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Are You Subject to Self-Employment Tax?

by
Spencer Wilson
on
9/18/2019
Are You Subject to Self-Employment Tax?

When a young adult first starts working for a traditional employer, they are almost always shocked by how much of the paycheck they had anticipated is missing, withheld by their employer to pay Social Security taxes, Medicare (FICA) taxes, and federal and state income taxes. As painful as those deductions may be, the fact that employers provide this service for their employees means that when tax time rolls around, most employees will find that the majority of their tax liability has been prepaid — and many will be entitled to a refund.

People who are self-employed are responsible for the payment of those very same taxes – in fact, they have to pay more for FICA taxes because they have no employer paying half — but they have to pay them on their own, from the profits of their business or businesses. This is just one more task that a self-employed person assumes when they decide to set off on their own. Though a single person who has multiple sources of self-employment income can combine them when calculating the amount they owe, two spouses who are each self-employed are not permitted to combine their incomes to pay self-employment income jointly. Each has to file for themselves.

How Self-Employment Tax Gets Paid

While employed individuals’ taxes are taken out of each paycheck, self-employed taxpayers are required to submit the amount that they estimate that they owe on what is referred to as a quarterly basis (though in reality the due dates are not split up evenly, and can change based on how the due date falls in relation to weekends or legal holidays). The payment is made using IRS Form 1040-ES, either by mailing a check or paying through the IRS website using the Electronic Federal Tax Payment System (EFTPS), and the calculation on what is owed is based on profits as well as whatever may already have been paid earlier in the year.

In addition to saving a stamp and avoiding filling out a form, using EFTPS offers the self-employed the advantage of scheduling their payments up to a year in advance. Doing so means that on or around April 15th, June 15th, September 15th and January 15th the amounts the individual wants to submit are automatically withdrawn from the taxpayer’s bank account.

Determining the Amount of Self-Employment Tax That Gets Paid

The taxation starting point for self-employment income is $400 in net profit. That means that those who take in money for services or products that amounts to less than $400 in net profit have no tax liability. Beyond that threshold, for 2019 taxpayers need to pay 12.4% in Social Security tax on the first $132,900 of profit from their business, as well as 2.9% for Medicare. Single taxpayers whose net profits exceed $200,000 are required to pay an additional 0.9% in Medicare tax. (For married filing jointly the threshold is $250,000 and for married filing separate it is $125,000.) These numbers are slightly different for farmers and fishermen, who are subject to special tax rules. Self-employed individuals have the ability to deduct half of their self-employment tax from their gross income when calculating their tax liability.

Estimating how much is owed can be tricky business, made all-the-more harrowing by the fact that prepayment that amounts to less than 90% of actual liability (for income, Social Security and Medicare taxes) can leave the taxpayer vulnerable to quarterly underpayment penalties. One way to avoid this is by taking advantage of what are known as Estimated Tax Safe Harbors, which the IRS has greenlighted as a way to avoid potential penalties. There are two options for this payment method:

  1. Taxpayers whose previous year’s adjusted gross income was $150,000 or less (or $75,000 for married filing separate) can make even quarterly payments totaling the full amount of the previous year’s tax liability
  2. Taxpayers whose previous year’s adjusted gross income was greater than $150,000 (or $75,000 for married filing separate) can make even quarterly payments totaling $110% of the previous year’s tax liability

Self-employed taxpayers can also avoid an underpayment penalty if their underpayment amounts to less than $1,000, or if in the previous year they had no tax liability at all for a full year.

Though the safe harbor rules offer a significant advantage in the certainty of not having to pay an underpayment penalty, taxpayers that have experienced a significant ship upward or downwards in income could find themselves in the predicament of either having overpaid for the current year (and therefore eligible for either a refund or the ability to apply the overpayment to the next year’s taxes) or having underpaid and owing a large amount at tax time.

It’s important for self-employed taxpayers to remember that they also owe taxes on other sources of income, whether from investments, retirement income, wages from an employer, or wages owed by a partner with whom they file joint taxes.  

Tracking Self-Employment Income

While employed individuals receive a W-2 at the end of each year that summarizes their earnings and tax payments, self-employed individuals receive forms known as 1099-MISC or 1099-K (and starting in 2021, Form 1099-NEC will replace the 1099-MISC for tax year 2020) which their clients complete and send to both the government and to the business owner.

In addition to the 1099 forms which are used to reflect direct payment, self-employed individuals who receive payment through a third-party such as a credit card payment or freelance work platform will receive a Form 1099-K from those businesses for earnings greater than $20,000 that represent 200 or more transactions. Self-employed taxpayers need to be careful not to double-count the amounts that they have recorded themselves and the filings submitted by clients or third parties. 

Who Else Has to Pay Self-Employment Tax?

Though self-employment tax liability seems very straightforward, there are others who are also required to pay taxes in the same way despite not being entrepreneurs. These include:

  • Clergy who receive housing allowances that are excluded from taxable income. Self-employment taxes are owed on these allowances.
  • General partners in trade or business partnerships who receive distributive shares of partnership income. These shares, and any guaranteed payments to partners, are subject to self-employment tax.
  • Taxpayers who qualify for foreign-earned self-employment income that is excluded from income tax are required to pay self-employment tax.
  • Retired farmers who are contractually obligated to supply an agricultural commodity to an agricultural cooperative are required to pay self-employment tax on their ‘value-added payments’ if they remain members. This is because they continue to be considered to be involved in producing, marketing, processing, and selling the commodity.
  • Directors of corporations that receive fees for performance of services such as attending a meeting have to pay self-employment tax on that income.
  • Fishing boat crew members who are compensated based on the proceeds of sale from the boat’s catch have to pay self-employment tax on those proceeds
  • Fiduciaries who are either professionals or nonprofessionals managing an estate including an active business or trade or managing an estate that needs extensive management for a prolonged period of time are required to pay self-employment tax on the fees they receive for their administrative role.

Income Not Subject to Self-Employment Tax

As extensive as the rules are for where self-employment tax is due, the IRS has also outlined areas where no tax liability exists on income. These include:

  • A self-employed taxpayer's child employee under the age of 18
  • A shareholder’s portion of an S corporation’s taxable income
  • Fees for the services of a notary public
  • Non-resident aliens
  • Real estate rental income
  • Rents paid in crop shares
  • Statutory employees
  • The fiduciary of an estate on an isolated basis

In addition to these situations, occasional income that is not accompanied by efforts to continue being paid without tax being reported are free of self-employment tax. This means that receiving a 1099 form may not require you to pay taxes on the reported payment.

Spencer Wilson writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].

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Spencer Wilson

Spencer Wilson

Spencer Wilson, EA is a tax preparer based in Long Beach, CA. Spencer Wilson Financial Management Services has been serving the Greater Los Angeles Area and Orange County since 2004. <br /> We began in the heart of Naples in Long Beach and we continue to work hard offering tax preparation and planning, business accounting and bookkeeping and payroll services . <br /> We have helped many different people and businesses succeed financially and take control over their finances.

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