Taxes Made Simple

One unpleasant aspect of being self-employed is paying the self-employment tax. In summary, the self-employment tax (SE tax) is a tax that gets added to your normal income tax. The SE tax is calculated by multiplying your earnings from self-employment by approximately 15%.

The Reason the Self-Employment Tax Exists

At first glance, it seems unfair that entrepreneurs—arguably the most important driving force behind our economy—would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.

If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the concept of part of your income being withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the social security and Medicare taxes.

When these taxes were originally created, Congress decided that the burden would be shared equally between the employer and the employee. These taxes are calculated as 6.2% and 1.45% of the employee’s wages. At the same time, employers are also paying social security and Medicare taxes for their employees. These taxes are calculated at the same rate as the amount that the employee is responsible for. As such, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for social security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for Medicare taxes.

Given that you are self-employed, you are both the employee and the employer. As such, you are responsible for paying both halves of the social security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the Self-Employment Tax.

How to Calculate Your Self-Employment Tax

As long as your earnings from self-employment are $400 or more, you will be responsible for paying the SE tax. Your earnings from self-employment basically consist of exactly what you’d think: your business revenues minus your business expenses. The tax is calculated as 15.3% of your earnings from self-employment.

However, the social security portion of the tax only applies to the first $97,500 of self-employment earnings. (This number is updated annually, so be sure to check what the most recent number is.) As such, for any self-employment earnings beyond $97,500, the self-employment tax is only 2.9% rather than the usual 15.3%.

The Importance of Business Expenses (a.k.a. Schedule C Deductions)

Think back to our discussion of “above the line” vs. “below the line” deductions. One of the wonderful things about being self-employed is that you now have an additional, extra-valuable level of deductions: business deductions. These business deductions are effectively above the “above the line” deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and as such your regular income tax), but also your earnings from self-employment, thus reducing your SE tax as well.

Incorporating this new information into our equation from before, we get this:

And…

And finally...

From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thus saving you even more money. However, be aware that the IRS isn’t usually very lenient with their definitions of what can be called a business expense. (We’ll be discussing several important business deductions later.) Generally speaking, if you doubt that something could reasonably be called a business expense, it probably can’t.

Deduction for One-Half of SE Tax

One small piece of good news relating to the SE tax is that you can deduct it, or rather, half of it as an above the line deduction. Don’t panic. That sounds far more confusing than it actually is. In fact, it simply ends up being a single line on your Form 1040. Even if you’re doing your own taxes, you won’t end up having any trouble with this part when it actually comes time to file your return. After using Schedule SE to calculate your self-employment tax, all you have to do is simply enter one-half of your self-employment tax on line 27 of your Form 1040. See? That’s not so tough.

Simple Summary

• The Self-Employment tax exists simply to take the place of the social security and Medicare taxes that you and your employer would be paying if you had a job as an employee.

• Your SE tax is calculated as 15.3% of your net earnings from self-employment.

• Business deductions (sometimes called Schedule C deductions) are more valuable than either above the line or below the line deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your SE tax.

• You will get a little bit of the money you pay for SE tax back when you file your taxes for the year. This is because you are allowed an above the line deduction equal to 50% of the amount you pay for SE tax.

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