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Self-Employment Tax

How to Plan for, Minimize, and Report the Self-Employment Tax

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The Self-Employment Tax is how an independent contractor pays Social Security and Medicare payroll taxes. In the case of employees, the employer and employee split the cost of these payroll taxes, each paying 7.65% of eligible wages. An independent contractor, by contrast, is both the employer and the employee, so a self-employed person pays both halves, or 15.3% total.

The 15.3% self-employment tax is composed of a Social Security tax of 12.4% on the first $117,000 of net self-employment income (for 2014), and a Medicare tax of 2.9% on all net self-employment income. Starting in 2013, there is a new Additional Medicare Tax of 0.9% for higher-income earners. The $117,000 amount is called the Social Security wage base, and represents the maximum amount income from wages and net self-employment income subject to the Social Security tax. For Social Security wage limits for other years, see the article What is the Social Security Tax?

Net self-employment income consists of income from self-employed business activities (Schedule C), farming (Schedule F), the self-employed earnings of a partner (Schedule E), and clergy and employees of churches and religious organizations. The amount is income after allowable business expenses have been deducted. This net income amount is then adjusted by multiplying by 92.35% to arrive at the net self-employment income subject to the self-employment tax. This 92.35% factor takes into account that part of the Social Security and Medicare taxes are a deductible business expense. Employers are permitted to deduct the employer-portion of Social Security and Medicare taxes (7.65%). Subtracting 7.65% from 100% results in 92.35%. This reduction in the base amount subject to the self-employment tax, along with the above-the-line deduction for the employer-portion of the self-employment tax, helps equalize the tax treatment between self-employed persons and employees.

 

Self Employment Tax Reduction for 2011 and 2012

For the years 2011 and 2012, the self-employment tax is reduced. Self-employment persons will pay Social Security tax of 10.4% on the net self-employment income up to the Social Security wage base of $106,800 (for 2011) or $110,100 (for 2012). The Medicare tax rate remains the same at 2.9%. Self-employed persons will take a deduction for the 6.2% employer's share of Social Security along with 1.45% employer's share of Medicare as an above-the-line deduction, which works out to a factor of 57.51% instead of the usual deduction for half the self-employment tax. This two-percentage-point reduction in the Social Security tax was legislated for 2011 as part of the Tax Relief Act of 2010, and then extended through the end of 2012 by HR 3765 and by HR 3630.

 

Strategies to Reduce the Self-Employment Tax

The self-employment tax is basically a percentage of your net income from self-employment activities. The only way to reduce your self-employment tax is to increase your business-related expenses, as this will reduce your net income, and correspondingly reduce your self-employment tax. Regular deductions, such as the standard deduction or itemized deductions, won't reduce your self-employment tax. Similarly, above-the-line deductions for health insurance, SEP-IRA contributions, or solo 401(k) contributions will not reduce your self-employment tax either; those deductions only reduce the federal income tax. One tactic to examine when preparing your tax return: the impact of taking the Section 179 deduction or bonus depreciation for fixed assets. This will impact both the income tax and the self-employment tax.

Strategies to Increase the Self-Employment Tax During Years with Losses or Very Low Income

Sometimes a person wants to increase their self-employment tax to maintain their eligibility for Social Security retirement or disability benefits. In general, people need at least forty Social Security credits over their lifetime to be eligible for retirement benefits, and at least five years of credits out of ten to be eligible for disability benefits.

Self-employed people who are facing a year in which they have lost money (expenses greater than income) or years in which their income is vastly lower, and who still want to build up Social Security credits towards their retirement or disability benefits, can use a special method to increase their self-employment tax. This is called the "Optional Method" and the rules are spelled out in the Instructions for Schedule SE (pdf file).

What's important to remember is this: self-employed persons who are not farmers or fisherman are limited to using this optional method only five times in their lifetime.

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