Posted by Abundant Wealth Planning LLC

Tax Treatment of Self-Employment Income

Tax Treatment of Self-Employment Income

Independent taxpayers, such as independent contractors and sole proprietors, receive compensation based on the fees they charge their clients. They also incur work-related expenses, which can directly reduce the amount of self-employment income, subject to federal and state taxes.

Although independent taxpayers receive some benefits that are not available to employees, they face challenges at tax time that employees do not share.


Tax breaks for the self-employed

Self-employed persons pay tax on net self-employment income, which remains after income, and deduct qualifying business expenses from Schedule C, "Business Profit or Loss."

Employees used to claim certain work-related expenses and reduce their taxable income. They had to list their deductions instead of claiming the standard deduction. But these various work-related deductions were removed from the tax code by the Tax Cuts and Jobs Act (TCJA) in 2018, at least until 2025.

Business expenses deductible in Schedule C directly from revenue include expenses for:

  • Advertising 

  • Equipment

  • Home office costs

  • Office supplies

  • Transportation costs

After making all of these qualifying deductions, the net amount of a self-employed person's income is subject to federal, state, and sometimes local taxes.


The qualified business income deduction

TCJA gave independent taxpayers a freebie in 2018: the Qualifying Business Income Deduction (QBI). This deduction allows "pass-through" entrepreneurs to reduce a further 20% of their taxable income after deducting gross income by deducting professional expenses.

Pass-through businesses are those in which profits and losses are reported, and taxes are paid on the owners' personal returns. The company itself does not pay taxes. Pass-through activities include Sole Proprietorships, Partnerships, LLCs, and S Corporations, but not C Corporations.

However, a total of 20% is only available for self-employed taxpayers with incomes below certain thresholds. In 2020, these limits were $326,600 for married filing jointly and $163,300 for married filing separately. The percentage begins to be eliminated for income above these limits until it is reduced to zero.

These limits increase to $329,800 in fiscal 2021 if you are married filing a joint tax return and to $164,900 for all other taxpayers.

The process and rules for calculating this deduction are particularly complex, so you may want to consult a tax professional to find out for sure if you qualify. However, you will probably find out if you run a pass-through company and earn less than these income limits.


Making estimated tax payments

The US federal government collects self-employed net income tax after all deductions, as in the case of W-2 employee income, with one major difference.

An employer withholds taxes from an employee and forwards them to the IRS on behalf of the employee. But federal income tax is not automatically deducted from taxes and other income that self-employed workers receive from their customers and clients.

Self-employed people must make their own tax payments using the estimated tax system. They need to make a good estimate of what their likely tax debt should be after all the deductions, and then they need to send quarterly payments to the IRS or face interest and penalties.

Estimated tax payments are generally due quarterly on:

  • April 15

  • June 15

  • September 15

  • January 15 of the following year

The April 15 payment covers the months of January, February, and March, so you can base your estimate of what you owe on what you earned during that time.

You had until June 15, 2021, to submit a tax estimate for the first quarter if you live in Texas, Louisiana, or Oklahoma. This was a one-time extension offered by the IRS in response to the winter storms of 2021. Taxpayers in other locations must continue to file estimated taxes by April 15, including the May 17, 2021 extension to file tax returns for 2020.


Self-Employment Tax

Self-employment tax includes taxes on health insurance and social security. Employees pay half of Social Security and Medicare taxes, and their employers pay the other half, but an independent taxpayer must pay both halves.

Social Security tax is a flat rate of 12.4% of all types of compensatory income, up to a maximum of $137,700 in 2020, which will increase to $142,800 in 2021. This cap is known as the social security wage base, and it is established annually by the Social Security Administration as it is adjusted for inflation.

The Medicare self-employed tax rate is also a flat rate of 2.9% for all compensation income. There is no wage base for Medicare.

Self-employed taxpayers can claim an above-the-line adjustment for what would otherwise be the employer's share of these taxes. Self-employment taxes and employer share deductions are calculated in Schedule SE.


If you are an employee and self-employed

Some self-employed also work as employees. In this situation, the total social security contributions on the two sources of income can be coordinated using Schedule SE, the form you would use to calculate your own tax.

The same social security wage base is used for both incomes earned from self-employment and employee income.

You can adjust the withholding tax on income to collect more taxes instead of sending the estimated quarterly tax payments to the IRS. Simply complete a new W-4 form and send it to your employer. There is also a special line on the 2020 form for this situation.


State, municipal and local taxes

State income tax rates also apply to net self-employment income. Nine states have a fixed tax system for 2020, where everyone pays a tax rate, regardless of their income.

The District of Columbia and 32 states have a graduated or progressive tax system. Tax rates increase as the taxpayer earns more in these jurisdictions.

Other states do not yet apply income tax. New Hampshire only taxes interest and dividend income, not income.

Tax-exempt states as of 2021 include Alaska, Washington, South Dakota, Wyoming, Nevada, Texas, Florida, and Tennessee.

Some cities across the country levy their own income taxes. New York is perhaps the most famous city when it comes to income tax.

Some local taxes are imposed at the county level, such as in Indiana. However, other local taxes are set by school districts, such as in Iowa. 

City and county governments can impose business taxes on the self-employed, usually by applying for a municipal business license or a municipal payroll tax. New York City imposes unincorporated corporation tax on self-employed workers.


Federal and state payroll taxes

Self-employed enjoy a short break here. Your income is not subject to federal and state taxes for unemployment insurance or state insurance funds, such as the California Disability Insurance Program. 


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