In previous articles, we have discussed the taxes that are taken out of your wages to fund Social Security and Medicare benefits. You pay a portion of these taxes, and your employer matches that amount. What happens if you are self-employed?
The same principle applies, except that you are responsible for both the employee and employer portions of Social Security and Medicare tax withholdings. Unlike traditional wages that have taxes withheld from them in every paycheck, self-employed wage withholdings (called self-employment or SE taxes) will be reconciled when you file your annual federal income tax return. You are also required to pay estimated taxes on a quarterly basis. Use Form 1040-ES to determine what your estimated taxes are.
The IRS has specific definitions for what it means to be self-employed. If you carry on a trade or business as a sole proprietor or independent contractor, you are considered self-employed. Similarly, if you are a member of a partnership that carries on a trade or business, you qualify as self-employed. The IRS also provides a catch-all for people otherwise in business for themselves, including part-time businesses, that meets the definition of self-employed.
Please note: owners of corporations are not considered self-employed because the actual owners of corporations are shareholders. Owning limited liability companies and other kinds of businesses, on the other hand, do qualify as self-employment.
The 2020 self-employment tax rate is 15.3%. Of that percentage, 12.4% of it goes to Social Security, and 2.9% of it goes to Medicare. If you are self-employed but only earned $400 or less in one year, you do not owe Social Security taxes. Additionally, the wage base in 2020 is $137,700, which means that you do not pay Social Security taxes on any income you earn above that threshold. There is no cap on Medicare tax contributions, however, so Medicare taxes are withheld at the same rate, regardless of how much earned income you report.
When the time comes, you must report your self-employed earnings and pay Social Security taxes directly to the IRS. If your net earnings are $400 or more, you must report earnings on Schedule SE. According to Social Security, “net earnings” equals gross earnings from your trade or business, minus any allowable business deductions and depreciation. Use Schedule C to report any income or loss from businesses you operate or professions you practice.
Lastly, certain tax deductions apply when you are self-employed, but make sure you understand which ones apply to your situation and how to properly apply the deduction.