With the number of self employed people growing each year one question that almost all ask me concerns self employment tax and I thought this was a good time to explain it.

WHAT IS SELF EMPLOYMENT TAX?

Self employment tax is the way in which the government collects social security and medicare taxes from self employed people.  The average person that works for a company is paid a salary.  The employee’s paycheck is reduced by 6.2% for social security tax (also shown as FICA).  This 6.2% is deducted until the employee’s wages exceed the social security limit ($118,500 in 2015).  In addition the employee’s paycheck is reduced by 1.45% for medicare tax. There is no wage limit on medicare tax.

Let’s look at an example:

An employee receives a salary of $1,000 per week.  The employee will see a deduction of $62.00 for FICA and $14.50 for medicare taxes resulting in a net check of $923.50.  This does not take in to account the federal and state withholding amounts or NJ unemployment withholding.

In my example above, the employee has had a total of $76.50 withheld from his/her paycheck.  The employer is required to make a matching contribution of $76.50 and thus the government collects $153 of FICA and medicare tax on the $1,000 salary.

Self employed individuals do not receive a paycheck and therefore the government needs another method of collecting social security and medicare taxes.  The method used is as follows:

A taxpayer calculates his/her net self employment income by taking all allowable deductions against the gross income earned by the individual.  The individual then pays both halves of the social security / medicare tax and receives a deduction for one half of the tax on their individual income tax return.

It is important to remember that this tax is separate from any other federal or state income taxes.  It is therefore possible that a taxpayer has $0 income tax because of itemized deductions, but still has a self employment tax liability.

WHAT INCOME IS SUBJECT TO SELF EMPLOYMENT TAX?

• Any income earned by a sole proprietor or the owner of a single member LLC would be considered self employment income.

• Income earned by general partners of partnerships.

• Income earned by members of LLCs if they perform services for their business or participate in management activities.

WHAT INCOME IS NOT SUBJECT TO SELF EMPLOYMENT TAX?

• Income from rental real estate

• Capital gains

• Dividend and interest income

HOW DO WAGES AFFECT SELF EMPLOYMENT TAXES?

Wages are subject to social security and medicare taxes and therefore are not subject to self employment taxes, however if you earn both wages and self employment income, then your wage income may reduce your self employment income.  An example of this would be if you earned $120,000 of wages, then you have already surpassed the social security limit and any self employment income you have would be subject to only the medicare tax of 2.9% and not the full 15.3%.

CONCLUSION

This article gives only a basic overview of the self employment tax.  This area can be quite complex and should be discussed with a competent tax professional.