Self-employment is becoming more and more popular, especially within the last few years. Many people may not realize that being self-employed comes with tax implications that they likely don’t deal with as a regular employee! Understanding the tax side of self-employment can be tricky but it doesn’t need to be as complicated as it may sound!
What Does Self-Employment Mean?
Before you can understand the tax implications that come along with self-employment, you should first understand what it means to be self-employed. The term “self-employed” refers to an individual that works for themselves. They are not employees at another company, so they are self-employed. However, there are different definitions of self-employment. That is why looking at the IRS definition can help clarify.
IRS Definition of Self-Employed
The Internal Revenue Service (IRS) has guidelines for what self-employment eligibility requires. As long as an individual meets at least one specified criteria then they are considered self-employed:
- An individual who is otherwise in business for themselves (including part-time business)
- A member of a partnership that carries on business or a trade
- An individual who carries on business or a trade as a sole proprietor or independent contractor.
For more clarification on what makes an individual self-employed, you can find additional information online on the IRS website.
Understanding the Tax Side of Self-Employment
There are a bunch of different aspects that you should take into consideration when it comes to understanding self-employment tax.
What is Self-Employment Tax?
The current self-employment tax rate is 15.3%. This rate is made up of social security and medicare taxes.
Social Security and Medicare Taxes
Both the social security tax rate (12.4%) and the medicare tax rate (2.9%) are what make up the self-employment tax rate. This rate is only applicable to the net earnings (also known as profit). Every tax situation is unique but some individuals are required to pay self-employment tax throughout the year instead of just during tax time. When you are self-employed you will usually need to also pay income tax as well.
You can think of the Social Security and Medicare taxes you pay as self-employed to be similar to the Social Security and Medicare taxes that wage earners get withheld. When you hear the term self-employment tax, it generally means that it is just accounting for the social security and medicare taxes and not the income tax as well.
How to Calculate Self-Employment Tax?
The best way to avoid errors on your tax calculations is to get the help from a professional like an accountant. You can find private accountants or go through companies like H&R Block. However, you should still learn how to calculate self-employment tax on your own so you can verify the workyour accountant does! This can act as another layer of ensuring you submit the right information to the Internal Revenue Service (IRS).
For tax purposes (like calculating how much self-employment tax you will be responsible for) you can look at the amount of gross income you received for the year. Once you figure out your gross income, you can take out business expenses (deductions) so that you can find your net earnings. Once you find your net earnings, you can account that usually 92.35% will be subject to self-employment tax. For example, if your net earning for the year was $100,000 then $92,350 will be what should be considered taxable. Now that you know how much of your net earnings will be subject to getting taxed, you can apply the 15.3% rate. You can make the guess that you will be responsible for $14,129.55. However, tax laws, deductions, and other factors may influence how much you are actually responsible for. That is why you should always confirm with a professional!
Who is Responsible for Self-Employment Taxes?
You can always review who must pay self-employment tax online at the IRS website. However it is important to keep in mind that tax rules apply to anyone who is self-employed regardless of age. In fact, even if you are receiving help from programs like Social Security or Medicare, you could still have to pay self-employment tax.
Basics of Paying Self-Employment Tax
We are going to sound like a broken record but we recommend getting help from a professional before paying self-employment tax. This will ensure that you are paying the correct amount to the IRS at first and could prevent you from dealing with more headaches down the line.
If you want to pay self-employment tax you will typically need to use an IRS Schedule C. This will allow you to calculate your net earnings from self-employment. Then you will use an IRS Schedule SE to calculate the amount of self-employment tax that you are responsible for. From there, you will need to give information like your Social Security number or individual taxpayer identification (ITIN) number. Taxes in America vary but generally you should expect to make payments as you go throughout the year. If you don’t do this, then you may deal with tax penalty fees.
Are Self-Employment Taxes Higher Than Employed Taxes?
Unfortunately those that are self-employed can expect to pay more taxes than someone who is employed by someone else. Think about it like this: when you are a normal W-2 , your employer covers half the amount of taxes that you pay. For example, if you need to pay a total of $1,000 in taxes, you and your employer would be responsible for $500. When you are self-employed, you are basically the employer and the employee. This means the same $1,000 will be due but instead of someone splitting it with you, you are responsible for making the payment on your own. So even though it can be a common misconception that self-employment taxes are lower, that’s actually not the case.
How to Reduce Self-Employment Tax?
Since self-employed individuals usually have to deal with more taxes, there are ways that you can reduce the impact to your wallet! You could choose between an LLC or a corporation.
Taxes of an LLC
If you decide that you want to reduce your self-employment tax by setting up an LLC, then you are in luck. You have a couple options for LLC self-employment taxes. You could either choose:
- Disregarded LLC: If you make an LLC with one member and don’t choose to be taxed as a corporation then you will still have self-employment tax just as an LLC. This does not change the amount of tax liability for self-employment tax that you have and self-employment tax applies.
- S Corp LLC: S Corp (short for S corporation) is an option that you can choose if you want to be taxed as such. If you pick this LLC option, you will not have to pay self-employment tax!
Taxes of a Corporation
Just how you can choose to form an LLC, you could also choose to form a corporation instead. There are two main types that you could from which would be:
- C Corporation: When you choose to set up this type of corporation, you are responsible for paying corporate tax on what the corporation earns throughout the year. You will also need to pay income tax on any salary that you pay to yourself. Since you are an employee of the corporation you will not be responsible for paying self-employment tax, instead the corporation pays the employer’s portion of those taxes. If the corporation is yours, then you have to deal with that responsibility.
- S Corporation: Don’t get this confused with an S Corp LLC! Instead, this S-corporation setup is referred to as a pass-through entity and the corporation isn’t responsible for paying income tax. S corporations can be a little complicated to understand but basically you have the option to separate the income earned by the corporation into two different methods of payment to yourself as the individual. This provides the opportunity to avoid self-employment tax on funds paid as a distribution. This benefit also applies if you have an S corp LLC!
Unfortunately self-employment taxes tend to be higher since an individual who is self-employed is still responsible for income tax at a local, state, and federal level as well as the self-employment tax rate which accounts for both Social Security and Medicare taxes. There are ways that you can reduce the overall amount of self-employment tax that you deal with but only in specific situations. Dealing with self-employment taxes can be very difficult so it is important that you ensure everything is accurate with the help of a professional if you can.
Commonly Asked Questions About Self-Employment
There are plenty of questions that many other people have when it comes to understanding self-employment and the tax implications that go along with it!
What are Benefits of Self-Employment?
Just like any career choice, there are both benefits and drawbacks of self-employment. When it comes to self-employment, some of the biggest benefits include:
- You Have More Control
- Work Schedule Flexibility
- More Passion with What You Do
You Have More Control
When you choose self-employment, you have more control over a bunch of factors like who you will work with, all aspects of your company, creative control, work environment, and more. This control can allow you to work more efficiently since everything revolves around the wants and needs of yourself.
Work Schedule Flexibility
There is no “company time” when you choose your own work schedule. For example, if you are a painter and you have a commission due in three months. You know how much work it would require for you to finish the commission. If you only need to spend 25 hours working on a specific project over the course of three months, then you can decide when to work when it’s convenient for you!
More Passion with What You Do
There’s an old saying, “if you love what you do for work then you never work a day in your life.” This saying refers to the idea that if you enjoy what you do for work then you don’t actually feel like you’re working. If you are self-employed, then you can choose a career that you want to do. For example, if you want to specialize in art then you have the ability to focus your efforts there.
What are the Drawbacks of Self-Employment?
Just as there are benefits of self-employment, there are also drawbacks that you want to keep in mind:
- No Employee Benefits
- A Lack of Stable Income
- Potentially Long Work Hours
- More Paperwork
No Employee Benefits
Oftentimes employers will offer employee benefits like paid vacation time, maternity leave, sick days, etc. Self-employment doesn’t have the luxury of these employee benefits. Instead, you are responsible for making sure the work gets done regardless of what you are dealing with.
A Lack of Stable Income
While self-employed businesses can become successful and provide financial stability, that isn’t always the case. For example, if you sell soaps but no one is buying your product, then you are earning no money. Businesses usually take time to turn into a success. If you already deal with financial hardship with a consistent income, then you may run into severe rough patches if you choose self-employment.
Potentially Long Work Hours
Depending on your self-employment set up, you may be responsible for a bunch of aspects about the business. Aspects like production, marketing, legal issues, etc., can be a lot to deal with. This heightened workload can be a lot to handle, especially if you are one person. In order to properly manage these aspects of your business, you will need to dedicate time. This can lead you to working long hours. Unlike an hourly pay from a company, how long you work may not matter. If you work 60 hours you may make the same amount of money if you work 30 hours.
You are responsible for making sure your business is set up properly. That is why getting help from a professional can make a world of difference, but it will cost you more. You will need to deal with the paperwork side of things from tax documents, legal documents, and more.