Many people operate their own businesses. Many of those businesses are sole proprietorships, partnerships or LLC’s. Separately, many businesses are looking to get their workers “off the payroll” by treating them as independent contractors rather than as employees. These factors make it increasingly important to be aware of the Self-Employment Tax (“SE Tax”) rules.
What Is The SE Tax:
If you are an employee (and receive a Form W-2 at the end of the year) then Social Security Tax and Medicare Tax are withheld from your wages by your employer and remitted to the IRS. Your employer is then required to match these taxes, dollar for dollar.
The SE Tax is basically Social Security and Medicare Tax for self-employed people. Not surprisingly, the SE Tax rates are set up to roughly equal the total Social Security Tax and Medicare Tax that the IRS would have collected had you received the income as an employee. This includes the portion that would have been taken from your wages as well as the matching portion that the employer would have to pay.
The SE Tax is often a very large unhappy surprise to taxpayers. It is assessed in addition to income tax.
What Income Is Subject to SE Tax:
Self-Employment Income (“SE Income”) is subject to SE Tax. Briefly, SE Income is net earnings from self-employment. According to the Internal Revenue Code, sole proprietors, partners in partnership and members of LLC’s (that do not elect to be taxed as a corporation) are self-employed for SE Tax purposes. Here are some common examples:
- Sole Proprietor: In general, someone who owns and operates an unincorporated business by himself or herself is considered to be a sole proprietor and self-employed.
- Partner in a Partnership: A partner in a partnership is generally considered to be self-employed for purposes of the SE Tax. Partners are subject to the SE Tax on guaranteed payments and their distributive share of SE Income flowing to them from the partnership.
- Limited Liability Companies: LLC’s are income tax chameleons. They can elect to be taxed as a partnership, as a Subchapter S Corporation, or as a Subchapter C
Corporation. LLC’s that elect to be taxed as partnerships follow the rules discussed above for partnerships. Single member LLC’s are considered to be sole proprietorships for purposes of SE Tax.
SE Tax Rates:
The SE Tax rate is 15.3%. This is comprised of 2 parts, the Social Security equivalent (12.4%) and the Medicare equivalent (2.9%). These are multiplied by SE Income to determine the SE Tax. Since there is a cap on how much of your wages are subject to Social Security Tax there is also a cap on how much of your SE Income is subject to the 12.4% Social Security portion of the SE Tax. However, since there is no cap on wages subject to Medicare Tax, there is likewise no cap on how much of your SE Income is subject to the 2.9% Medicare portion.
The Federal Government sets the Social Security cap for each tax year. The Social Security cap for 2009 and 2010 is the first $106,800 of wages or SE Income.
Taxpayers with SE Income must prepare and attach IRS Schedule SE to their Individual Income Tax Returns (Form 1040).
Payment of SE Tax:
The SE Tax is combined with income tax in determining when and how the tax is paid. That is, for calendar year taxpayers, it must be paid not later than April 15th. If SE Tax is due on April 15th, the taxpayer may be subject to Underpayment Penalties for not having paid in the SE Tax during the tax year. If SE Tax is due on April 15th and not paid by April 15th, the taxpayer is subject to interest and penalties.
SE Tax Deduction:
There is a small silver lining on the SE Tax cloud. The tax laws allow taxpayers a deduction equal to 50% of the SE Tax. This deduction is taken on Form 1040, Page 1, Line 27. Because this deduction it is taken “above the line” it reduces both Federal and State income tax.
Employee’s Who Also Have SE Income:
It is not uncommon for employees to also have their own business, be partners in partnerships or be members of LLC’s. Fortunately, the Social Security cap applies to total cumulative wages and SE Income. For example, if an employee earns $100,000 of wages and has $50,000 of SE Income in 2010 only the first $6,800 of SE Income will be subject to the 12.4% Social Security portion of the SE Tax ($106,800 cap – $100,000 = $6,800). This is because the taxpayer gets credit against the cap based upon the $100,000 of wages. There is no cap on wages subject to Medicare Tax or the SE Income subject to the 2.9% Medicare portion of SE Tax.
While net income from S Corporations flows to the S Corporation shareholders in much the same way that income flows to partners of partnerships, the income flowing from S Corporations is not subject to SE Tax.
Of course, S Corporation shareholders who are also employees are expected to be paid fair wages for their services as employees. Social Security Tax and Medicare Tax are required to be withheld from the employee’s wages whether or not they are shareholders. It is not uncommon for the IRS to attempt to re-characterize a portion of “dividends” to S Corporation shareholders as being “wages” where the shareholder is an employee and wages appear to be understated.
The special treatment for income flowing from S Corporations is often a consideration in determining selecting the form of the entity (i.e. sole proprietorship, partnership, LLC or corporation) and how to elect for income tax purposes (e.g. S Corporation or Partnership).
Employee versus Independent Contractor:
Is a worker an employee or an independent contractor? Often “employers” prefer to treat workers as independent contractors rather than as employees. Among the reasons is that the “employer” does not want to have to deal with Social Security and Medicare Tax. This not only costs the “employer” money (i.e. the matching portion of 3 Social Security and Medicare Tax) but also places administrative burdens on them (i.e. forms to prepare and file, deadlines to meet, etc.). In some cases, workers also prefer being treated as independent contractors for tax or other legal purposes.
Of course, the true determination of whether someone is an employee or an independent contractor is not solely determined by what the “employer” and worker would like. Rather, it is based upon the facts and circumstances of a particular situation. However, in general, the government would prefer that workers be considered employees and often challenges the characterization of independent contractor.
Whether they realize it or not, many taxpayers are subject to SE Tax. Some are aware of the rules, prepare Schedule SE and pay the tax. Others are unaware and only find out later, when they receive a Notice from the IRS for a tax that they did not know existed. To make matters worse, they must also pay interest and penalties on the unpaid SE Tax. Careful planning may allow a taxpayer to limit or eliminate the SE Tax.
I would like to thank law school graduate (and soon to be licensed attorney) Mr. Pawel Gacek for his contributions to this article.
Copyright ©, Keith B. Baker – 2010
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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