Individuals whose businesses are incorporated do not have to think about self-employment tax. Any salary they take from their corporations as owner-employees are subject to FICA taxes. In contrast, those with other types of business entities—sole proprietorships, partnerships, and limited liability companies (LLCs)—are not employees; they are self-employed individuals. As such they meet their Social Security and Medicare taxes obligation through the payment of self-employment tax.
Self-employed individuals pay what amounts to the employer and employee share of FICA tax; the employer share is deductible. In other words, they pay 15.3% (comprised of 12.5% for Social Security tax and 2.9% for Medicare tax). The self-employment tax is applied to net earnings from self-employment, although only net earnings up to an annual threshold ($118,500 for 2016; $127,200 for 2017) are taken into account for the Social Security tax portion. In basic terms, net earnings from self-employment are income minus expenses. It sounds simple enough, but there are some ins and outs that may impact your payments.
While FICA taxes apply to the first dollar of wages paid to an employee, there is no self-employment tax due if net earnings from self-employment are less than $400. So a self-employed individual with only losses for the year, or someone with a modest sideline business, may be below the threshold for self-employment tax.
However, if net earnings are $400 or more, then the tax applies to all net earnings. There’s no exemption for this amount.
Self-employed individuals who have modest earnings may want to voluntarily pay self-employment tax. The reason: This enables such individuals to earn Social Security credits, which translate into higher benefits in retirement.
There are two optional methods for figuring earnings: one for farmers and one for all other self-employed individuals (nonfarm optional method). The farm optional method applies for 2016 returns if gross farm income was not more than $7,560 or net farm profits were less than $5,457. The nonfarm optional method can be used if net nonfarm profits were less than $5,457 and also less than 72.189% of gross nonfarm income but you had net earnings from self-employment of at least $400 in two of the prior three years. The nonfarm income optional method cannot be used more than five times by a self-employed individual
Determining self-employment income
In most cases, it’s easy to know what is or is not self-employment income for purposes of the self-employment tax. But there continues to be confusion about certain types of payments. Here are some recent matters concerning this issue:
- Payments for past performance. A former employee received a payment resulting from 34 years of services for a company. The IRS said it is subject to self-employment tax because there is a nexus between the income received and a trade or business. A court said the same thing for retirement payments made to a former Mary Kay sales person.
- Separate lines of work. A plastic surgeon who conducted his medical practice through a single-member professional limited liability company (PLLC) also had a minority interest in a limited liability company that ran a surgery center. The Tax Court said that his earnings from the surgery center were not subject to self-employment tax because he was a mere investor here; the activities did not have to be grouped as a single activity. He did not manage the center or have any day-to-day responsibilities there.
It should be noted that the IRS has yet to issue regulations explaining the extent to which a member’s distributive share from an LLC is subject to self-employment tax. This issue is on the IRS’s Priority Guidance Plan for 2016-2017.
Self-employment tax must be taken into account in figuring estimated tax payments, and the first estimated tax payment for 2017 is due by April 18, 2017. Self-employed individuals should work with a tax professional to make sure this tax obligation is being handled properly.