Table of Contents:
What is Self-Employment Income?
Self-employment income is any earned income not in the form of wages. Wages exist when there is an employer-employee relationship. Wages are subject to income taxes and payroll taxes which are discussed further HERE. The payroll tax rate on the first $132,900 in 2019 is 7.65% on the employee and 7.65% on the employer. For every dollar of an employee’s wage over $132,900 in 2019 the rate goes down to 1.45% on the employee and 1.45% on the employer. To further complicate things, in March of 2010 the Affordable Care Act was passed which added the Additional Medicare Tax. Beginning in 2013, the Additional Medicare Tax increased the rate from 1.45% to 2.35% on earned income over $200,000 for single filers and $250,000 for married couples filing joint. The self-employment tax is the fraternal twin of the payroll tax; the structure is the same except for a few important details.
The primary difference between the self-employment tax and the payroll tax is self-employment taxes are paid entirely by the individual. The self-employment tax rate is 15.3% (7.65% x 2) on the first $132,900 of self-employment income and 2.9% (1.45% x 2) on self-employment income over $132,900 in 2019. The Additional Medicare Tax also applies to self-employment income increasing the rate from 2.9% to 3.8% for self-employment income over $200,000 for single filers or $250,000 married filing joint. In theory this makes sense because a self-employed individual is the both the employer and employee. Theory aside the self-employment tax is a significant cost to entrepreneurs, business owners, and freelancers. However, with adequate planning the self-employment tax can be minimized or even eliminated in many cases.
Bill works for a computer company designing and building computers. He has a $100,000 salary. Bill’s 2019 income tax and his portion of the payroll taxes are shown below. In other words, Bill’s after-tax take-home pay is $77,103.
Single Employee in 2019
|2019 Earned Income:||$100,000|
|Social Security Tax||$6,200|
Bill wakes up one day and says “I’ve had enough of my boss. I want to be my own boss.” With the goal of building his own worldwide computer company and becoming the richest man on the planet, Bill organizes an LLC and starts building custom computers in his garage. To his surprise he makes $100,000 of net business profit in his first year. As you can see below, Bill must carry what is essentially both sides of the payroll taxes imposed on wages since he is now both the employer and the employee. Bill can deduct one-half of his self-employment taxes in figuring his tax burden but is still out of pocket $4,853 in additional total tax burden when compared to his previously earned salary.1 Bill’s after-tax-take-home pay went from $77,103 to $72,250. The good news is there are many options available to self-employed individuals that can result in reduction or elimination of the self-employment tax however, the point of this article is to simply lay the foundation for what the self-employment tax is.
Self-Employed Individual 2019
|2019 Earned Income:||$100,000|
Sources of Self-Employment Income
Sole Proprietor Income
The most common source of self-employment income is income from a sole proprietorship. This can be any business owned by a solo individual that is not a corporation or simply just an independent contractor or freelancer. Sole proprietorships are easy to set up and administer and are often the choice for businesses that are just getting started. Every dollar of net income from a sole proprietorship is subject to the 15.3% self-employment tax rate up to $132,900, 2.9% rate over $132,900, and the additional 0.9% rate over $200,000 single or $250,000 married filing joint.
Partnership Earned Income
A business can also be operated as a partnership when there are two or more owners. Every dollar of partnership income from an operating partnership in which the partners work is subject to the 15.3% self-employment tax rate up to $132,900 of each partner’s allocable share of the partnership income, 2.9% on allocable income over $132,900, and 0.9% over $200,000 single / $250,000 married filing joint.
It is equally important to highlight what is not subject to self-employment tax. Investment income, flow through income from S-corporations, passive income, flow through income to limited partners from a limited partnership, and gains on sale of assets to name a few. If the income can be structured to fit in one of these categories, then the self-employment tax is no longer relevant.
Self-Employment taxes can take a meaningful slice out of a business owner’s take home pay or the amount available to re-invest in the business. Understanding what is subject to self-employment tax and what is not can be a powerful asset for you and your business. This article seeks to lay the ground work for what the self-employment tax is and how it is calculated.
1For illustration purposes various items such as the Qualified Business Income deduction, the self-employed health insurance deduction, and any self-employed retirement plan contributions have been ignored.