This article is for educational purposes and does not constitute legal, employment, or tax advice. For specific advice applicable to your business, please contact a professional.
Self-employment comes with a vast list of benefits, from setting your own schedule to keeping all of the profits your business generates. However, self-employed individuals are saddled with at least one drawback: the self-employment tax.
If you run a business, it’s crucial to understand how self-employment taxes work and how you might save on these taxes with the right business structure. Here’s a beginner’s guide to self-employment tax and other key information you should know about taxes when you’re self-employed.
What is the federal self-employment tax?
Self-employment tax refers to the federal payroll taxes you pay for income derived through self-employment. More specifically, these are taxes for Social Security and Medicare. Here’s how it works.
If you run one of these business types, you probably have to pay self-employment tax:
- Sole proprietorship
- Independent contractor
- Part-time self-employment
- Side hustles
When you work for someone else, your employer deducts a percentage of your income for contributions to your Canada Pension Plan (CPP), Employment Insurance (EI) premiums, and income tax, as well as other deductions as necessary. If you have an old paycheque, this information is typically broken down in the Deductions section.
Note: If you’re an employee in Quebec, you and your employer make contributions to the QPP, or Quebec Pension Plan, instead.
Many people don’t realize that their employer also pays into these accounts on your behalf. When you’re self-employed, you have to cover the employee and employer portions. This combined tax is the self-employment tax. Currently, the self-employment tax rate is 15% of all self-employment income up to $50,197. Self-employment tax rates increase from $50,198 and up. The Canada Revenue Agency (CRA) posts updated self-employment tax tables annually.
Self-employment tax example
Let’s say you freelance and earn exactly $50,197 in profits over a year. Your self-employment taxes would be calculated like this:
$50,197 x 15% = $7,529.55 (rounded up to $7,530)
That’s a pretty big chunk of your earnings. But some business owners may be able take advantage of deductions and different business structures to lower their self-employment tax liability legally.
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Lowering your self-employment taxes with incorporation
If you work under one of the business structures listed above, you’re required to pay self-employment taxes on your full earnings. You may not know about a method to legally lower self-employment taxes.
Business owners that operate as a sole proprietor can reduce tax obligations by using business deductions, but if you incorporate your business you could save even more.
Using a payroll software can help you pay yourself accordingly as well as file your tax forms—without the need for manual math skills. With a robust reporting feature, you can see all your revenue and expenses at a glance, making calculating deductions that much easier. Please note, however, that the CRA expects that you compensate yourself appropriately for your contributions to your business.
We can’t say what business structure is right for your business, as each is unique. If you have any questions, it’s best to work with a trusted accountant, attorney, or other small business financial expert.
Taxes play a big role in your bottom line
When you run a profitable business, paying taxes comes with the territory. But as a self-employed business owner, arming yourself with a working knowledge of how self-employment taxes work can help you take steps to minimize what you have to pay legally.