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.
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 expenses for:
- Office supplies
- Home office costs
- Transportation costs
The net amount of self-employed income after all 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.
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 2020, these limits were $326,600 for those married and filing a joint return, and $163,300 if single married filing and separately. The percentage begins to phase out for incomes above these thresholds until it reduces to zero.
These thresholds increase to $329,800 in the 2021 tax year if you're married and filing jointly, and to $164,900 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 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 this period.
You have until June 15 in 2021 to file your first-quarter estimated taxes if you live in Texas, Louisiana, or Oklahoma. This is a one-time extension provided by the IRS in response to the 2021 winter storms. Taxpayers in other locations still must file estimated taxes by April 15, even with the May 17, 2021 extension for filing 2020 tax returns.
The Self-Employment Tax
The self-employment tax comprises Medicare and Social Security taxes. Employed workers pay half the 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 $137,700 in 2020, increasing to $142,800 in 2021. 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. 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.
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 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 as a taxpayer earns more in these 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 taxes are imposed at the county level, such as in Indiana. Still, other local 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. 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. 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.
Some states do permit self-employed persons to voluntarily opt in to state insurance programs. They can collect unemployment benefits in the event they should suddenly find themselves out of work in these jurisdictions, if they pay into this type of program.