Self-employment Tax

Employees pay social security and Medicare taxes on their wages. Self-employment (SE) tax is the equivalent tax paid by self-employed individuals. In this post we’ll discuss the rate of SE tax; types of income subject to it; how to report it; reducing tax by using an S corporation; and special considerations.

Self-employment tax rate

The SE tax rate depends on how much SE income you earn, and on how much wages subject to FICA (social security tax) you earn. The tax rate on SE income for 2013 begins at 15.3%. This rate consists of two parts:  12.4% for social security, and 2.9% for Medicare. The social security part of the SE tax is limited to the first $113,700 of SE income (less wages subject to FICA tax – see example below). This ceiling amount is adjusted annually for inflation.

There is no limit to the Medicare part of the tax. SE income in excess of $113,700 is taxed at a minimum rate of 2.9%.

These rates are double the rates of withholding from an employee’s wages for FICA and Medicare taxes. This is because an employee’s withholdings are matched by his employer. A self-employed taxpayer is effectively paying both the employee and employer portions of the tax.

SE and wage income in excess of $200,000 may also be subject to the 0.9% Medicare surtax, for a total rate of 3.8%. See our post on the Medicare surtax for more details.

Tip: If your net SE income is under $400, you don’t owe SE tax.

Tip: This rate is for the SE tax only. Regular income tax also applies!

Example

Freda is an employee of an IT firm. She also has her own IT consulting business on the side. In 2013, her W-2 from her employer shows $80,000 of wages subject to FICA. The Schedule C for her consulting business shows $50,000 of net income. Freda’s SE tax is $5,629, computed as follows:

• Take the social security ceiling of $113,700 and subtract her wages subject to FICA of $80,000. The result – $33,700 – is subject to SE tax at the full rate of 15.3%. $33,700 X 15.3% = $5,156.
• The remaining SE income of $16,300 ($50,000 total less $33,700 taxed at the full rate) is subject to the 2.9% Medicare portion only. $16,300 X 2.9% = $473.
• Freda’s total wages and SE income are less than $200,000, so the 0.9% Medicare surtax does not apply.
• Total SE tax is $5,156 + $473 = $5,629.

Income subject to SE tax

The following types of income are generally subject to self-employment tax:

• Net income from a trade or business reported on Schedule C of your Form 1040.
• Non-employee compensation reported to you on Form 1099-MISC, Box 7. (In limited cases this is not SE income – please consult your tax advisor.)
• Guaranteed payments reported on Schedule K-1 to a partner in a partnership.
• Business income reported on Schedule K-1 to a general partner in a partnership.

These types of income are generally NOT subject to SE tax:

• Interest and dividend income.
• Business income reported on Schedule K-1 to a shareholder of an S corporation.

These types of income MAY be subject to SE tax – consult your tax advisor:

• Rental real estate income. This is typically not subject to SE tax, but may be if you are a real estate dealer, or provide substantial services to the occupants.
• Business income reported on Schedule K-1 to a limited partner of a partnership or a member of an LLC taxed as a partnership. According to proposed regulations issued by the IRS, business income reported to an LLC member IS subject to SE tax if any of the following are true:
  • The member is wholly or partially responsible for the LLC’s obligations under state law;
  • The member has statutory or contractual authority to make contracts on behalf of the partnership or LLC; or
  • The member participates in the partnership or LLC’s business for more than 500 hours during the tax year.
  • If none of these apply, the business income reported to the limited partner or LLC member should not be subject to SE tax.
  • Tip: Review your partnership or LLC operating agreement and state law to determine which partners or members have authority to make contracts on behalf of the business. Partners or members who devote less than 500 hours per year to the business may be able to avoid SE tax if the agreement specifies that they are not authorized to make contracts on behalf of the business.

SE losses

Some of the sources of self-employment income noted above can generate losses.

SE tax is based on net SE income. SE income and losses from all sources are aggregated, and the tax calculation is performed on the total.

Example

Michael is a sole proprietor. In 2013, he reports net income of $60,000 on his Schedule C. He is also a general partner in a partnership, and receives a K-1 showing a business loss of ($50,000).

Michael’s SE income for 2013 is $10,000. His SE tax is $10,000 X 15.3% = $1,530.

Tip: It may be beneficial for a limited partner or LLC member to establish SE liability (see above) if the business is expected to generate a loss. Consult your tax advisor.

How to report SE income and tax

SE income and tax are reported on Schedule SE and attached to your Form 1040. The form also calculates a deduction from taxable income for one-half of the SE tax that you pay. This deduction mirrors the deduction that an employer gets for matching its employees’ social security and Medicare withholding.

Using an S corporation to reduce SE tax

As we’ve seen, the entire net income of a sole proprietor is subject to SE tax. Tax may be reduced by forming an S corporation for the business, or an LLC which elects to be taxed as an S corporation. (See the example below.)

An owner of an S corporation who actively works for the corporation must be put on the payroll as an employee. Social security and Medicare taxes are withheld from the owner-employee’s wages and matched by the company. The owner’s wages must be reasonable considering the work the owner performs, the type and location of the business, and other factors.

Any profits of the company after owners’ wages and other expenses are reported to the owners as business income on Schedule K-1. This S corporation business income is not subject to SE tax. The reasoning is that a business generates income from factors other than the owners’ personal services, such as capital invested in the business or client relationships built up over time.

Note that an S corporation requires additional tax preparation and other costs. Compare the potential tax savings to the expected costs when considering forming an S corporation.

Example

Dan is a self-employed contractor. In 2013 he reports $100,000 of net income on his Schedule C.

The SE tax on his income is $100,000 X 15.3% = $15,300.

Now suppose Dan formed an S corporation at the beginning of 2013. He determines that a reasonable salary for his services is $60,000 and takes that amount as W-2 wages. The remaining $40,000 of income is reported to Dan on Schedule k-1 and is not subject to SE tax. Dan pays $2,000 for tax preparation and other costs related to the S corporation.

The payroll tax on Dan’s wages (employer and employee combined) is $60,000 X 15.3% = $9,180. Adding the $2,000 of professional fees and other expenses, Dan’s cost as an S corporation is $11,180. Compared to the $15,300 SE tax as a sole proprietor, Dan saved $4,120 operating as an S corporation.

Housing provided to ministers

• In some circumstances, a housing allowance paid to a minister of the gospel or and/or the fair rental value of provided housing may be excluded from the minister’s taxable income. However, these are subject to SE tax.
• Housing and/or a housing allowance provided to a retired minister arenot subject to SE tax.