Small Business Taxes & ManagementTM--Copyright 2016, A/N Group, Inc.
If you're just beginning business as a sole proprietor, a partner in a partnership or a member of an LLC (limited liability company), it's vital you understand the self-employment tax. Failure to take the tax into account when making your estimated tax payments could result in a substantial penalty. At the very least, you'll have a big surprise when you file your 1040 in April. If you're familiar with the tax, you should still read this article. There are plenty of pointers that many taxpayers overlook. If using tax preparation software, this can help alleviate some of the deductions you might have otherwise overlooked.
What is the self-employment tax? If you're a sole proprietor or a partner or an LLC member, you're not considered to be an employee. You get no W-2 and nothing is withheld from your pay for FICA or medicare taxes. (If you're an employee, 7.65% is withheld from your pay and your employer matches that amount, paying a total of 15.3% to the government.) In order to collect a similar amount for social security and medicare, a sole proprietor has to pay 15.3% of his self-employment income. (The tax is sometimes called SECA.) It's actually more complicated than that; we'll go into the details shortly.
While we've provided enough information for you to do the calculations by hand, you may want to buy a tax preparation software program that will do planning for future years. The program will handle the details of the calculations and allow you to examine different scenarios.
Employers make regular deposits of FICA and other withheld taxes to the IRS. Individual taxpayers who owe the self-employment tax are responsible for paying the FICA and medicare taxes directly to the IRS. That's done through quarterly estimated tax payments. For most taxpayers that's April 15, June 15, September 15, and January 15. There's no separate return. Instead, when you file your individual income tax return you must complete Schedule SE (Self-Employment Tax) to compute the tax and report the liability on the back of Form 1040. The self-employment tax is reported separately and added to your individual income tax on Form 1040. Estimated tax payments and withholdings are credited against your total tax liability.
Example--Sue Sharp will has self-employment income during 2016. The associated tax is $4,500. Her regular income tax liability for the year will be $3,250. In addition, she withdrew money from an IRA and owes a penalty of $500. She worked a regular job for part of the year and had $1,500 in income tax withholdings. She made estimated tax payments of $3,000. Here's how to compute what she owes with the return.Income tax liability $3,250 Self-employment tax 4,500 Early withdrawal excise tax 500 Total liability 8,250 Less: Withholdings (1,500) Estimated tax payments (3,000) Net tax due with return 3,750
Sue owes $3,750 with her return. Even though it's paid to the IRS, the self-employment tax portion will end up with the Social Security Administration. However, when it comes time to compute the penalty due for tax underpayments during the year, no distinction is made. If you're in the 15% bracket or the lower portion of the 25% bracket, the self-employment tax can easily be more than your income tax. For example, you're married, no children, take the standard deduction, have $40,000 of net income on your Schedule C and have $3,000 of other income. For 2016 your income tax liability would be about $1,990 (after accounting for a deduction for one-half of the self-employment tax on your income taxes); your self-employment tax would be $5,652.
Detailed computation. While all you need do is complete Schedule SE to figure your tax liability, you should know that the computations aren't as simple as portrayed above. Keep in mind that the total FICA tax is really made up of two pieces. The first is the 12.4% old age, survivors, and disability insurance. The tax only applies to earnings of $127,200 or less (2017 amount; it's indexed for inflation; go to Corporate and Individual Tax Rates for other years). The second portion is for medicare. That's 2.9% of all your self-employment income or wages. There's no upper limit on that portion. Beginning in 2013 an additional 0.9% medicare tax is assessed on self-employment income in excess of $200,000 (single) or $250,000 (married filing joint). In an effort to equalize the tax burden of individuals and corporations (who get to deduct their half of the FICA taxes), the calculations involve several steps. Assume in the steps below your net self-employment income is $140,000.
Step 1. The tax isn't on all of your net earnings. The base is only 92.35% of net earnings. Thus, the base using our $140,000 of self-employment income is $129,290.
Step 2. Only the first $127,200 (2017 amount) is subject to the full 15.3% tax. Thus, multiply $127,200 by 15.3%; the result is $19,461.60. The difference between $129,290 and $127,200 is $2,090. That amount is taxed at only 2.9%, so the tax is $60.61. The total tax is $19,522.21 ($19,461.60 + $60.61).
If your self-employment income was only, say $60,000, you would only have to first multiply by 92.35%, then by the full tax rate, 15.3%.
Step 3. If, during the year, you also received wages or a salary as an employee and your employer withheld FICA, the computations are more complex. Those wages will count toward meeting the wage base. Use the 'long-form' on Schedule SE to compute the tax. Thus, if you've already had a salary of $127.200 or more, the earnings from your sole proprietorship (or partnership, etc.) would only be subject to the 2.9% medicare tax and the 0.9% additional Medicare tax (when applicable).
Step 4. You can deduct one-half of the self-employment tax on the front page of Form 1040. Using the numbers from our example, that would be $9,761.11. Since this amount reduces your adjusted gross income (AGI), the deduction is worth more than if it were simply an itemized deduction.
When computing your earnings subject to the tax, you've got to net your profits and losses from all your business activities that would be subject to the tax. For example, you have $60,000 of self-employment income as a partner and a $35,000 loss from your auto repair shop you run as a sole proprietorship. Your net earnings subject to the tax are $25,000. If you have a net loss, you're not liable for the tax.
Beginning in 2013 there's an Additional Medicare Tax of 0.9% on self-employment income (as well as regular wages) on income over $200,000 ($250,000 for a married couple filing jointly; $125,000 married filing separate). For a single individual, computation is easy since there's only one income. For a married couple the threshold applies to the couple. For example, Sue has a job at Madison and makes $175,000 a year. Fred works at Chatham and makes $50,000. Fred has a side business and made $45,000 in 2014. The couple has a total of $270,000 in earned income and pays tax an additional tax of 0.9% on the $20,000 ($270,000 less the threshold amount of $250,000).
Persons subject to the self-employment tax. You're subject to the tax if you were self-employed and your net earnings from that source were $400 or more. (You're considered self-employed if you carry on a trade or business either as a sole proprietor or partner in a partnership.) You don't have to be in business on a full-time basis. Part-time work also qualifies.
A trade or business is generally an activity carried on for a livelihood or in a good faith attempt to make a profit. While this depends heavily on the facts and circumstances, the IRS wins most of the cases on this issue. There have been a few situations where a taxpayer was able to show he wasn't in a trade or business, but don't count on being able to do so. You might be able to show that, for example, you grow fruit for your own consumption. You've done so for a number of years and never sold any. Because of crop losses by others in your area, you can sell enough one year to show a small profit. In subsequent years you don't sell any of your crop. You might be exempt. Get good advice if you're going to make such a claim.
Inactive partners are subject to the self-employment tax.
Limited partners are only subject to the tax on guaranteed payments such as salary and professional fees received for services performed.
Retired partners are not subject to the tax on retirement income. However, the amounts received must be under a written plan that meets certain requirements.
The income from a single member LLC (treated as a sole proprietorship for federal tax purposes) is self-employment income.
The law is not entirely clear on LLC members where the LLC is treated as a partnership. However, guaranteed payments to a member should be considered self-employment income. An LLC member who is active in the LLC should also be considered liable for the self-employment tax on his or her distributive share. Check with your tax advisor.
Resident aliens are generally subject to the same rules as U.S. citizens. Nonresident aliens generally do not pay the self-employment tax.
Executors and administrators of estates may or may not be liable for the tax. You are liable if you're a professional fiduciary, an attorney, or a nonprofessional fiduciary and your duties require extensive managerial activities on your part for an extended period of time or your fees are related to the operation of the business and you actively participate in the business. If your duties are limited to handling an ordinary estate where any business management is small or nonexistent, then the income is not subject to the self-employment tax.
Fishing crew members come under some special rules. Generally, they're considered self employed if they take a share in the catch.
Newspaper carriers and distributors are generally considered independent contractors and subject to the tax. Carriers or distributors and vendors under the age of 18 are not subject to the self-employment tax.
Notary public fees are not subject to the tax.
Trailer park owners may or may be liable for the tax. The outcome here depends on the amount of services provided to the tenants. Minimal services such as sewerage, water, electrical connections, etc. won't result in the income being subject to the tax. Substantial services beyond those required for occupancy (such as maintaining a recreational hall, operating a laundry facility, etc.) will make the earnings self-employment income.
Director's fees received in performing services as a director of a corporation are self-employment income.
S corporation income distributed to you is not subject to the self-employment tax. However, you can't avoid the FICA taxes by not taking a salary. If you take no, or too low a salary, the IRS can recharacterize some of the earnings as salary that's subject to FICA taxes.
Your spouse is subject to the self-employment tax if he or she is a partner in your business. You may want to put him or her on the payroll as an employee. That way you withhold FICA taxes and your business pays its portion, just as you would for a regular employee. Talk to your tax advisor about this approach. You may be able to make higher contributions to your pension plan and deduct health insurance premiums.
Income subject to the tax. Finding your self-employment income is generally straight forward. It's the bottom line on your Schedule C. If you're a partner, you should be able to get the info from your K-1. The instructions to the partnership return (Form 1065) includes a worksheet for computing your net earnings from self-employment.
Even though associated with the business, some income is not considered self-employment income. For example, gains and losses on the following types of property are not included:
Income from the sale of property that is stock in trade or held primarily for sale to customers is subject to the self-employment tax.
Example--Madison Co., a sole proprietorship, sells small tractors, lawn mowers, etc. At the end of 2017 it sells some old inventory at a substantial loss. The loss reduces the owner's self-employment income (the loss is taken on Schedule C).Dividends and interest received on securities are generally not self-employment income. However, interest you receive in your business (e.g., interest on overdue accounts receivable) is part of your self-employment income and subject to the tax.
Example--The facts are the same as in the example above, but Madison also owns some equipment that is used only for rentals. Madison sells this equipment at a loss. The loss doesn't reduce the owner's self-employment income. Similarly, if the equipment were sold for a gain, it wouldn't increase the owner's self-employment income.
Payments for lost income, such as insurance payments after a casualty to your business, are subject to the tax.
Real estate rental income and personal property leased with the real estate is generally not self-employment income. However, if you receive rent as a real estate dealer, the income is included in your self-employment income.
Renting personal property (e.g., equipment) generates self-employment income.
Hotel or motel income is generally subject to the tax. Whether or not income from a real estate rental or hotel is subject to the tax depends on the facts and circumstances. If you provide substantial services for the convenience of the occupants, not normally provided with the rental of rooms for occupancy only, the income is subject to the self-employment tax. For example, providing maid service for individual rooms would make the income subject to the tax. On the other hand, the cleaning of stairways and lobbies would not.
Optional methods. If your gross income is $2,400 or less you may be able to use an optional method of computing the self-employment tax. You've got to meet a number of tests. We won't go into the details here, because so few readers normally qualify. However, you should be aware the method exists. It allows you to pay the self-employment tax if your profit for the year is small or if you have a loss. Why pay more taxes than you have to? Using the method allows you to qualify for social security coverage when you normally wouldn't. That increases your quarters of coverage. It may also allow you to claim a larger credit for dependent care expenses and the earned income credit. Get IRS Publication 533 for the details.
Estimated tax payments. As discussed, you pay the self-employment tax along with your estimated individual income taxes during the year. The law doesn't make a distinction. That is, your income tax and self-employment tax are added together and treated as one. The same rules apply. That is, you can usually avoid a penalty if you pay in at least as much as your prior years' liability. You may be able to reduce your estimated payments by annualizing your income and making payments based on your actual income during the year.
Copyright 2009-2016 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 12/01/16