Self Employment Taxes for Small Businesses

Starting and running a small business comes with many financial considerations. One obligation that surprises some new entrepreneurs is having to pay self employment tax on their earnings in addition to regular income tax. Unlike employees who have payroll taxes split with their employer, self employed individuals pay the full payroll tax amount themselves.

Understanding what self employment taxes entail, how they are calculated, and strategies to reduce your tax exposure can help business owners plan for and manage this responsibility. This comprehensive guide covers everything small business owners need to know about self employment taxes.

What is Self Employment Tax?

Self employment tax refers to the Social Security and Medicare taxes that apply to income earned from running your own business rather than working for an employer. These taxes fund important federal benefits programs:

Social Security Tax – Funds the Social Security program which pays retirement, disability, and survivor benefits. The Social Security portion of self employment tax in 2023 is 12.4% up to the wage base limit.

Medicare Tax – Funds the Medicare program providing health coverage for seniors and some disability benefits. The Medicare portion is 2.9% of all self employment income with no limit.

So combined, the self employment tax rate is the sum of these two: 15.3% total

This compares to employees, whose employer pays half of their Social Security and Medicare taxes for them. When you work for yourself, you pay an extra 7.65% that an employer would cover.

Who Pays Self Employment Tax?

You pay self employment tax if:

• You earn income from running your own business or freelancing as a sole proprietor. This includes income from selling products and services.
• You are member of a partnership earning income from the partnership.
• You are otherwise self employed and earn income that does not have taxes withheld.

Common examples who owe self employment tax include:

• Sole proprietors and independent contractors
• LLC or S-Corp owners
• Freelancers and gig workers
• Independent real estate agents
• Partners in a partnership

Essentially, earning income from your own business efforts rather than on payroll for an employer means owing self employment tax. Some limited exemptions apply.

Self Employment Income Subject to Tax

What types of self employment or 1099 income are subject to self employment taxes?

• Revenue from services you provide to clients or customers
• Sales of products created by your business
• Business profits passed through from an S-corporation
• Your share of income generated by a partnership
• Commissions and fees from services
• Rental income and royalties
• Payments made in exchange for work directly to you

If the income results directly from operating your own business or freelancing work, it typically triggers self employment tax. Some exceptions like certain rental real estate income apply if you are not acting as a real estate professional.

How Self Employment Tax is Calculated

Computing how much self employment tax you owe follows a few steps:

1. Determine your net self employment income

This is your gross self employment income from your business minus allowed business deductions for expenses. It is the profit or net income left over after subtracting business expenses. Special business deductions reduce the amount subject to self employment tax.

2. Multiply net income by 92.35%

A 92.35% deduction applies in 2023 equal to the employer half of payroll taxes. You subtract this percentage from your net income.

3. Apply the 15.3% self employment tax rate

This includes the 12.4% Social Security tax and 2.9% Medicare tax. You multiply your income from Step 2 by 15.3% to get your total self employment tax owed.

4. Report on Schedule SE and Schedule C

Schedule SE is filed with your 1040 to report your self employment tax liability. Business income and expenses used to compute your net self employment income are recorded on Schedule C and flow to Schedule SE.

Self Employment Tax Example

Let’s look at an example:

• Gross self employment income: $100,000
• Allowable business deductions: $25,000
• Net business income: $75,000

1. Net income: $75,000
2. Deduct 92.35%: $75,000 x 92.35% = $69,262
3. Apply 15.3% tax on $69,262 = $10,601 self employment tax

$10,601 would be the total self employment tax owed in this example. The Social Security portion would cap once net income exceeds the wage base limit.

Self Employment Tax Deductions

Certain business deductions reduce your income amount subject to self employment tax:

Qualified Business Income Deduction – QBI

A 20% QBI deduction off net business income if taxable income under $170,050 (2022). Phases out above that. Lowers income subject to self employment tax.

Employer Portion of Self Employment Tax

The 92.35% deduction for the hypothetical “employer share” of payroll taxes you would have paid.

Health Insurance

Deducts your health insurance premiums paid if self employed.

Retirement Contributions

Self employed 401(k) contributions reduce your net earnings.

Other Ordinary Business Expenses

Any qualifying business deductions like office supplies, equipment, mileage, etc.

Maximizing these deductions leads to substantial self employment tax savings.

Self Employment Tax & Estimated Quarterly Payments

Unlike payroll taxes which come out of each paycheck automatically, self employed individuals must pay taxes quarterly. Steps include:

1. Estimate your expected net income for the year
2. Calculate the expected self employment tax on 92.35% of this amount
3. Divide expected tax by 4 to determine quarterly payment amounts
4. Make quarterly payments to the IRS by April 15, June 15, September 15, and January 15

If your income varies drastically quarter to quarter, you can adjust payment amounts. But be careful to not underestimate and underpay. Underpayment penalties can apply if quarterly payments are too low.

How to Reduce Self Employment Taxes

Strategies to reduce your self employment tax bill include:

Maximize Deductions – Take all allowed business deductions to lower your net income.

S-Corp Election – Pay yourself a reasonable salary, then take remaining profits as distributions not subject to payroll taxes.

**Defer Income **- Delay billing or provided services until the next tax year if it moves income out of a higher tax bracket.

Contribute to Retirement Plans – Max out deductible contributions to Solo 401(k)s, SEP IRAs, etc.

Buy Business Equipment and Supplies – Depreciate equipment and deduct eligible purchases.

Expense Health Insurance – Deduct premiums if not covered by spouse’s employer plan.

Hire Family – Paying family for services lowers self employment income. Follow wage rules.

Live in a State Without Income Tax – Seven states have no income tax which lowers overall tax liability.

To the extent possible, shift and defer income to maximize deductions in the most strategic years. But avoid overly aggressive tax strategies that could raise audit risk.

Self Employment Tax Rules and Limits

Additional rules and limitations include:

• You must pay by quarterly estimated payments, not just your annual tax return.
• Failure to make estimated quarterly payments triggers underpayment penalty.
• SE tax only applies to 92.35% of net income due to the QBI deduction.
• Income earned above the Social Security wage base limit ($160,200 in 2023) is not subject to the 12.4% Social Security portion but still owes the 2.9% Medicare tax.
• Taxpayers cannot deduct 50% of self employment tax on their personal tax return like they can with federal income tax.
• SE tax still applies even if business operated at a loss after deductions. Losses carry forward to offset future SE income.
• Specific deduction limits and carryover rules exist for pass-through S-Corp income subject to SE tax.
• Some partnership income only requires SE tax on guaranteed payments to partners.

Understanding the nuances as both your income and your business structure evolve is key to maximize write-offs and minimize taxes owed.

Frequently Asked Questions

Below are some common self employment tax questions:

Do independent contractors pay self employment tax?

Yes, contractors owe self employment taxes on 1099 income since it is earned from self employment, not as an employee.

What percentage of self employment income is taxed?

The effective rate after deductions is 15.3% (12.4% Social Security and 2.9% Medicare). Only 92.35% of net income is taxable for the Social Security portion.

Is rental income subject to self employment tax?

Typically only if real estate is your full-time business. Passive rental income is not subject to payroll taxes.

When do you have to start paying self employment taxes?

Income over $400 triggers self employment tax liability. Quarterly estimated payments to the IRS are required to avoid underpayment penalties.

Can I reduce how much self employment tax I pay?

Yes, by maximizing all available business deductions, retirement contributions, and using a S-Corp structure.

Do I pay self employment tax on all business income?

You only pay self employment taxes on your net income after accounting for all qualifying business deductions claimed against gross revenues or sales.

The Bottom Line

Paying self employment taxes represents a major shift from traditional employment. But understanding tax obligations upfront and taking available deductions allows small business owners to curb taxation where possible.

The key is working closely with your accountant or tax advisor to project potential liability based on your expected income. With sound projections and timely quarterly payments, you can stay on the right side of self employment taxes.