Self employment taxes FAQs
In most cases, if you earned more than $400, you will need to pay self-employment taxes. Unlike federal income taxes, these taxes are based on net earnings and not adjusted gross income. Self-employment taxes include both the “employer” and “employee” portion of Social Security and Medicare taxes.
For the 2020 tax year, the self-employed tax rate is 15.3% of the first $137,700 of combined wages, tips, and net earnings ($142,800 for 2021). The self-employment tax consists of 12.4% for Social Security and 2.9% for Medicare. It is important to understand that the Medicare tax applies to all of your net earnings, even those exceeding the Social Security limit. If you earn over $200,000, you may have to pay additional Medicare taxes. To help you stay compliant, you should make self-employment tax payments quarterly.
In many ways, self-employed and sole proprietorships are the same. Both have to pay self-employment taxes and they have no liability protection. The only difference is how you get paid. If you are operating a sole proprietorship, your customers make payments to your business. If you are self-employed, your client pays you individually and supplies you with a 1099-MISC form to report your income to the IRS. There are few advantages to operating your business or earning income in this way.
You may want to consider starting your own business. Even if you are a one-person business, there are potential advantages to incorporating or establishing a limited liability company (LLC). The first is that using a business entity separates your business and personal incomes and expenses. The second is liability protection. If your business fails, your personal assets may be protected. If you are sued, your personal assets may be protected should you lose your case. The only difference to your clients is that they would be paying your business rather than paying you personally.
Self-employed business owners are subject to the same income tax brackets as people who are employed by other businesses. However, entrepreneurs must also pay self-employment taxes on their earnings. In this respect, self-employed individuals pay higher taxes than people who work for other companies.
Self-employment taxes include Medicare and Social Security taxes. Everyone must pay these taxes. Individuals who earn wages from employment and have taxes deducted from their regular paychecks pay the employee portion of Medicare and Social Security taxes and their employers are responsible for the other one-half of these taxes. Self-employed persons are responsible for the entire 15.3% of the first $137,700 of earnings.
Self-employed persons may benefit from a variety of tax deductions for expenses directly related to the business. To qualify as deductible, claimed expenses must be deemed both ordinary (customary for the type of business) and necessary.
Small business owners and entrepreneurs may be able to deduct expenses associated with:
Office or retail space
Vehicles used for business purposes
Equipment and technology
Materials and supplies
Business retirement plans, and more
If you borrowed money for business purposes, you can generally deduct interest paid on such loans, as well as taxes paid for the business. For any items acquired or used for both business and personal use, your tax deduction will be limited to the portion/percentage related to the business.
The income tax system in the U.S. is a “pay-as-you-go” system, whether you are employed by someone else or are self-employed. If you do not pay your self-employment taxes or underpay your taxes, you may also have to pay penalties and interest. To help comply with IRS requirements, it is best if you make quarterly payments rather than facing a large tax bill at the end of the year.
However, don't expect to avoid penalties. To avoid having to pay penalties, pay your quarterly estimated taxes as accurately as you can. If you owe, try to make payment arrangements with the IRS. If you forgot to include a 1099-MISC with your taxes, you can file an amendment (1040X). If you do not pay the IRS, your income and assets may be at risk. Talk to an attorney or tax professional if you require assistance.