The Tax Treatment of Self-Employment Income

Taxes—and Tax Breaks—That Apply to Self-Employment Income

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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 might 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.

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."

Note

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 expenses for:

  • Advertising
  • Office supplies
  • Equipment
  • Home office costs
  • Transportation costs

The net amount of self-employed income after all of these allowable deductions are made is subject to federal, state, and sometimes local taxes.

The Qualified Business Income Deduction

The TCJA gave self-employed taxpayers a gift in 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.

Note

Pass-through businesses are those where profits and losses are reported, and taxes are paid, on the owners' personal tax returns. The businesses themselves don'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. For tax year 2021, these limits are $329,800 for those married and filing a joint return, $164,900 if single, or $164,925 if married and filing separately. The percentage begins to phase out for incomes above these thresholds until it reduces to zero.

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 whether you qualify. You most likely do if you have a pass-through business, however, and if you 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 incomes, with one major difference. An employer withholds taxes from an employee's pay and sends it to the IRS on the employee's behalf, but federal income tax is not deducted automatically from the fees and other 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 usually 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'll owe on what you earned during that period.

Important

Residents and business owners in Louisiana and parts of Mississippi, New York, and New Jersey were granted extensions on their deadlines for filings and payments to the IRS due to Hurricane Ida. Due to the tornado in December 2021, taxpayers in parts of Kentucky were also granted extensions. You can consult IRS disaster relief announcements to determine your eligibility.

The Self-Employment Tax

The self-employment tax comprises Medicare and Social Security taxes. Employed workers pay half of their Social Security and Medicare taxes, and their employers pay the other half, 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 $142,800 in 2021, increasing to $147,000 in 2022. 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.

Tip

Self-employed taxpayers can claim an above-the-line adjustment to income for what would otherwise be the employer's portion of these taxes. The self-employment tax and the deductions for the employer portion are calculated on Schedule SE.

If You're Both an Employee and Self-Employed

Some self-employed persons also work as employees. Your total Social Security tax on both sources of income can be coordinated using Schedule SE in this situation, the form you would 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.

Tip

You can adjust withholding on your wage income to have more taxes taken out in lieu of sending 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 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 2021, 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 as a taxpayer earns more in those jurisdictions. Still other states have no income tax at all. New Hampshire taxes only interest and dividend income, not earned income.

States without an income tax include Alaska, Washington, South Dakota, Wyoming, Nevada, Texas, Florida, and Tennessee as of 2021.

Some cities and localities throughout the nation impose their own income taxes. New York City is perhaps the most famous city with an income tax.

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

City and county governments can impose business taxes on self-employed individuals, often by requiring a city business license or city payroll taxes. New York City imposes an unincorporated business tax on those who are self-employed.

Federal and State Payroll Taxes

Self-employed persons get a bit of a break here. 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. Business owners could be out of luck if they were to find themselves out of work or disabled, however, because they haven't been paying into these benefits. They wouldn't be able to collect, though some people may have become eligible due to the passage of the CARES Act in 2020 and the American Rescue Plan in 2021.

Key Takeaways

  • Self-employed taxpayers can refer to their profit and loss statements when paying income tax, as they are taxed on net income.
  • Pass-through businesses may be able to deduct an extra 20% through the qualified business income deduction.
  • Self-employed taxpayers are responsible for making quarterly filings to the IRS to report estimated taxes.
  • Social Security and Medicare taxes are normally split between employees and employers, but many self-employed taxpayers must pay both.
  • At the state and local levels, business income may be taxed differently, depending on the state and municipality of operation.


Frequently Asked Questions (FAQs)

What qualifies as self-employment income?

The IRS defines self-employment as operating a trade or business as a sole proprietor or an independent contractor, or being in a partnership of such a business, or if you are otherwise in business for yourself, whether full- or part-time.

Can I deduct my self-employment tax?

In most cases you can deduct a portion of self-employment tax as a business expense. On Form 1040 in the line for adjustments to income, you can claim up to 50% of what you've paid in self-employment taxes as an income tax deduction.

Do I have to file an income tax return if I didn't make any money in my self-employment business?

If your self-employment earnings were less than $400 you do not have to file. However, this is only true if you had no other source of income. The IRS taxes your income in the aggregate, from all sources. Also, even if you are not required to file, it may be in your best interest to file income taxes in years that your business lost money, as this may qualify you for certain credits or future deductions.