Self-Employment Tax

Definition

The self-employment tax is a tax that self-employed individuals must pay to the federal government to fund Social Security and Medicare. It is calculated as a percentage of the individual's net earnings from self-employment and is paid in addition to any income taxes owed.

5 Must Know Facts For Your Next Test

1. The self-employment tax rate is currently 15.3%, with 12.4% going towards Social Security and 2.9% going towards Medicare.
2. Self-employed individuals must pay the entire self-employment tax, unlike employees who split the Social Security and Medicare taxes with their employer.
3. Allowable business deductions, such as for health insurance premiums and retirement plan contributions, can reduce the net earnings subject to the self-employment tax.
4. Self-employment tax payments can be claimed as a deduction on the individual's personal income tax return, lowering their overall tax liability.
5. Certain types of self-employment income, such as rental income from real estate, may be exempt from the self-employment tax.

Review Questions

• How does the self-employment tax differ from the income tax paid by self-employed individuals?
  • The self-employment tax is a separate tax that self-employed individuals must pay in addition to their regular income tax. While the income tax is calculated based on the individual's total taxable income, the self-employment tax is specifically levied on the net earnings from their self-employment business. The self-employment tax funds the Social Security and Medicare programs, whereas the income tax goes towards general government operations and services.
• Explain how the self-employment tax affects the tax planning and financial management of a sole proprietorship.
  • The self-employment tax is a significant consideration for sole proprietors when it comes to tax planning and financial management. Sole proprietors must account for the self-employment tax, which is 15.3% of their net earnings, in addition to their regular income tax liability. This can impact their overall tax burden and the amount of profit they are able to retain from their business. Sole proprietors must also be mindful of deductions and strategies that can help reduce their net earnings subject to the self-employment tax, such as claiming business expenses and contributing to retirement plans.
• Analyze the potential impact of the self-employment tax on an individual's decision to start a limited liability company (LLC) instead of a sole proprietorship.
  • The self-employment tax can be a significant factor in an individual's decision to form a limited liability company (LLC) rather than operate as a sole proprietorship. LLCs provide the opportunity for owners to structure their business in a way that can potentially reduce their self-employment tax liability. For example, LLC owners may be able to classify a portion of their business income as 'guaranteed payments' rather than self-employment income, which would be subject to a lower self-employment tax rate. Additionally, the legal structure of an LLC can provide more flexibility in terms of tax planning and income distribution strategies that can help minimize the overall tax burden, including the self-employment tax. These considerations can make LLCs a more attractive option for individuals seeking to start a new business venture.

Related terms

Net Earnings from Self-Employment: The total profit from a self-employment business, after deducting allowable business expenses, that is subject to the self-employment tax.

Social Security Tax: The portion of the self-employment tax that goes towards funding the Social Security program for retirement, disability, and survivor benefits.

Medicare Tax: The portion of the self-employment tax that goes towards funding the Medicare program for healthcare coverage for individuals aged 65 and older, as well as some younger people with disabilities.