What is Self-Employment Tax and Which Business Entities Have to Pay It

Simply put, self-employment tax (SE tax) is Social Security and Medicare taxes paid by individuals who work for themselves. If you are self-employed as a solopreneur (aka sole proprietor), freelancer, or independent contractor, you will owe SE tax if you make at least $400 in one year.

Many people are familiar with the taxes that are taken out of their paychecks. SE tax is the self-employed person’s equivalent to this. As an employee, if you are paid $1,000 in gross wages, your paystub will include a deduction for Social Security and Medicare taxes. This deduction will equal 7.65% of your gross wages. You might not realize that your employer is required to match the amount they took out of your check for these taxes. Your employer deducts $76.50 from your paycheck and sends $76.50 of their own money to the IRS, for a total of $153 (15.3% of your wage).

When you are self-employed, you are the employer and the employee. So, you must pay taxes as the employer and the employee. Social Security and Medicare (also
known as FICA) are split evenly between the employer and employee. Each side pays 6.2% for Social security and 1.45% for Medicare. So, the total SE tax rate is, therefore, 12.4% + 2.9% = 15.3%.

(There is a wage limit on Social Security, meaning that tax is only applied to the first $142,800 of earnings, for a maximum total tax liability of $17,707.20 (as of 2021)). SE tax is a deductible expense. The IRS lets you count the employer half of the SE tax, or 7.65% (calculated as half of 15.3%), as a business deduction for purposes of calculating the tax.

A few examples:

If a business owner is a single-member LLC (taxed as a sole proprietor) with $80,000 in revenue and $20,000 of expenses, his net profit is $60,000. To determine his SE tax, we would take $60,000 *.9235 *.153=$8,478.

The .9235 is 1.00 – 0.0765 = 0.9235. We do this before calculating SE tax because the IRS allows you to deduct half of the SE tax against your income for SE tax purposes. SE tax isn’t deducted on the Schedule C (form where sole proprietors report income), so the IRS only makes you pay SE tax on 92.35% of your net income since 7.65% of your income isn’t going to make it into your pocket. Essentially, the .9235 figure prevents you from paying SE tax on money that is going towards the employer portion of your SE tax.

Additionally, the taxpayer would deduct ½ of the $8,478 against regular income tax on their return. So, they would get a deduction of $4,239. This essentially makes up for the fact that it wasn’t deducted on schedule C because it hadn’t been paid yet. It’s the self- employed person getting to deduct the employer portion of FICA just like any corporation would be able to.

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If a business owner is a single-member LLC taxed as an S Corp, and that business made the same amount of money and had the same amount of expenses, their total tax liability would be calculated like this:

As a single-member LLC taxed as an S Corp, the SE tax is only paid on the amount designated as a wage. So, if this business had a $60,000 net profit and designated a wage of $30,000, they would pay the 15.3% on their wage only. This opens a whole new can of worms because;

1. The wage must be reasonable in the eyes of the IRS
2. Owners aren’t allowed to take the 20% Qualified Business Income (QBI) deduction on your wage, whereas the single-member LLC without the S corp status can take QBI on the entire net profit.

Sit tight – we’ll come back to #2.

To determine this owner’s SE tax, we would take the wage of $30,000 times the 15.3% tax rate. ($30,000 * 0.153 = $4,590)

Because of the QBI issue, the person pays more regular income tax but less SE tax. The breakeven for this is around $80,000 in net profit.

So, while the advantages of paying less in SE tax are present, the owner would ultimately pay more in personal income tax. Even if an individual has $80,000 in net profit, there are additional requirements associated with S Corp status, including quarterly payroll reports and a separate tax return that includes a balance sheet, etc. If you are contemplating being taxed as an S Corp, you will need to make sure your financials are in order. SE tax is a complicated and broad issue.

This post is meant only as an overview. Do not feel bad if you still don’t completely understand it. We understand this issue and would be happy to help you!

If you’re contemplating changing your tax status, please reach out, and we’d be happy to help you make the switch and get your financials in order to do so. We can be reached at (701) 492-9000 or visit www.arrowadvisors.com for more information.