Understanding Self-Employment Tax

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Article Highlights:

• Self-Employment Tax
• Exemptions From Self-Employment Tax
• Occasional Income
• Computing the Self-Employment Tax
• Farm and Non-Farm Optional Methods
• Foreign Earned Income

Self-employment (SE) tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is like the Social Security and Medicare taxes withheld from the pay of most wage earners. But unlike wage earners who pay half the Social Security and Medicare taxes with their employers paying an equal amount of these employment taxes, the self-employed person pays both halves of the taxes.

Self-employment tax applies to individuals who work for themselves and make a net profit. The profit is derived from carrying on a trade or business, and it is generally reported on Schedule C. If the net profit exceeds $400 for a tax year, then self-employment tax applies. It is calculated using Schedule SE, which is filed with the individual's federal tax return.

In general, you're considered self-employed if you are a sole proprietor, independent contractor, member of a partnership, or are otherwise in business for yourself. You can be a full-time business owner with or without employees or just do freelance or gig work on the side.

Exemptions From Self-Employment Tax - There are several situations where individuals are exempt from self-employment tax. These include:

1. A shareholder’s portion of an S corporation’s taxable income.

2. Fees for the services of a notary public.

3. Non-resident aliens.

4. Real estate rental income.

5. Rents paid in crop shares.

6. Statutory employees.

7. The fiduciary of an estate on an isolated basis.

8. Members of the clergy who take a vow of poverty.

9. Termination payments of former insurance salespeople.

In addition to these situations, occasional income that is not accompanied by efforts to continue in the activity for compensation are free of self-employment tax. This means that receiving a 1099 form that reports the income may not require you to pay SE tax on the payment but income tax may still apply.

The inflation adjusted SE tax rate for 2024 is 15.3% on the first $168,000 (up from $160,200 in 2023) of net SE income and then continues at a rate of 2.9% on the net income more than $168,000. The 15.3% rate is the sum of a 12.4% Social Security tax and a 2.9% Medicare tax on net earnings.

For net profits more than $200,000 for single taxpayers ($250,000 for married filing jointly), an additional 0.9% in Medicare tax is required.

Where an individual also has wages from an employer, the amount of self-employment income subject to the 12.4% portion of the self-employment tax cannot exceed the $168,000 cap for the year less the amount of the W-2 income subject to FICA withholding.

For example, if an individual earns $140,000 in W-2 wages and $40,000 in self-employment income in 2024, they will only owe the 12.4% self-employment taxes on $12,000 ($140,000 + $40,000) - $168,000). But the entire $40,000 will be subject to the 2.9% Medicare tax.

It's important to note that self-employed individuals can deduct half of their self-employment tax from their gross income when calculating their tax liability. This helps to equalize the overall tax burden for self-employed individuals, who must pay both the employer and employee portion of Social Security and Medicare taxes, compared to those who are employed by others. This deduction is not claimed on the Schedule C form as a business expense, but does reduce income when figuring the individual’s adjusted gross income.

Farm and Non-farm Optional Methods - The farm and non-farm optional methods are two ways to calculate self-employment tax that can be beneficial for taxpayers who have low earnings or a loss from self-employment.

• Farm Optional Method: This method can be used by self-employed farmers who have gross farm income of not more than $9,840 (for 2023) or a net farm loss. Using this method, farmers can report two-thirds of their gross farm income, up to $6,560, as their net earnings for Social Security purposes. There is no limit on the number of years the farm optional method can be used.
• Non-Farm Optional Method: This method can be used by other self-employed individuals who have net non-farm profits of less than $6,560 (for 2023) or a net non-farm loss. Using this method, self-employed individuals can report two-thirds of their gross non-farm income, up to $6,560, as their net earnings for Social Security purposes. An individual can use the nonfarm optional method to figure their self-employment earnings for only 5 years, which don’t have to be consecutive.

The reason for these methods is to allow self-employed individuals to continue to earn credits toward Social Security benefits even in years when their business has low earnings or a loss. However, these methods can only be used if they result in a higher SE tax than the regular method.

To use the nonfarm optional method, the individual must be regularly self-employed, meaning that their actual net earnings from self-employment were $400 or more in 2 of the 3 years before the year they use the nonfarm optional method.

Foreign Earned Income - A frequent question is whether foreign earned self-employment income is subject to self-employment tax. Even if you qualify for the Foreign Earned Income Exclusion and can exclude up to $126,500 (2024 amount) of your foreign self-employment income from income tax, that SE income is still subject to self-employment tax.

Since the Foreign Earned Income Exclusion does not apply to self-employment tax, self-employed individuals with foreign SE income must pay Social Security and Medicare taxes on their net earnings from self-employment, even if they can exclude the income for income tax purposes.

However, the United States has entered into “Totalization Agreements” with several countries to avoid double taxation of income with respect to social security taxes. These agreements must be considered to determine whether any foreign social security tax paid on foreign self-employment income can be credited against U.S. self-employment tax.

If you have questions related to self-employment tax and how it might impact you, please give the office a call.