The self-employment (SE) tax is, as the name suggests, a tax on self-employment income, and consists of Social Security and Medicare taxes, otherwise known as FICA (Federal Insurance Contributions Act) taxes. The employment tax, often referred to as the payroll tax, is also assessed on employees. The employer pays 6.2% of the Social Security (SS) tax and 1.45% of the Medicare tax on behalf of the employee; the employee pays the remaining part. Since, by definition, self-employed people do not have employers, they must pay the full amount of the tax. However, they are allowed to deduct the employer's portion of the tax and they can deduct a portion of the tax paid as an adjustment for gross income on Form 1040. Typically, the deductible amount is usually 50%, but for tax years 2011 and 2012, it is 59.6%.
The self-employment tax is calculated on Schedule SE, Self-Employment Tax, which must be filed by every taxpayer who earns $400 or more in self-employment income, even if they are already retired and collecting Social Security and are enrolled in Medicare. If the taxpayer has more than 1 business, then the income is netted among all businesses and listed on Schedule SE.
Schedule SE consists of 2 major parts: Short Schedule SE and Long Schedule SE. The Short Schedule can be used by taxpayers whose total earnings are within than the SS income base, which for 2012, is $110,100 and who only earned wages from employers who withheld the SE tax. Most other taxpayers must use the Long Schedule SE.
Self-employment tax must be paid on net business income or income from a partnership or farm. If the taxpayer has more than one business, then self-employment income is paid on the net earnings from all businesses. So losses in 1 business can be offset by the income of another. Although business expenses reduce the amount of net earnings, and, therefore, self-employment tax, many of the other deductions on Form 1040, such as contributions to retirement plans, and most tax credits do not reduce self-employment tax.
For 2011 and 2012, there has been a temporary reduction in the tax rate. The self-employment tax rate is 13.3%: 10.4% of that part goes to Social Security and 2.9% for Medicare. This rate applies to 92.35% of self-employment income within the Social Security contribution and benefit base (hereafter: SS income base):
The 92.35% rate is derived from the fact that self-employed taxpayers can deduct the employer's portion of the tax, which is 6.2% +1.45% = 7.65% (100% – 7.65% = 92.35%). The Medicare tax applies to 92.35% of all income. In 2013, the self-employment tax is scheduled to return to the value that it had in previous years: 15.3%.
Self-Employment Taxable Income = Net Business Income × .9235
Self-Employment Tax = Self-Employment Income × .133
Since multiplication is commutative — meaning that the order of multiplication does not matter — the actual self-employment tax rate can be found by the following equation:
Actual Self-Employment Tax Rate = .9235 × .133 ≈ 12.28%
Example 1: if you had self-employment earnings of $100,000, then $92,350 is subject to self-employment tax, which is equal to $92,350 × .133 = $12,282.55, which is approximately equal to $100,000 × .01228.
People who earn more than the SS income base only have to pay the Medicare tax on additional income. Although the Medicare tax rate for the self-employed is nominally 2.9%, the actual rate is lower because, like the SS tax, it only applies to 92.35% of self-employment income:
Actual Self-Employment Medicare Tax Rate = .9235 × .029 = .0267815 ≈ 2.68%
The self-employed taxpayer can deduct a part of the tax paid, which is equivalent to the employer's portion. In past years, the amount deductible was 50% of the self-employment tax because the employer paid half of it for incomes within the SS income base, but during 2011 and 2012, the amount that can be deducted is 57.51%, which is approximately equal to (6.2% +1.45%)/13.3%. In other words, the employer's portion is approximately equal to the employer's SS tax liability plus the employer's Medicare liability divided by the total payroll tax rate. The deductible amount is higher because the employer's liability for the SS tax is the same as in previous years: 6.2%. The 2% reduction applies only to the to the employee share of the SS tax. However, starting in 2013, the employer's percentage of the SS tax will return to 50%.
Example 2: the taxpayer in Example 1 can deduct $12,282.55 × .5751 = $7,063.69
If the taxpayer earns more than the SS income base, then the deductible portion of the SE tax is a little more complicated to calculate. In this case, the deduction for the SS tax and the Medicare tax are calculated separately, then added together. For 2012, the employer's portion of the SS tax is 59.6%, which is equal to 6.2% divided by the 10.4% SS tax rate. The employer's portion of the Medicare tax is 50%. To calculate the deduction:
- Multiply the SS tax by 59.6%
- Multiply the Medicare tax by 50%
- Add the 2 together.
- Multiply the SE tax by 50%
- Add $1100, which is the difference between multiplying the SE tax on the SS income base by 57.51% and multiplying it by 50%. The employer's portion of the Medicare tax is always 50%, regardless of income.
Self-employment tax is additional to the ordinary income tax on earned income. It is also a regressive tax because it places a greater tax burden on lower-income taxpayers. Only refundable tax credits — earned income credit, additional child tax credit, and the adoption credit — can lower the self-employment tax liability. However, because most tax credits are nonrefundable, they cannot be applied to the self-employment tax.
Moreover, even the effective SE tax rate is higher on lower income people than it is for higher income taxpayers, because of the SE tax deduction. The highest effective self-employment tax rate is paid by those who earn the threshold amount that makes them ineligible for the earned income credit, which, for 2012, is $13,980 for a single taxpayer, and those whose earnings are within the Social Security income tax base, which for 2012, is $110,100, pay the lowest rate.
|Lowest Income for which Single Taxpayer Becomes Ineligible for EIC||$13,980|
|Social Security Income Base||$110,000|
|Employment Tax Rate||13.30%|
|Deductible SE Tax Rate||57.51%|
|Self-Employment Tax = Wages × .9235 × .133 =||$1,717.10||$13,523.09|
|SE Deduction = SE Tax × Deductible SE Tax Rate||$987.50||$7,777.13|
|Tax Savings from SE Deduction = SE Deduction × Marginal Rate =||$98.75||$2,177.60|
|Effective SE Tax = SE Tax – SE Deduction =||$1,618.35||$11,345.49|
|Effective SE Tax Rate = Effective SE Tax / Income =||11.58%||10.30%|
As can be seen in the above table, the effective SE tax rate ranges from 11.58% for a single taxpayer with an income equal to the phaseout amount for the earned income credit to 10.30% for a taxpayer who earns the Social Security income base.
For 2013 and after, the Social Security tax rate is scheduled to return to its previous rate of 12.4%, which, when combined with the Medicare tax, yields a total rate of 15.3%. Since the deduction for the employer's half of the payroll tax will still be deductible, the self-employment tax rate will be 14.13% (≈ .9235 × .153) for incomes within the SS income base.
However, a new additional Medicare tax of 0.9% is scheduled to take effect in 2013 for taxpayers with income greater than $200,000, or $250,000 for a joint return ($125,000 for taxpayers filing separately). The 2.9% rate applies to all earned income; the 0.9% applies to income above the threshold amount. Only the employee pays the 0.9% tax — there is no employer contribution — so the self-employed also only pay the 0.9%. For these taxpayers, investment income will also be subject to an additional Medicare surtax of 3.8%.
Married couples filing jointly must each file Schedule SE for income that they earn from their business or respective shares of the business. Also, business income is not treated as community property, so the spouse who actually earns the money must pay the tax.
Generally, investment income is not subject to the self-employment tax. Limited partners do not have to pay self-employment tax, but general partners do, since they are active in the business. Generally, partners and limited liability company members owe self-employment tax for compensation received for services rendered. If they are not active in the business, then it is considered to be investment income not subject to the self-employment tax.
The self-employment tax also applies to foreign earned income. Although tax law allows the deduction of foreign income that is taxed in the foreign country from ordinary income taxes, it does not apply to the self-employment tax. Since the maximum foreign earned income that can be excluded in 2011 is $92,900, the entire amount is subject to self-employment tax.
How Self-Employment Tax Is Calculated If the Taxpayer Has Both Wages and Self-Employment Income
By law, the employer must withhold employment taxes from the wages paid to employees. Therefore, if a taxpayer has both wages and self-employment income, then the amount due on the self-employment income can be determined by the following procedure:
- If Wages + Self-Employment Income ≤ Social Security Income Base, then Self-Employment Tax = Self-Employment Income × 92.35% × Self-Employment Tax Rate.
- If Wages > Social Security Income Base, then Self-Employment Tax = Self-Employment Income × 92.35% × 2 .9%
- Else Self-Employment Tax = Lesser of [(Social Security Income Base – Wages) or SE Income] × 92.35% × SS Tax Rate (2012: 10.4%) + Total Income from Earnings × 92.35% × 2.9%
|2012 Social Security Income Base||$110,100|
|Self-Employment Income Subject to Self-Employment Tax||$73,880||= Self-Employment Income × 92.35%|
|2012 Social Security Tax Rate||10.4%|
|Medicare Tax Rate||2.9%|
|Social Security Taxable Self-Employment Income||$50,100||= Lesser of (Social Security Income Base – Wages) or Self-Employment Taxable Income|
|Social Security Tax on Income Below Base||$5,210||= Social Security Taxable Self-Employment Income × Social Security Tax Rate|
|Medicare Tax on Self-Employment Income||$2,143||= Self-Employment Taxable Income × Medicare Tax Rate|
|Total Self-Employment Tax||$7,353|
|Employer-Equivalent Deduction of Self-Employment Tax from Gross Income on Form 1040|
|Social Security Tax Deduction||$3,105||= Self-Employment Income Subject to Social Security Tax × 59.6%|
|Medicare Tax Deduction||$1,071||= 1/2 of Medicare Tax|
|Total Deduction from Gross Income||$4,177|
New for 2013
Starting in 2013, a new Additional Medicare Tax of 0.9% will be added to those taxpayers with incomes above the following threshold amounts:
- $250,000, married filing jointly;
- $125,000, married filing separately;
- $200,000 for all others.
Employers are required to withhold the tax for any payments in excess of $200,000 to an employee during the calendar year, regardless of the filing status of the employee.