It was recently determined that nearly 30% of Americans are self-employed, and 100% of the self-employed hate paying taxes.
If you can relate to that, this post is for you. We, the founders of LYFE, have been self-employed since 2011 and had to learn many of these things on our own.
So our goal for this post is to demystify the 70,000-page tax code for the self-employed into a simple post that will help you understand what self-employment tax is.
As well as how to calculate your self-employment taxes, and how to pay them.
So let’s get started!
Self-employed Definition
According to the IRS, you are self-employed if:
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business.
- You are otherwise in business for yourself (including a part-time business).
In short, if you are in business for yourself, have complete control over how you perform your job, and don’t receive a W-2 from an employer but receive income for services performed, you are self-employed.
Note that another name for the self-employed is a 1099 worker or an independent contractor.
Are Taxes Taken Out for the Self-employed?
Unlike W-2 employees who have their taxes withheld from their paychecks by the company they work for, the self-employed are responsible for withholding their own taxes.
We’ll say this again, you are solely responsible for paying your own taxes.
You wouldn’t believe how many business owners simply forget about paying their taxes.
And in some cases, not only do they end up owing the IRS, but also are hit with penalties for paying late.
But don’t worry, let’s talk about taxes, starting with the 2 basic principles.
First, if you are a sole proprietor, single-member LLC, partnership, or S-corp, you benefit from pass-through taxation.
This simply means that business profits, losses, and any taxes, pass through to your personal tax return where you pay for those taxes.
Second, the self-employed pay taxes on their net earnings also known as profit, and not their revenue.
Net earnings or profit is calculated by calculating your total revenue and subtracting your expenses.
Got it? Let’s dig deeper into self-employment taxes!
What are Self-employment Taxes?
Self-employment tax is a combination of Social Security and Medicare taxes.
12.4% goes towards Social Security and 2.9% goes towards Medicare for a total self-employment tax rate of 15.3%.
When you are a W-2 employee, the company you work for is responsible for 7.5% or half of the tax, and the rest, you never have to worry about because it’s taken right out of your paycheck.
But when you are self-employed, you are responsible for 100% of the self-employment taxes – the entire 15.3%.
Note that every dollar earned is subject to Medicare taxes, but for 2021, the Social Security portion of the tax maxes out at $142,800 of earnings.
Anything above $142,800 is not subject to the social security portion, which is the larger portion of the tax.
When to Pay Self-employment Taxes
In most cases, if you meet any of the following criteria, you will have to pay self-employment taxes:
- You made $400 or more in net income from self-employment (excluding anything you made from being employed at a church).
- You made $108.28 or more in income from being employed at a church.
When Do You Not Have to Pay Self-employment Taxes?
You do not have to pay self-employment taxes if:
- Your business did not make more than $400 in net income or
- The income is considered passive.
It is considered passive income is derived from a business you do not actively participate in during the year.
Or, if the income is derived from rental activities, aka owning rental property.
Be sure not to confuse Income tax and self-employment tax for being the same thing.
Your income tax is based on all wages tips and salaries minus any deductions, credits, and adjustments.
On the other hand, self-employment tax is based only on the net income from being self-employed and not all other income.
How to Calculate Your Self-employment Taxes
As mentioned, self-employment taxes are based on your net earnings also known as profit, and not your revenue.
Therefore, to calculate your self-employment taxes, there are three steps:
Step 1: You must first calculate your net earnings.
To calculate your net earnings, take your gross income from the business and subtract any deductions, tax credits, and depreciation allowances you have for the year.
The calculation may differ depending on your business type, but this is the general formula.
Additionally, if your business has a net loss or a small amount of income, you do not have to pay any self-employment taxes.
But in some cases, it may benefit you to use the optional methods provided by the IRS to pay self-employment taxes.
That is even though you have a loss or a small amount of income from self-employment.
Step 2: You multiply your net earnings by 92.53%.
Why 92.53%?
Well, 50% of your self-employment tax is deductible when calculating your self-employed taxable income.
The IRS calls this the “employer-equivalent” portion of your self-employment tax.
Step 3: You multiply the result of step number 2 by 15.3%.
Now that you know how to calculate your self-employment taxes, let’s look at how to pay them.
How to Pay Self-Employment Taxes
There are two ways to pay your self-employment taxes: Annually or Quarterly
You have to pay estimated quarterly tax payments if:
- You will owe $1,000 or more in federal income taxes for the year.
- Your withholding and refundable credits will cover less than 90% of your tax liability for this year or 100% of your liability last year, whichever is smaller.
If you decide not to pay quarterly, your risk incurring late-payment penalties.
If you do not have to file quarterly or choose not to, you will file with your annual return.
- Most people will use IRS Schedule C to calculate their net earnings from self-employment.
- Use IRS Schedule SE to calculate how much self-employment tax you owe.
Other Taxes To Keep In Mind When Self Employed
When you are self-employed, self-employment taxes are not the only taxes you may have to pay.
You may have to pay federal income tax, state taxes, local taxes, payroll taxes for employees, excise tax, and sales tax.
It’s best to get with your CPA to understand and prepare for the taxes specific to your situation and business type.
How To Save On Taxes
The best way to save on taxes is to get familiar with the applicable business deductions and credits that are available to you as a business owner.
Here is a quick list to get you started:
- Startup and organizational costs
- Office expenses and technology
- Business meals
- Home office deduction
- Vehicle use
- Salaries and benefits
Well, there you have it – a complete beginner’s guide to self-employment taxes!
If you want to save more on your taxes, it’s possible! Let our team of CPA tax experts help you. Contact us today to get started.