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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 may 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 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:
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Sole proprietorship
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Independent contractor
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Partnership
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Part-time self-employment
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Side hustles
When you work for someone else, you pay 6.2% of your income toward Social Security and 1.45% of your income for Medicare. If you have an old paystub around, you can easily find this broken out in your deduction section. It may be labeled as FICA, an acronym for Federal Insurance Contributions Act, the law that put these payroll taxes into place.
Many people don’t realize that their employer matches this amount. They also pay 6.2% of your income for the Social Security’s Old-Age, Survivors, and Disability Insurance (OASDI) program and 1.45% for Medicare. You have to cover the employee and employer portion when you’re self-employed. That combined tax is the self-employment tax. Certain limits and additional tax rates may apply for six-figure incomes or higher.
Self-employment tax rate
Here’s a breakdown of the current total self-employment tax rate:
| Tax | Employee Portion | Employer Portion | Total |
|---|---|---|---|
| Social Security | 6.2% | 6.2% | 12.4% |
| Medicare | 1.45% | 1.45% | 2.9% |
| Total | 7.65% | 7.65% | 15.3% |
Source: IRS.gov
The 12.4% Social Security tax is limited to the first $142,800 of your income for 2021 taxes, $147,000 for 2022, and increases annually following the National Average Wage Index. If you earn more than $200,000 per year when single or $250,000 when married and filing jointly, you are liable for an additional 0.9% Medicare tax.
Self-employment tax example
Let’s say you own an LLC on your own and earn $80,000 in profits over a year. Your self-employment taxes would be calculated like this:
$80,000 x 15.3% = $12,240
That’s a big chunk of your earnings. But some business owners may be able take advantage of business structures to lower their self-employment tax liability.
Lowering your self-employment taxes with S Corp taxation
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 an S Corporation or as an LLC taxed as an S Corp may be able to lower their self-employment tax. With this model, self-employment taxes are required on your paychecks. Any additional income is taxed at your regular income tax rate and isn’t subject to self-employment taxes.
If you earn $80,000 per year and use a payroll software such as Square Payroll to pay yourself a $60,000 annual salary and file your employer tax forms, for example, here is how the math would work for your taxes:
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Self-employment taxes: $60,000 x 15.3% = $9,180
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Taxed at your regular income tax rate: $20,000
Compared to the example above, the business owner here would save $3,060 in self-employment taxes for the year. Over many years, the saving can be very significant. Be aware that the IRS requires you to pay yourself “reasonable compensation” for the efforts you contribute to the business.
This becomes worthwhile when your self-employment income exceeds around $40,000 to $80,000 per year. We can’t say what 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 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.
