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The self-employment tax is the equivalent of the combination of social security tax (12.4% of gross pay) and Medicare tax (2.9% of gross pay) that an employee sees as a deduction from his paycheck. The difference is that the employee will pay half of the tax or a combined 7.65%, and the employer will pay the other half. The self-employed individual is responsible for the entire tax of 15.3%. The tax is in addition to any Federal income tax.
NOTE: For 2011, there is a special 2% credit to reduce the social security tax for the employee part only. Therefore, the self-employment tax for 2011 is a net of 13.3% for 2011. Watch for updates regarding whether this will be extended to 2012 taxes.
By paying self-employment taxes, the individual earns credit toward future social security earnings, Medicare benefits, disability pay, and survivor benefits. There is no age limit on owing this tax, nor is there any exemption from this tax if you are already drawing social security.
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Self-employment earnings have two general sources, or types. The first type is an individual’s earnings from his unincorporated business. For example, the owner may be running a small flower shop, or a perhaps a pet-sitting service. The owner, also called the sole proprietor, will report his income and expenses on the Federal Schedule C (Profit or Loss from Business (Sole Proprietorship)). The net earnings from the Schedule C will then be carried to the Schedule SE (Self-Employment Tax).
The second general type of self-employment is income from a partnership. This comes from the partnership tax return and is reported to the individual on a Schedule K-1. The figure reported on the K-1 is then carried to the Schedule SE to calculate the self-employment tax.
There are other types of self-employment income, such as farming income, and even some types of tip income, but the most common type of self-employment is from an individual who is running his own business.
Note that you will also be considered to be running your own business, or self-employed, if you are working for someone as an independent contractor. At the end of the year, the person or company you are working for will issue you a 1099-MISC to report your earnings. The income on the 1099-MISC will be reported on the Schedule C. Any expenses, such as mileage, tools, or supplies will be deducted to calculate the net Schedule C earnings. This is then carried to the Schedule SE to calculate the self-employment tax.
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Calculating the Self-Employment Tax
The self-employment tax rate is 15.3% (2010) (less 2% credit in 2011 only for a total of 13.3%) for earnings up to the social security tax limit ($106,800 for 2010 and 2011). After that, the tax drops to just the Medicare tax of 2.9% on the balance above the limit. The tax is calculated and reported on Schedule SE.
The first $400.00 of self-employment earnings are not taxed. If your self-employment earnings are less than $400.00, or if you experienced a net loss, you do not need to file a Schedule SE, although you may want to file it to elect to pay self-employment tax. This optional election will be explained later in this article.
Follow the flow chart on the front of the Schedule SE to determine if you need to fill out the “short” section or the “long” section. Most self-employment tax is calculated by using the short form of the Schedule SE. This is a very simple calculation. The Schedule C earnings are carried to the form (Section A, Line 2 for 2010). This number is then multiplied by 92.35% to get the amount of income subject to the self-employment tax. The tax is 15.3% (2010) or 13.3% (2011) of this figure.
In 2010 only, you may subtract your self-employed health insurance payments from your self-employment earnings on Line 3. This deduction has not been renewed for 2011.
Once the tax is calculated, it is carried to the second page of the Form 1040 - (Line 56 for 2010). You will be able to deduct ½ of this tax as a deduction from income on the front of the Form 1040 (Line 27 of the 1040 for 2010).
One very important item to note is that the self-employment tax is independent of the Federal income tax. It is a tax in addition to the income tax. Itemized deductions and personal exemptions do not affect self-employment taxes. You will pay the calculated self-employment tax even if you do not owe any income tax. You may be able to subtract some refundable credits from the self-employment tax, such as earned income credit, additional child tax credit, American opportunity credit, and first time home-buyer credit. Most other credits, such as educational credits, regular child tax credits, and the credit for child and dependent care expenses, are not subtracted from the self-employment tax.
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Optional Self-Employment Tax
Since the self-employment tax can affect eligibility for social security and Medicare benefits, there is an election on the Schedule SE to pay tax even if your earnings are below $400.00 or even negative. Use Part II on Page 2 of the Schedule SE, and you will pay an optional tax on up to $4480.00. Why would you want to elect to pay this tax? There are many potential benefits besides the qualification toward future social security benefits. Using the optional method may qualify you to claim the earned income credit, the additional child tax credit, or the child and dependent care credits. It may even allow you to take the self-employed health insurance deduction. You may want to calculate your return both with and without the optional self-employment tax to see which is more beneficial on your tax return. If you are using a computerized tax program, this should be very easy to compare.
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If you are a new sole proprietor, you should calculate projected self-employment taxes in the early budgeting stages of your business start-up. Seasoned sole proprietors should make this estimate at the beginning of every year. Both should then update the estimate throughout the year, based on actual earnings. This can save financial shock and allow for planning that may reduce the tax.
If you expect to owe more than $1000.00 in combined self-employment and Federal income tax at year-end, then you should probably make quarterly estimated tax payments. Use Form 1040-ES to make these payments. Note that you pay self-employment tax estimated payments in combination with estimated income taxes, not as a separate payment. See a tax professional if you need assistance.
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IRS 2010 Schedule SE http://www.irs.gov/pub/irs-pdf/f1040sse.pdf
IRS Instructions to 2010 Schedule SE http://www.irs.gov/pub/irs-pdf/i1040sse.pdf
Note that 2011 forms will not be released by the IRS until November or December of 2011. (Later if there is new or pending legislation that may affect the forms.)
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This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.
CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties