Self-employed individuals, unlike employees, don’t have someone withholding Social Security or Medicare (FICA) taxes along with pre-payments toward their federal (and state, where applicable) income tax from their wages during the year.
They are not being paid a wage; instead, a self-employed individual must keep a set of books showing income and expenses associated with their self-employed business that will allow them to determine their taxable profits (or losses). While an employer and an employee each pay half of the FICA taxes due on an employee’s wages, a self-employed person pays 100% of these taxes, termed the self-employment tax or SE tax for short, on his or her self-employment profit. If the individual has more than one self-employment activity, the net profits and losses from all of the self-employment activities are combined to determine the amount of the SE tax. However, two spouses have self-employment income, the couple cannot combine their SE incomes when figuring their individual SE tax.
Estimated Taxes – Since self-employed taxpayers don’t have taxes withheld on their self-employment income, they need to pay estimated taxes quarterly based upon their taxable profits for the quarter and, after the first quarter of the year, taking into account prior quarterly profits and estimated taxes already paid for the year. These estimated taxes are paid with an IRS Form 1040-ES and include the taxpayer’s income and SE taxes. In lieu of filing Form 1040-ES and sending a check to the U.S. Treasury, the payments can be made online through the IRS’s website or by using the government’s Electronic Federal Tax Payment System (EFTPS), which allows payments to be scheduled up to a year in advance, by having payments automatically withdrawn from the individual’s bank account at specified dates. The payments are due April 15, June 15, September 15, and January 15. If the due date falls on a weekend day or legal holiday, the due date will be the next business day. And if you didn’t notice, the second “quarter” is two months, and the third one is four months: one of many quirks in our tax system.
Self-Employment Tax – All self-employed taxpayers who have more than $400 in net profit from their self-employment must pay self-employment tax, which is made up of Social Security tax of 12.4% on the first $132,900 (2019) of profit from the business and a 2.9% Medicare tax on all of the profits. In addition, there is an additional 0.9% Medicare tax to the extent the profits exceed $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. In addition, half of the self-employment tax can be deducted from gross income. There are special rules for determining the self-employment taxes for farmers and fishermen. If a self-employed taxpayer pre-pays less than 90% of his or her current year’s tax liability, including Social Security and Medicare taxes for the year, then the taxpayer can be subject to a penalty that assesses interest on underpayments by the quarter.
Estimated-Tax Safe Harbors – However, rather than having to determine their quarterly profits and estimate their income tax and SE tax liabilities, some self-employed individuals instead opt to use a quarterly safe-harbor-payments method allowed by the IRS, which avoids the underpayment penalty if used correctly. There are two safe harbors available:
- 100% of the prior year’s tax liability paid evenly for each quarter, provided the prior year’s adjusted gross income was $150,000 or less ($75,000 if using the filing status of married filing separate).
- 110% of the prior year’s tax liability paid evenly for each quarter if the prior year’s adjusted gross income was greater than $150,000 ($75,000 if filing married filing separate).
The underpayment penalty does not apply if the final amount due on an individual’s tax return is less than $1,000. The penalty also does not apply if a taxpayer did not have a prior year tax liability for a full 12-month year.
One thing to consider when deciding whether or not to use the safe harbor method is that because the safe harbor estimates are not based on the current year’s profits, a self-employed individual could be in for an unexpected substantial tax liability at tax time. Or, if their current year’s income is significantly less than it was in the prior year, they could be overpaying their current year tax and be eligible for a large refund when they file their current-year return. If an overpayment results, all or part of it can be applied to the next year’s estimated taxes, instead of the taxpayer receiving a refund payment.
Also remember that tax pre-payments are not just based on the self-employment income and must factor in all other taxable income, including investment income, retirement income, the self-employed individual’s wages from other work, and a spouse’s wages or self-employment income, as well as account for withholding from other sources.
1099-MISC and 1099-K – Generally, a self-employed individual keeps track of his or her own income but may also receive one or more 1099-MISC forms issued by a customer showing the amount of self-employment income paid by the customer. If that income has already been accounted for in the business’s income records, it should not be included again. Also, beginning in 2021 for earnings received in 2020, Form 1099-NEC will be used in place of the 1099-MISC to report nonemployee compensation.
Self-employed individuals that take credit card payments for sales of their business products or services use third parties to settle the transaction and return payment to the self-employed individual. To combat fraud, the IRS requires all third-party network transactions to be reported on Form 1099-K if the amount is $20,000 or more and the number of transactions is 200 or more. Again, the sales should have already been included as income and should not be included a second time.
Others Subject to Self-Employment Tax – Besides self-employed individuals having to pay SE tax on their trade or business income, the SE tax also applies to other situations:
- Member of the Clergy – A housing allowance paid to a member of the clergy is generally excludable from taxable income, but it is subject to self-employment tax.
- Partnership Distributions – If a taxpayer is a general partner of a partnership that carries out a trade or business, his or her distributive share of the partnership’s income is self-employment income and subject to self-employment tax, as are guaranteed payments to partners.
- Foreign Self-Employment Income – If a taxpayer qualifies for excluding foreign-earned self-employment income, the income is still subject to self-employment tax.
- Agricultural Co-op Payments to Retired Farmers – Even when retired from daily farming activities, taxpayers who are still contractually obligated to supply an agricultural commodity to the agricultural cooperative of which they remain a member are considered to be in a trade or business of producing, marketing, processing, and selling the commodity. The “value-added” payments received from the co-op are subject to self-employment tax.
- Director Fees – Fees received for the performance of services as a director of a corporation, including a director attending a meeting, are self-employment income and subject to self-employment tax.
- Fishing Boat Crew Members – Members of a fishing boat crew are self-employed when they are compensated solely from the proceeds of the sale of the boat’s catch.
- Executors and Administrators (Fiduciaries) – A person who administers the estate of a deceased person is subject to SE tax if (a) the person is a professional fiduciary or (b) the person is a nonprofessional fiduciary who manages an estate that includes an active trade or business or manages an estate that required extensive management activities over a long period of time.
Income Not Subject to Self-Employment Tax – Income from an occasional act or transaction, absent proof of efforts to continue those acts or transactions on a regular basis, isn’t income from self-employment subject to the self-employment tax. In addition, the following are some sources of income as well as individuals not subject to self-employment tax.
- A shareholder’s portion of an S corporation’s taxable income.
- Fees for the services of a notary public.
- Non-resident aliens
- The fiduciary of an estate on an isolated basis
- Rents paid in crop shares
- Real estate rental income
- Statutory employees
- A self-employed taxpayer’s child employee under the age of 18.
So just because a taxpayer receives a 1099-MISC (or 1099-NEC, beginning in 2021) does not mean that the taxpayer is subject to self-employment tax. Please call this office with questions related to self-employment tax.