The Self-Employment Tax

So, you’ve started a business and freed yourself from the daily grind of that old job. But there’s no freedom from paying taxes. In fact, you’ll owe tax that you never had to pay as an employee: The self-employment tax (officially known as the SECA tax for Self-Employment Contributions Act tax). It's the self-employed person's version of the FICA (Federal Insurance Contributions Act) tax paid by employees to pay for Social Security and Medicare, and it's due on your net earnings from self-employment.

Many newly self-employed people—sole proprietors, independent contractors and the like—are surprised at their tax bills at the end of the year because they notice they're suddenly paying a lot more in tax as a self-employed person than as an employee. That's because they're carrying the full burden of paying for Social Security and Medicare. Employees share that cost with their employers, with each paying the 7.65 percent FICA tax. When you're self-employed, though, you're stuck with the full 15.3 percent levy.

• 12.4 percent for Social Security. For 2008, this part of the tax applies to the first $102,000 of earnings. If you earn more than that (from your business or, if you also have a job, from the combination of your job and your business), then the 12.4 percent part of the tax that pays for Social Security stops. (For 2009, the tax applies to the first $106,800 of self-employment income.)
• 2.9 percent for Medicare. The Medicare portion of the self-employment tax is unlimited. No matter how much you earn, you'll pay the 2.9 percent Medicare tax. Even if you have investment losses that offset part of your self-employment income for income tax purposes, such losses will not affect the amount of self-employment tax you owe. For more information on this tax, see IRS Tax Topic 554: The Self-Employment Tax.

Of course, a new tax means new paperwork, too. When you start a small business and you do not incorporate or form a partnership, you report the results of your operations on Schedule C and file that with your Form 1040. The result of netting your revenues and expenses is a net profit or loss.

You calculate your self-employment tax on Schedule SE and report that amount in the "Other Taxes" section of Form 1040. In this way, the IRS differentiates the SE tax from the income tax.

When figuring self-employment tax you owe, you get to reduce self-employment income by 7.65 percent before applying the tax rate. Say, for example, that your net self-employment income is $50,000. That's the amount you report as taxable for income tax purposes on Form 1040.

But when figuring your self-employment tax on Schedule SE, Computation of Social Security Self-Employment Tax, the taxable amount is $46,175. Not paying the 15.3 percent tax on $3,825 difference in this example saves you $585.

You can claim 50 percent of what you pay in self-employment tax as an income tax deduction. A $1,000 self-employment tax payment reduces taxable income by $500, for example. In the 25 percent tax bracket, that saves you $125 in income taxes. This deduction is an adjustment to income claimed on the Form 1040, and is available whether or not you itemize deductions.

You run a catering business as a sole proprietor. In 2008 your net profit as reported on Schedule C is $35,000.Your net earnings as calculated on Form SE would be $32,323 ($35,000 x 0.9235). Your self-employment tax would be $4,945 (32,323 x 0.153) and you would report that amount on Form 1040 in the "Other Taxes" section.

Then you would report one-half of your self-employment tax, $2,473, ($4,945 X .50) on the 1040 as an adjustment to income, which reduces your Adjusted Gross Income and the amount of income tax you owe.

If you have worked as an employee, you know that the net earnings on your paycheck are much less than your gross earnings.

Why? Because your employer withheld money for Social Security, Medicare and income tax and sent that money to the government.

When you are self-employed, the entire burden for paying employment taxes and prepaying estimated income tax liability is left to you. That's why you need to pay estimated taxes in quarterly installments to the U.S. Treasury; otherwise, you may be subject to underpayment penalties.

If you're not sure whether you meet the definition of being self-employed, see IRS Tax Topic 554: The Self-Employment Tax.