Tax Deductions and Tax Credits

While self employment tax can certainly be a significant financial obligation, there are potential deductions and credits that can help alleviate the burden. Self-employed individuals can take advantage of various deductible business expenses to reduce their self employment tax liability. These expenses may include costs related to operating a business, such as office rent, supplies, and equipment. Keeping detailed records of these expenses is crucial for accurate reporting and maximizing deductions.

Self Employment Tax Deduction

Additionally, there is a specific deduction available for self employment tax. This deduction allows self-employed individuals to deduct the employer-equivalent portion of their self employment tax when calculating their adjusted gross income. By deducting the employer-equivalent portion, individuals can lower their overall taxable income, ultimately reducing their tax liability.

When it comes to reporting self employment tax on tax forms, the primary form utilized is Schedule SE (Form 1040). This form is used to calculate the self employment tax liability and report it on the individual's personal tax return. It's important to note that self-employed individuals must file both their income tax return and Schedule SE.

Retirement Contribution Limits

Simplified Employee Pension (SEP) plans provide self-employed individuals with a tax-advantaged way to save for retirement. It's important to note that SEP plan contributions are subject to certain limitations in relation to the amount of earnings subject to self-employment tax. Under IRS regulations, the maximum annual contribution to a SEP plan is the lesser of 25% of the individual's net earnings from self-employment or a designated dollar limit. This means that self-employed individuals can contribute up to 25% of their self-employment income to a SEP plan, taking into account the earnings subject to self-employment tax. By contributing to a SEP plan, individuals can both save for retirement and potentially reduce their taxable income, thereby managing their overall tax liability effectively.

Qualified Business Income (QBI) Deductions

The amount of earnings subject to self-employment tax can have an impact on the qualified business income deduction. This deduction allows self-employed individuals to subtract a portion of their business income from their taxable income. However, the calculation of the deduction varies depending on whether the taxpayer is over or under the phase-out threshold for qualified business income deductions based on their filing status. If the taxpayer's earnings subject to self-employment tax are below the phase-out threshold, they may be eligible for the full QBI deduction. On the other hand, if their earnings exceed the threshold, the deduction gradually reduces. It is crucial for self-employed individuals to carefully consider their earnings and filing status to determine the extent to which they can benefit from the qualified business income deduction.

Other Tax Credits

Earnings from self-employment can have an impact on other tax credits, such as the Earned Income Credit (EIC) and the Child and Dependent Care Credit (CDCC). Let's delve into how these credits are affected by self-employment earnings.

1. Earned Income Credit (EIC):
The EIC is a tax credit designed to assist low to moderate-income individuals and families. The amount of EIC you are eligible to receive is primarily based on your earned income, including self-employment income.

When calculating the EIC, your earned income is compared to a set income limit based on your filing status and the number of qualifying children you have. As your self-employment earnings increase, it can positively impact your eligibility for the EIC, potentially resulting in a higher credit amount.

However, it's worth noting that as your self-employment income continues to rise, there may be a point where your eligibility for the EIC phases out. This phase-out happens at higher income levels, and the specific thresholds depend on your filing status and the number of qualifying children you have.

2. Child and Dependent Care Credit (CDCC):
The CDCC provides a tax credit to taxpayers who incur expenses for the care of their dependents, such as children under the age of 13 or disabled dependents. These expenses allow individuals to work or seek employment.

While self-employment income itself does not directly affect the CDCC, the expenses you incur for child and dependent care can be impacted by your self-employment earnings. The CDCC is calculated based on a percentage of your eligible childcare expenses, and the credit amount gradually decreases as your income increases.

Therefore, if your self-employment income rises, it may result in a reduction in the CDCC amount you can claim. It's crucial to track your child and dependent care expenses accurately, as they play a vital role in determining your eligibility for the CDCC.

In conclusion, self employment tax calculation involves considering the self employment tax rate, which comprises two components: Social Security tax and Medicare tax. Deductible business expenses and the self employment tax deduction can help reduce the tax liability. Lastly, reporting self employment tax is accomplished using Schedule SE (Form 1040). By understanding these aspects, self-employed individuals can ensure accurate reporting and minimize their tax obligations while navigating the complexities of self employment tax.


Managing Self Employment Tax is Different Than Payroll Taxes as an Employee

Managing Self Employment Tax

When it comes to self employment tax, proper record-keeping is of utmost importance, which is why doing your books is Step 2 of our 4-Step Process. As a self-employed individual, it is crucial to maintain accurate financial records to ensure compliance and avoid any potential issues with the IRS. By keeping detailed records of your income, expenses, and deductions, you can accurately calculate your self employment tax liability and effectively manage your finances.

In addition to record-keeping, understanding and fulfilling your estimated tax payment obligations is another essential aspect of self employment tax management. Unlike traditional employees who have taxes withheld from their paychecks, self-employed individuals are responsible for making estimated tax payments throughout the year to cover their tax liabilities. These payments are made on a quarterly basis and are based on an estimate of your income and self employment tax liability for the year.

Making quarterly estimated tax payments can help you stay on top of your self employment tax obligations and avoid any penalties or interest charges. It is important to calculate your estimated tax liability accurately and make timely payments to the IRS. To ensure you are meeting your obligations, consider the following tips:

1. Keep track of your income: Maintain a record of all your self-employment income, including earnings from freelance work, contract jobs, or any other sources of income. By accurately tracking your income, you can calculate your self employment tax liability more effectively.

2. Monitor your expenses: As a self-employed individual, you can deduct certain business expenses from your self-employment income, which can reduce your overall tax liability. Keep track of all deductible expenses, such as office supplies, travel expenses, or equipment costs, and ensure they are properly documented. Use the advanced strategies covered in Step 3 of our 4-Step Process.

3. Estimate your tax liability: Use the information from your income and expense records to estimate your self employment tax liability for the year. This will help you determine the amount you should be paying in quarterly estimated taxes.

4. Set aside funds for tax payments: Regularly set aside a portion of your income to cover your self employment tax obligations. Use the modified Profit First method to set up an designated account for tax payments. By allocating funds specifically for taxes, you can ensure you have the necessary funds available when quarterly payments are due.

While managing self employment tax can be complex, seeking professional assistance can alleviate some of the burdens and provide expert guidance. Consulting a tax professional or accountant who specializes in self employment tax can help ensure you are complying with all the necessary requirements and taking advantage of any available strategies to minimize your tax liability.

A tax professional can assist you in accurately calculating your self employment tax liability, keeping your financial records in order, and helping you navigate the complex tax laws. They can also provide valuable advice on deductions, credits, and other tax-saving opportunities specific to self-employed individuals. By engaging the services of a professional, you can have peace of mind knowing that your self employment tax matters are being handled with expertise and precision.

Managing self employment tax requires careful attention to detail and a thorough understanding of your tax obligations. By maintaining accurate financial records, making timely estimated tax payments, and seeking professional guidance, you can effectively manage your self employment tax and ensure compliance with IRS regulations. Remember, it is always better to be proactive and stay ahead of your tax responsibilities to avoid any undesirable consequences.


Conclusion

In this article, we have covered some important aspects of self-employment tax. Let's recap the key points discussed so far. We started by highlighting the significance of understanding and fulfilling self-employment tax obligations for self-employed individuals. The self-employment tax, also known as SE tax, is imposed on individuals who work for themselves and are not employees of a company. It is a combination of Social Security and Medicare taxes that would normally be paid by an employer and employee in a traditional employment arrangement.

Knowing your self-employment tax obligations is crucial for a few reasons. Firstly, failing to accurately calculate and pay your self-employment tax can result in penalties and fines from the Internal Revenue Service (IRS). It's important to be aware of the tax rate, which is currently 15.3% of your net earnings, to ensure compliance. Secondly, paying self-employment tax also contributes to your eligibility for Social Security and Medicare benefits, which are vital for your financial security and healthcare coverage in the future.

While the concept of self-employment tax may seem straightforward, navigating the intricacies of tax laws and regulations can be challenging. This is why it is highly recommended for self-employed individuals to seek further information or professional guidance when it comes to their specific situations or questions regarding self-employment tax.

A Tax Sherpa can provide valuable insights and assistance tailored to your unique circumstances. They can help you understand deductions and credits you may be eligible for, assist with quarterly estimated tax payments, and ensure compliance with tax laws.

Consult a Tax Sherpa to Manage Your Self Employment Taxes

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It's important to remember that every self-employed individual's situation is different, and there may be specific deductions or credits that apply to your line of work or industry. Seeking professional advice can help you optimize your tax strategy and minimize your tax liability while staying within the boundaries of the law.

In conclusion, understanding and fulfilling your self-employment tax obligations is crucial for self-employed individuals. By being knowledgeable about self-employment tax, you can avoid penalties, contribute to future benefits, and optimize your tax strategy. If you have specific questions or are uncertain about any aspect of self-employment tax, it is highly recommended to seek further information or professional guidance to ensure you are on the right track.

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Neal McSpadden

Neal went from owing the IRS over $1,300,000 to Zero and in so doing discovered the world of tax planning. Since 2011 he's helped tens of thousands of clients save hundreds of millions of dollars on overpaid income taxes.

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What's the difference between tax advisory and just filing my taxes?

Filing your taxes each year is a necessary task, but it is always backwards looking. Tax advisory works with you throughout the year to make sure that you are on the right track when it comes to your taxes and have strategies in place to save money now.

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I've heard about tax write-offs for small businesses. What exactly can I write off, and how does it benefit my business?

Tax write-offs, also known as tax deductions, are expenses that a business incurs that can be subtracted from its revenue to reduce the amount of taxable income. Common write-offs include office supplies, mileage, rent for a business location, and advertising expenses, among many others. By writing off legitimate business expenses, you can significantly reduce your taxable income, which can lead to a lower tax bill. It's essential, however, to maintain proper records and ensure that the expenses are truly business-related.

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What's the difference between a tax deduction and a tax credit?

A tax deduction reduces the amount of your income that is subject to taxation, which in turn can lower your tax liability. Common deductions include expenses like mortgage interest, student loan interest, and business expenses. A tax credit, on the other hand, is a direct reduction of your tax bill. This means if you owe $1,000 in taxes and have a $200 tax credit, your tax due would be reduced to $800. Some popular credits include the Child Tax Credit, the Earned Income Tax Credit, and credits for energy-efficient home improvements.

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I'm thinking of hiring an independent contractor instead of an employee. Are there different tax implications for each?

Yes, there are significant tax differences between hiring an employee and an independent contractor. When you hire an employee, you're responsible for withholding federal and possibly state income taxes, Social Security, and Medicare taxes from their paychecks. You also typically pay unemployment taxes on wages paid to employees. Independent contractors, on the other hand, are responsible for their own taxes. As a business owner, you'd provide them with a Form 1099-NEC (if you pay them $600 or more during the year) instead of a W-2, and they would be responsible for their own self-employment taxes. It's important to correctly classify your workers, as misclassifying can lead to penalties.

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