Understanding Self-Employment Tax
Ah, self-employment tax!! Something that many business owners have to deal with if they are lucky enough to be profitable but have very little understanding of what it is or why they must pay it. Consider this your crash course on self-employment tax, what it is, and what it costs.
What the heck is it?!?
Most people pay into the Social Security and Medicare systems through their paycheck. However, there is an entire community of people who do not receive paychecks. I’d like to introduce you to the sole proprietor small business owner and partnerships. For sole proprietors and partnership LLCs, the only good way to get money out of the company is by making draws of cash. Unfortunately, Payroll, which sounds like a great idea, actually subjects a person (not the business with pass-through companies) to double taxation. This is because Schedule C businesses (sole proprietors) and LLC partnerships that have not made the s-election are not considered expenses to the company. Government’s solution to this gap was the 1954 Self-Employment Contributions Act, which makes sure that this small business community is still contributing to the Social Security and Medicare program. So, what does it cost?
How much?
The self-employment tax rate of 15.3% has remained the same since the 1990s and is currently split between Social Security contributions (12.4%) and Medicare contributions (2.9%), but there are some caveats. The first caveat is the total net income amount. The 15.3% tax rate is capped at $128,700 of net income, making the total tax $19,691.73. The second caveat is that any income ABOVE that $128,700 threshold is taxed at a rate of 2.9% and is earmarked for Medicare. The third caveat is that if you make over $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately), the government tacks on additional Medicare tax of 0.9% to the entire net income of the business. Let’s break that down with numbers, assuming that the business owner files jointly with a spouse.? Also, it’s important to note that only taxes reported using a Schedule C (Profit/Loss from business activities) or a 1065 (Profit/Loss of a Partnership) are subjected to self-employment taxes.
Illustration A
| Gross Receipts | $500,000.00 | Total amount you collected from clients before expenses |
| Total Expenses | 200,000.00 | Total amount of all expenses, including cost of goods sold, depreciation and amortization |
| Net Profit | 300,000.00 | Total net profit reported on the Schedule C (Profit/Loss from business activities) |
| Self-employment tax | 19,691.10 | This is the maximum amount of self-employment at the 15.3% rate ($128,700 x .153). |
| Additional Medicare | 4,967.70 | This is the income over $128,700 multiplied by 2.9%. |
| Additional Medicare | 27,000.00 | This is the net profit x .9% that is assessed when MFJ and business income is above $250,000. |
| TOTAL TAX | 51,658.80 |
While these are some scary looking numbers, it’s important to understand that a CPA would generally help you make adjustments before your business reached this point if aware of the situation. However, it is very illustrative of just how overwhelming the self-employment tax assessment can become. While this is a situation I see on a regular basis, typically from people who have not previously sought CPA advice, let’s take a look at a scenario I see most often.
Illustration B
| Net Profit | 25,000 | Total net profit reported on the Schedule C (Profit/Loss from business activities) |
| Self-Employment Tax | =3825 | 25,000 * .153 |
What are your options?
As you can see, this is a lot less intimidating, but this is also just about as far I would want a growing business to go before we considered the s-election. There are ways to mitigate and manage these numbers!
- If you are a small business owner, don’t do your own taxes!!! CPAs are designed to be consultants, not tax preparers, so our job is to use the bookkeeping and tax data to help guide clients on their business journey. CPAs must stay educated on the latest and greatest of accounting and tax rules and are in a unique position to help you put the puzzle together. Bottom line; You don’t know what you don’t know and I guarantee that if you are not a CPA or accountant you’re losing money without even knowing it.
- Talk to your CPA about your business structure. It may be time to consider other options. Business structure drives how you are taxed. Sole proprietors, LLCs taxed as sole proprietors and partnership LLCs are subject to self-employment taxes. S-corporations and LLCs (both single-member and partnership) that take the S-election eliminate self-employment tax and allow the owners to become an expense of the company through payroll. C-Corporations are entities that are responsible for their own taxes and owners can be on payroll and take taxable dividends. What’s important to understand is that these decisions should be made with professional (CPA) help as there are many things that must be considered when making a decision on business structure.
- Pay estimated taxes. The name of the game here is to keep your liability at the end of the year below $1000. Work with your CPA to determine what that looks like.
- Know your numbers! Put an accounting system in place or, better yet, hire a bookkeeper. Knowing these numbers is key when working with your CPA to make future plans for the company and project tax liability, as well as keep track throughout the year so there aren’t any surprises at the end of the year.
Wrapping Up
Self-employment tax and its impact on small businesses is no laughing matter, yet it’s one of the least understood concepts of small business owners. Some people have vaguely heard of it. Others know they have to pay it, but don’t understand why and don’t bother to find out. Many others don’t know that there are ways of mitigating its effects on their pocketbooks. If ignored, which it very often is, it can become overwhelming very quickly, a situation I have seen occur time and time again. While small business owners don’t need to understand all of the nuances of this tax concept, the important thing they need to keep in mind is that there are professionals out there that can help manage it. Take steps to make sure you are not the first illustration of self-employment tax and breathe easy when the end of the year approaches.