The Tax Treatment of Self-Employment Income
Taxes—and Tax Breaks—That Apply to Self-Employment Income
Self-employed taxpayers such as independent contractors and sole proprietors receive compensation based on the fees they charge to their clients or customers. They also incur expenses related to their work and these expenses can directly reduce the amount of self-employment income that's subject to federal and state taxation. It might sound promising, but you might not want to give your employer notice quite yet.
Although self-employed taxpayers receive a few breaks that aren't available to employees, they face a few challenges at tax time that employees don't share.
Tax Breaks for the Self-Employed
Self-employed persons are taxed on their net self-employment income—what's left over after they enter their earnings and deduct their qualifying business expenses on Schedule C, "Profit or Loss From Business."
Employees used to be able to claim some work-related expenses as well to reduce their taxable incomes. They had to itemize their deductions rather than claim the standard deduction. But these work-related miscellaneous deductions were eliminated from the tax code by the Tax Cuts and Jobs Act (TCJA) in 2018, at least through 2025.
Business expenses that can be deducted on Schedule C directly against income include things like expenses for advertising, office supplies, equipment, home office costs, and transportation costs. The net amount of self-employed income after all these allowable deductions is subject to federal, state, and sometimes local taxes.
The Qualified Business Income Deduction
The TCJA gave self-employed taxpayers a gift effective 2018—the Qualified Business Income (QBI) deduction. This deduction allows owners of "pass-through" businesses to shave an additional 20% off their taxable incomes after whittling away at their gross incomes by deducting business expenses.
Pass-through businesses are those where profits and losses are reported and taxes are paid on the owners' personal tax returns. The business itself doesn't pay taxes. Pass-through businesses include sole proprietorships, partnerships, LLCs, and S corporations, but not C corporations.
The full 20% is only available to self-employed taxpayers whose incomes fall below certain thresholds, however. As of 2019, the tax year for which you'll file in 2020, these limits are $321,400 if you're married and filing a joint return, $160,700 if you're single, or $160,725 if you're married filing separately or a married nonresident alien. The percentage begins phasing out over these thresholds until it reduces to zero.
These thresholds increase to $326,600 in the 2020 tax year if you're married and filing jointly, an to $163,300 for all other taxpayers.
The process and rules for calculations of this deduction are particularly complex, so you might want to consult with a tax professional to find out for sure if you qualify. But you most likely do if you have a pass-through business and earn less than these income thresholds.
Making Estimated Tax Payments
The U.S. federal government imposes income tax on net self-employed income after all deductions just as it does on employees' W-2 income, with one major difference. Employers withhold taxes from an employees' pay before they receive their paychecks, and they send it to the IRS on the employee's behalf. Federal income tax is not deducted automatically from the fees and income that self-employed individuals receive from their clients and customers.
Self-employed persons must remit their tax payments using the estimated tax system. They must take an educated guess as to what they expect their likely tax liability will be after all deductions, then they must send quarterly payments to the IRS or face interest and penalties.
Estimated tax payments are due quarterly on April 15, June 15, September 15, and 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'll owe on what you earned during this period. The June 15 payment was extended to July 15 in 2020 in response to the coronavirus pandemic.
The Self-Employment Tax
The self-employment tax is comprised of Medicare and Social Security taxes. Employed workers pay half the Social Security and Medicare taxes and the other half is paid by their employers, but a self-employed taxpayer must pay both halves.
The Social Security tax is a flat tax of 12.4% of all types of compensation income up to a maximum of $137,700 in 2020. This cap is known as the Social Security wage base and it's set each year by the Social Security Administration as it's adjusted for inflation.
The Medicare portion of the self-employment tax is also a flat tax at a rate of 2.9% on all compensation income. There is no Medicare wage base.
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 can be 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 can adjust withholding on your wage income to have more taxes taken out in lieu of sending in quarterly estimated tax payments to the IRS. It's a simple matter of filling out a new Form W-4 and submitting it to your employer. There's even a special line on the 2020 form for just this situation.
State, City and Local Taxes
State income tax rates also apply to net self-employment income. Nine states have a flat tax system as of 2020 where everyone pays one tax rate regardless of how much they earn. The District of Columbia and 32 states have progressive or graduated tax systems. Tax rates increase with the more income a taxpayer earns in these jurisdictions.
Still other states have no income tax at all. New Hampshire and Tennessee tax only interest and dividend income, not earned income.
States without an income tax include Alaska, Washington, South Dakota, Wyoming, Nevada, Texas, and Florida as of 2020.
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.
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 they could be out of luck if they find themselves out of work or disabled because they haven't been paying into these benefits. They wouldn't be able to collect.
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.
IRS. "Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs." Accessed Sept 1, 2020.
IRS. "2019 Instructions for Form 8995." Page 1. Accessed Sept 1, 2020.
NYS Society of CPAs. "A Primer on Qualified Business Income under IRC Section 199A." Accessed Sept 1, 2020.
IRS. "Frequently Asked Questions/Individuals 2." Accessed Sept 1, 2020.
Social Security Administration. "Contribution and Benefit Base." Accessed Sept 1, 2020.
IRS. "Self-Employment Tax (Social Security and Medicare Taxes)." Accessed Sept 1, 2020.
Tax Foundation. "State Individual Income Tax Rates and Brackets for 2020." Accessed Sept 1, 2020.