People who work for themselves instead of working through an employer receive compensation income based on the fees charged to their clients or customers. Self-employed persons also incur expenses related to their work, and such business-related expenses directly reduce the amount of self-employed income that is subject to various federal and state taxes.
The Self-Employed Tax Base
Self-employed persons are taxed on their net self-employed income, in contrast to employees who are for the most part taxed on their gross wages before any work-related deductions.
Various business expenses can be deducted directly against income by a self-employed person, such as expenses for advertising, office supplies, and equipment. The net amount of self-employed income, that is after allowable deductions have been subtracted out, is subject to the following federal and state taxes.
Federal Income Tax
The US federal government imposes income tax on net self-employed income. This tax is calculated on the Form 1040 each year. The income tax rate gradually becomes higher as income rises. Federal income tax is not deducted automatically from the fee income received by clients and customers. Instead, self-employed persons remit their tax payments using the estimated tax system.
Social Security Tax
The Social Security tax is a flat tax with a maximum cap. The Social Security tax is a flat 12.4 percent of all compensation income, up to a maximum compensation amount of $118,500.
This $118,500 amount is called the Social Security wage base. The wage base amount is set each year by Social Security. The Social Security tax is paid for half by the employer and half by the employee. The self-employed person pays both halves of Social Security, but also takes a deduction for the employer’s portion of the Social Security tax as an additional deduction against the income tax.
The Medicare tax is a flat tax at a rate of 2.9 percent on all compensation income. Half of the Medicare tax, or 1.45 percent, is paid for by the employer. The other half of the Medicare tax, also 1.45 percent, is paid for by the employee. The self-employed person pays both halves, but takes a deduction for the employer’s portion of Medicare as a deduction against the income tax.
The Self-Employment Tax
The self-employment tax is the combined Social Security and Medicare taxes due on net self-employment income. Self-employed persons take a deduction for the employer’s portion of the Self-Employment tax as a line item deduction on page 1 of their Form 1040. The self-employment tax itself and the deduction for the employer portion is calculated on Schedule SE.
State Income Tax
State income tax rates apply to net self-employment income. Some states have a flat tax rate (such as Massachusetts‘ 5.3 percent flat rate), other states have progressive or graduated tax rates, and still other states have no income tax at all.
City and Local Taxes
Cities and localities throughout the nation impose their own income taxes. New York City is perhaps the most famous example of a city income tax.
Some local taxes are imposed at the city level (such as in Ohio), other taxes are imposed at the county level (such as Indiana), while other taxes are set by school district (as in Iowa).
More about city and local taxes.
Various Local Business Taxes
City and county governments may impose business taxes on self-employed persons, such as city business license or city payroll taxes. New York City, for example, imposes an Unincorporated Business Tax on self-employed persons. And San Francisco applies its city payroll tax to income from self-employment.
Federal and State Payroll Taxes
Unlike wage and salary income, self-employed income is not subject to federal and state unemployment insurance taxes, nor is it subject to state insurance funds such as the California state disability insurance program.
Some states, however, permit self-employed persons to voluntarily opt-in to state insurance programs.
Income Reporting for Self-Employed Persons
Your customers and clients may request that a self-employed vendor fill out a Form W-9. The information contained on this form will be used to provide the self-employed person with a Form 1099-MISC after the year is over to report repayments during the year that totaled $600 or more. Form 1099-MISC is sent to the IRS as well.
The self-employed person might likewise need to request W-9 Forms from vendors and subcontractors and in turn issue 1099-MISC if they paid $600 or more to any single vendor.
Additionally, the self-employed person will report their total gross income for the year on Form 1040 using either Schedule F if they are running a farm or Schedule C if they are conducting a non-farm-related business.
Work Both as an Employee and Self-Employed
Some self-employed persons also work as employees. In this situation, their total Social Security tax will be coordinated using Schedule SE when calculating their Social Security and Medicare taxes. A single Social Security wage base, currently at $118,500, is used for compensation income, whether as an employee or self-employed. Additionally, the self-employed person might be able to adjust their withholding on their wage income to have more taxes taken out, in lieu of sending in estimated payments.
What If You’re Not Really Self-Employed
Some employers mistakenly classify their employees as self-employed contractors. This has the advantage (to the employer) of not having to incur the administrative and financial costs of payroll withholding. But this can have a huge tax impact on the worker, who now has to pay twice the Social Security and Medicare taxes they ordinarily would pay. Workers who think they may have been wrongly classified as an independent contractor can contact the IRS to request that the agency look into the matter. To facilitate this IRS investigation, the worker should use Form SS-8, requesting that the IRS make a determination of whether the worker is self-employed or an employee.