Self-Employment Tax: You Can Stop Staring At Me Now!

I was in the attic once hunting down a noise, of course it was at night and I don’t have any lights in the attic to assist me. I grabbed my son’s Boy Scout Flashlight that mounts on your forehead and headed up to find a raccoon staring at me. Of course once that light hit his eyes, he had that big eyeball look and just stared at me with a mean frown look. WOW I said, that’s the same look I get from clients when I explain about the Self-Employment Tax.

What is this tax? How much do I pay?

Simply put, this is a tax on your net earnings from your small business operation. If you are unincorporated, you have to pay this tax. This includes those in partnership arrangements, and in any form of Limited Liability Company status. Why don’t corporations pay the tax? Actually they do, it’s just called a different name. In an incorporated status, the employee pays one half and the company matches that tax as a part of the federal employment tax.

In general the tax is the Social Security amount plus the Medicare tax. It used to be called FICA at one time but has been divided into these two subsections. If you are an employee of a business, you have this amount withheld from your paycheck, and then your employer pays a matching tax for a combined 15.3%. For the tax years 2010 and 2011, Congress reduced the amount employees pay for Social Security to 4.2% from 6.2%. However, the employer still has to pay the matching 6.2%. The Medicare rate is 1.45% and it is matched by the employer for 1.45%. The total tax is 13.3% for tax years 2010 and 2011. Effective in 2012, the tax rate went back to 15.3% and still exists to this day.

When you become self-employed this tax has to be paid. It is called self-employment tax and it is 15.3% of your total net income from your small business operation. If you are a partner or a member of a limited liability company, then your assigned income becomes your net income as if you were self-employed and now you have to pay that tax. It is reported on Schedule SE (for Self Employment) and is attached to your Form 1040 each year.

Now I know most of you have that look in your eyes. This can’t be right? Is it? Yes it is. Look at it from a different view, if you were incorporated, you would have to pay yourself some form of compensation and that tax is paid via withholding from your paycheck and of course your company matches the tax. At the end of the day, the final net cash to your personal bank account is the same. It really is semantics. At the corporate level it is referred to as employment tax, at the individual level it is called self-employment tax.

Now for the fun part, you pay this tax via an estimated amount each quarter. It is documented in Form 1040-ES (estimated taxes) and paid by certain deadlines. You MUST pay at least 90% of the tax plus your estimated income tax in each quarter. I always recommend to my clients to withhold about 35% of each month’s net income in a savings account to pay the taxes as they come due. This way you don’t spend the money; it’s as if you were employed by some company and they withheld taxes from your paycheck.

If you’ll check the resources page of this website you see a link to download Pub 334 from the IRS. Section 10 explains the self-employment tax.

OK, you can stop staring at me now, I’ve turned off the flashlight. Act on Knowledge.

Value Investing

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