The Tax Treatment of Self-Employment Income
Taxes—and Tax Breaks—That Apply to Self-Employment Income
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 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.
Self-Employed Tax Breaks
First, let's look at the bright side. Self-employed persons are taxed on their net self-employment income—what's left over after they deduct their qualifying business expenses on Schedule C. 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. But these work-related deductions have been eliminated by the Tax Cuts and Jobs Act (TCJA), at least from 2018 through the 2025 tax year.
Various business expenses that can be deducted directly against income by self-employed taxpayers 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.
The New Pass-Through Tax Deduction
The TCJA gave self-employed taxpayers another big gift effective 2018—the pass-through tax deduction. This deduction allows owners of pass-through businesses to shave an additional 20% off their taxable profits after whittling away their gross incomes by deducting business expenses to arrive at their net incomes.
Pass-through businesses are those where profits and losses are reported on owners' personal tax returns. The business itself does not pay any taxes of its own. 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: $321,400 if you're married and filing a joint return, or $160,725 if you're single as of 2019. The percentage begins phasing out over these thresholds and different rules can apply.
The process and rules for calculations of this deduction are particularly complex and the law is relatively new, so you might want to consult with a tax professional to find out for sure if you qualify. But if you have a pass-through business and earn less than these income thresholds, you most likely do.
You Must Make Estimated Tax Payments
Now for the not-so-great news. 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 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 must remit their tax payments using the estimated tax system. They must take an educated guess at what they expect to earn and calculate what their likely tax liability will be after all deductions. Then they must send quarterly payments to the Internal Revenue Service or face interest and penalties because the IRS prefers to be paid as you earn, not at the end of the tax year.
The Self-Employment Tax
The Medicare tax and the Social Security tax comprise the self-employment tax.
The Social Security tax is a flat tax of 12.4 percent of all types of compensation income up to a maximum $132.900 as of 2019. This $132.900 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 their employers, but a self-employed taxpayer must pay both halves.
The Medicare portion of the self-employment 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 by the employer of an employed worker. The other half, also 1.45 percent, is paid by the employee. Again, you must pay both halves if you're self-employed.
Self-employed taxpayers can claim an above-the-line adjustment to income for what would otherwise be the employer's portion of these taxes, however. 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. 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.
State, City and Local Taxes
State income tax rates also apply to net self-employment income. A few states have a flat tax rate where everyone pays this same rate regardless of how much they earn. All 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 2019.
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 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.