„Holy cow! That can’t be right! I usually only owe a few hundred, not six grand!“ My buddy stared at the return I had just help him prepare with shock and horror. He had lost his job in the recession but had been able to pick up work as an independent contractor. Although he worked exclusively with one company they had preferred to keep him off the official payroll. He had diligently saved up some money for his tax bill but had used the prior year’s return as a guide, back when he was still a regular employee. self employed
I showed him the Schedule SE, „Bro, this is what’s hitting you hard, self-employment tax, which is basically Medicare and Social Security payments for the self-employed. Back when you were an employee, your employer was responsible for half and you were responsible for the other half, about 7.65% of your wages each. It was all deducted from your wages and you probably never really thought about it, except to look at your check stub and bitch about high taxes every now and again. Now that you’re self-employed, you pay the whole 15.3% when you fill out your tax return.“
He looked miserably at his return, „Man, I knew that I was going to be responsible for my own tax payments and that I wouldn’t get any benefits, but I had no idea the taxes were going to be this high. I didn’t factor that into the wage back when I first got the job, I was just happy to be working at all.“
I shook my head in sympathy and replied, „you know, about every year I get a client in this exact same situation. They get hit with a tax bill that is much bigger than what they had expected and they’re not sure why. I wish you had come to me back when you took the job, we could have done some planning that may have reduced or even eliminated this bill.
What’s Self-Employment Tax?
Self-employment tax is 15.3% of your first $106,800 of earned income and then 2.9% for every buck after that (2010 rates). In return, your self-employment wages are included in the equation to calculate your benefit from social security; the higher those wages, the higher the benefit you will receive (in general and up to a point). Not enough detail for you? Then check out the IRS website!
Who Has to Pay It?
The tax for self-employment is levied on net earnings from your business. If you are reporting your business income on a Schedule C then it will be the bottom line (31 in 2009) of the return. If you file a Schedule C (Profit or Loss From Business), a Schedule F (Farming), or a Schedule E with income from a partnership then you will need to file Schedule SE and, if you have more than $433 total income from all the above sources then you will have to pay self-employment tax.
Who Doesn’t Have to Pay It?
Self-employment tax is on earned income from your labor and so it must follow that investment income is not subject to self-employment tax. Capital gains, interest, dividends, and most rents and royalties are therefore excluded. Notably, income from a Subchapter S corporation (S Corp) are also excluded on the grounds that they are investment income and not self-employment income. Many business entities could easily qualify to be organized as either a partnership or an S Corp and so the opportunity to avoid self-employment tax has been a factor that has made the S Corp very attractive as an entity.
How to Minimize or Avoid It
Thinking back to the type of income that is subject to self-employment. If you want to reduce or avoid the tax therefore, you need to have a legitimate reason to recognize your income as excluded in nature. A popular method for doing this is to charge your business rental income for the use of your real property. Let’s say I own a small office building where I do most of my tax and accounting work. I have my office building charge my professional practice rent and thereby effectively and legally (when done right) characterize some of my income as free from self-employment tax.
I will tell you right now that this is a big factor overlooked by many self-employed and entrepreneurs, who have a tendency to lump every bit of income into the same basket. Paying attention and doing some tax planning could save some bucks here.
As noted above, income from an S-Corporation is not subject to self-employment taxes. That’s the good news. The bad is that the IRS demands that the owners pay themselves wages (subject to payroll tax, which is essentially the same as self-employment tax) in order to close this loophole somewhat. Also, there is noise about charging self-employment tax on S Corp earnings, so you run the risk of going through trouble of making your business an S Corp and then having the exemption pulled right out from under you.
What This Means to You
Regular income tax is graduated, meaning that the rate of the tax increases as the amount of the income increases. Due to this graduation many low income filers owe very little tax, no tax at all, or even get money instead of paying when they file a return! Self-employment tax, however, is on a straight percent of earnings (up to the $106,800 limit, at least) and therefore if you clear the $433 hurdle then you will pay it. This can come to a shock to the newly self-employed and to smaller operators who are making enough to keep things afloat but have never really had to pay income tax due to their low incomes. Also, it would make you cry to see how many first year independent contractors have not budgeted for the tax and get a hefty bill at the end of the year when they are used to a refund.
Self-Employment tax may be calculated differently from regular tax, but it is collected the exact same way. This means that you will need to make quarterly estimates on your tax obligation you and, if the estimates aren’t enough or if you don’t pay them, you could be subject to interest and penalties. Again, if you income fluctuates from year to year or if you have had a major deal or a gigantic sale go through, revisit your planned estimate payments to see if they don’t need to be increased.
A Tax You May Actually WANT to Pay!
I have clients that I strongly discourage from reducing their self-employment tax. National Enquirer Headline, „An Accountant that Tells His Clients to Pay More Tax! Before you get all bent out of shape and sic Sarah Palin on me hear me out. If your income is low and your retirement contributions are also low or nonexistent, Social Security might be what keeps you off the bread line when you retire. For taxpayers in this situation, contributing to Social Security is a positive benefit and beyond a shadow of a doubt better than nothing at all. So hesitate before you cut that payment too low.