Self-employment tax

Definition

Self-employment tax is a tax imposed on individuals who work for themselves, which consists of Social Security and Medicare taxes primarily for individuals who earn income from self-employment. This tax ensures that self-employed individuals contribute to these federal programs, similar to how employees have payroll taxes withheld by their employers. It's important for those operating as sole proprietors, single-member LLCs, or partners in a partnership to accurately calculate and report this tax to avoid penalties and ensure compliance with federal regulations.

5 Must Know Facts For Your Next Test

1. Self-employment tax is calculated on net earnings of $400 or more from self-employment activities.
2. The self-employment tax rate is currently 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare.
3. Self-employed individuals can deduct the employer-equivalent portion of self-employment tax when calculating their adjusted gross income, which is half of the self-employment tax paid.
4. Unlike employees, who share Social Security and Medicare taxes with their employers, self-employed individuals are responsible for the entire amount of self-employment tax.
5. Certain deductions like business expenses and contributions to retirement plans can lower the net earnings subject to self-employment tax.

Review Questions

• How does the self-employment tax impact individuals operating as sole proprietors and what forms must they file?
  • Self-employed individuals operating as sole proprietors must calculate their self-employment tax using Form SE, reporting their income and expenses on Schedule C. The net earnings reported determine the amount of self-employment tax owed. By accurately completing these forms, they ensure compliance with federal regulations and contribute appropriately to Social Security and Medicare programs.
• Compare the self-employment tax obligations of single-member LLCs with those of traditional partnerships.
  • Single-member LLCs are treated as disregarded entities for federal tax purposes, meaning the owner reports business income on their personal return and pays self-employment tax accordingly. In contrast, partnerships require each partner to report their share of the partnership's income on their returns, also subjecting them to self-employment tax based on their share of net earnings. Both structures necessitate careful reporting to avoid penalties.
• Evaluate the implications of self-employment tax for an S corporation shareholder-employee in terms of taxation and benefits.
  • An S corporation shareholder-employee has a unique taxation scenario regarding self-employment tax. Unlike sole proprietors or partners, they are not subject to self-employment tax on distributions received from the corporation; however, they must pay themselves a reasonable salary that is subject to payroll taxes. This structure allows for potential tax savings, but it requires careful balance to ensure compliance with IRS regulations regarding reasonable compensation.

Related terms

Schedule C:

A tax form used by sole proprietors to report income and expenses from their business activities.

Form SE: The form used to calculate and report self-employment tax owed on net earnings from self-employment.

Net Earnings: The profit remaining after all business expenses have been deducted from total income, which is subject to self-employment tax.