The Tax Treatment of Self-Employment Income

Taxes That Apply to Self-Employment Income

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People who work for themselves receive compensation based on the fees they charge to their clients or customers. They also incur expenses related to their work and these business-related expenses can directly reduce the amount of self-employed income that's subject to federal and state taxes.

Sound good? Don't give your employer notice quite yet. Self-employed taxpayers face a few challenges at tax time that employees don't share.

The Self-Employed Tax Base

Self-employed persons are taxed on their net self-employed income—what's left over after they deduct their qualifying business expenses. Employees, on the other hand, are taxed on their gross wages.

Employees used to be able to claim some work-related expenses to reduce their taxable incomes if they wanted to itemize their deductions rather than claim the standard deduction. Most of these work-related deductions were eliminated by the Tax Cuts and Jobs Act, at least through the 2025 tax year.

But various business expenses can be deducted directly against income by self-employed taxpayers. These include things like expenses for advertising, office supplies, and equipment. The net amount of self-employed income after all these allowable deductions have been subtracted is subject to several federal, state, and sometimes local taxes.

Federal Income Tax

The U.S. federal government imposes income tax on net self-employed income just as it does on employees' W-2 income with one major difference. Employers withhold taxes from an employee's pay before she receives her paycheck. Federal income tax is not deducted automatically from the fees and income that self-employed individuals receive from their clients and customers.

Instead, self-employed persons remit their tax payments using the estimated tax system. They must take an educated guess at what they expect to earn for the year and calculate what their likely tax liability will be after deductions. Then they must send quarterly payments to the Internal Revenue Service.

Social Security Tax

The Social Security tax is a flat tax of 12.4 percent of all types of compensation income up to a maximum $128,400 as of 2018.

This $128,400 cap is known as the Social Security wage base and it's set each year by the Social Security Administration. Half the Social Security tax is paid by employed workers and the other half is paid by the employer. A self-employed taxpayer must pay both halves but she can also claim a deduction for the employer's portion.

Medicare Tax

The Medicare tax is also a flat tax at a rate of 2.9 percent on all compensation income. Like the Social Security tax, half the Medicare tax or 1.45 percent is paid for by the employer of an employed worker. The other half, also 1.45 percent, is paid by the employee.

You must pay both halves if you're self-employed but, again, you can take a deduction for the employer's portion as an "adjustment to income" deduction on your tax return.

The Self-Employment Tax

Collectively, the Medicare tax and the Social Security tax comprise the self-employment tax. The self-employment tax itself and the deductions for the employer portion are calculated on Schedule SE.

State Income Tax

State income tax rates also apply to net self-employment income. Some states have a flat tax rate such as Massachusetts at 5.1 percent as of 2018. Everyone pays this same rate regardless of how much they earn.

Other states have progressive or graduated tax rates—tax rates increase with the more income a taxpayer earns. Still other states have no income tax at all. They include Alaska, Washington, South Dakota, Wyoming, Nevada, Texas, and Florida as of 2018.

City and Local Taxes

Some 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, while other taxes are imposed at the county level, such as in Indiana. Still other local taxes are set by school districts. This is the case in Iowa.

Various Local Business Taxes

City and county governments can impose business taxes on self-employed individuals, such as by requiring a city business license or city payroll taxes. New York City imposes an unincorporated business tax on those who are self-employed and San Francisco applies its city payroll tax to income from self-employment.

Federal and State Payroll Taxes

Self-employed persons get a bit of a break here...sort of. Their 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. But if they find themselves out of work or disabled, they could be out of luck because they haven't been paying into benefits.

Some states do permit self-employed persons to voluntarily opt in to state insurance programs, however. They can collect unemployment benefits in the event they should suddenly find themselves out of work in these jurisdictions if they pay into the program.

Reporting Income When You're Self-Employed

Your customers and clients might request that you fill out a Form W-9 if you're self-employed, particularly if you do ongoing work for them. The information you enter on this form is used to create Form 1099-MISC at year's end. Clients and customers must report payments made to you during the year if they total $600 or more. Form 1099-MISC is sent to both you and to the IRS.

You might likewise have to request W-9 Forms from vendors and subcontractors who perform work for you, and in turn you would have to issue them Forms 1099-MISC if you paid them $600 or more and send a copies to the IRS.

Finally, you must report your total net income for the year on Form 1040 using either Schedule F if you're running a farm or Schedule C if you're conducting a non-farm business. These schedules calculate your taxable income after deducting your business expenses.

If You're Both an Employee and Self-Employed

Some self-employed persons also work as employees. In this situation, your total Social Security tax on both sources of income is coordinated using Schedule SE, the form you use to calculate your self-employment tax.

The same Social Security wage base is used for both employee income and income earned from self-employment. You might be able to adjust withholding on your wage income to have more taxes taken out in lieu of sending in quarterly estimated tax payments to the IRS.

What If You're Not Really Self-Employed?

Some employers mistakenly classify their employees as self-employed independent contractors. This benefits the employer because he doesn't have to incur the administrative and financial costs of payroll withholding. He doesn't have to match Social Security and Medicare contributions.

But this can have a huge tax impact on the worker who now has to pay twice the Social Security and Medicare taxes that she would normally pay as an employee. In many states, such a worker would find that she's not eligible for unemployment insurance, either, if she loses the job.

Workers who think that they might have been wrongly classified as independent contractors can contact the IRS to request that the agency look into the matter. Use ​Form SS-8 to facilitate this IRS investigation and to request that the IRS make a determination as to whether you're self-employed or an employee.