Saturday, November 3, 2007

What is Self-employment (SE) Tax?

While income tax is paid on any kind of taxable income, self-employment (SE) tax is paid only by people who work for themselves. SE tax is social security and Medicare tax for self-employeds and is paid on a self-employed’s net earnings.

Net earnings – think of it as net profit. It's what you have left after subtracting all business expenses from your gross self-employed income.

You must pay self-employment tax if net earnings from self-employment are $400 or more. The SE tax rate is 15.3% and is made up of two components: 12.4% social security tax plus 2.9% Medicare tax.

Social security benefits are available to self-employed persons just as they are to wage earners. Your payments of SE tax contribute to your coverage under the social security system which provides you with retirement, disability, and survivor benefits.

Medicare coverage provides hospital insurance benefits.

There is a cap on the amount of earned income on which you must pay social security tax. The cap for 2009 and 2010 is $106,800.

That means that you do not pay social security tax on income over $106,800. If you were to make $106,800 as an employee and also have an indie venture with a $20,000 profit, you would pay no social security tax on the $20,000 profit because you had already paid the maximum social security tax for 2009 or 2010 via withholding on your wages.

If you had a job and were also self-employed you would pay social security tax on both wages and profit until you met the $106,800 limit.

If you earn $106,800 in 2009 or 2010 you will pay the same amount of social security tax as Max Millionaire who earns $1,000,000. Hmmmm... do you see an opportunity here for filling the social security coffer?

There is no cap on Medicare tax. You pay 2.9% Medicare tax on all earned income.

{revised 1/31/10}

9 comments:

Michelle B said...

Nice post. I want to run my own business soon, so this is helpful. Instead of starting a business from scratch though, I'm interested in buying a business. I know it'll be hard and challenging, but I'm up for it. Any suggestions? Advice? Thanks.

June Walker said...

Dear Michelle,

You're in a new situation. You need information, too much for me to provide in one comment.

I recommend you start by reading a short column on my website, like: Is it a deductible business expense? and ”Estimated Taxes a post on my blog.

If you like what you read there, I encourage you to buy a copy of my book, Self-employed Tax Solutions. The book answers many of the most common self-employed questions in the same easy-to-understand style you'll find in my columns.

And more than just answering those taxing questions, the information in Solutions will give you a firm foundation on which to build your solo venture!

I wish you much success.
-- June

L. Edwards said...

@Michelle -- If you're thinking about buying a business, I know there are websites you could browse for more info. There's one called BizTrader.com, which is an online global marketplace where you can buy or sell a business. It has a lot of helpful advice and tips, and you can also use it find a lender, broker, etc.

You can also check out small business groups in your area. They can also be very helpful, and it's always good to network.

Good luck!

Anonymous said...

I'm confused... I have a regular full time job in an irrelevant field. I did a small graphic design job for a business, charge them $400 and fill out a W-9. Because this is $400, I will need to pay SE tax?? This is the only freelance gig I will do this year. Should I submit a revised invoice along with the W-9 for $399 to avoid having to pay SE tax?

June Walker said...

Hi Anonymous,

I have mentioned in my writing and seminars that the IRS is disposed to set up similar-sounding names for similar – but not identical – kinds of income.

If you earned $400 and have no business expenses against that income then your net "profit." is $400.

Net "earnings" are a portion of net profit and are tabulated according to the following formula:

NET PROFIT times 92.35% = NET EARNINGS.

The reason for that peculiar percentage is not important. What is important for you to know is that you must pay self-employment tax if net earnings from self-employment are $400 or more.

The other way to look at it: you must pay SE tax if your net profit is $433 or more.

Here’s the arithmetic:
$433 Net Profit times .9235 = $400 Net Earnings.

So you don't need to revise your invoice.

-- June

Stephen said...

Hi June:

I'm confused. My wife made $20,000 working for a non-for-profit during 2009. However, she was let go (for all purposes, she was a real employee). She has basically been unemployed for the past 4-5 months, only making a couple thousand dollars from nanning (which she has taxes withheld on). How in anyway can the IRS assume she has enough money to pay $3000 in taxes? I get $3000 because $20,000 x 15.3 = rough $3,000. Thanks for any help you can give.

Steve

Mike said...

here is my situation, maybe you can help. i am employed full time as an art director/graphic designer. I also do freelance part time. my freelance work is not an official LLC or business or anything like that. my wife is a hair stylist and recently she went from being employed to renting, which now makes her self employed. I was wondering if there was any benefit to us if we were to combine our businesses somehow. either for tax reasons or for accounting reasons. if it is a good idea where should i start.

thanks for the help. great blog!

mike - MJCGraphics

June Walker said...

Hello Stephen,

The IRS does not assume. There are laws and regulations which say that on earned income a worker must pay approx 7 1/2% of those earning for social security and Medicare Tax. The employer pays the other 1/2.

Since your wife "for all purposes, she was a real employee" you need to go after her employer for his 1/2 of the payment. If the employer won't help call the IRS fraud line at 800.829.0433.

-- June

June Walker said...

Hello Mike,

Short answer is I can't see how you could combine both businesses into one even tho' there could be substantial tax savings.

Read my posts on "payroll -- spouse as employee" for a complete answer.

-- June