How to Plan for and Minimize the Self-Employment Tax
The Self-Employment Tax is how an independent contractor pays Social Security and Medicare payroll taxes. In the case of an employee, the employer and employee split the cost of Social Security and Medicare taxes, each paying 7.65 percent of eligible wages. An independent contractor, by contrast, is both the employer and the employee, so a self-employed person pays both halves, or 15.3 percent total.
The 15.3 percent self-employment tax is composed of a 12.4 percent Social Security tax on the first $127,200 of net self-employment income for the year 2017, and a Medicare tax of 2.9 percent on all net self-employment income. The $127,200 amount is called the "Social Security wage base" and represents the maximum amount of income from wages and net self-employment income subject to the Social Security tax. For Social Security wage limits for other years, see the article Overview of Social Security Taxes.
Net self-employment income consists of income from self-employed business activities (Schedule C), farming (Schedule F), the self-employed earnings of a partner (Schedule E), and clergy and employees of churches and religious organizations. The amount is income after deducting business expenses, such as furniture, building repairs and purchased inventory.
Then you adjust the amount by multiplying it times 92.35 percent. This 92.35 percent factor takes into account that part of the Social Security and Medicare taxes are a deductible business expense. Employers are permitted to deduct the employer’s portion of the Social Security and Medicare taxes (7.65 percent). You come to 92.35 percent by subtracting 7.65 percent from 100 percent resulting in 92.35 percent.
This reduction in the base amount subject to the self-employment tax, along with the above-the-line deduction for the employer-portion of the self-employment tax, helps equalize the tax treatment between self-employed persons and employees.
Strategies to Reduce the Self-Employment Tax
The self-employment tax is basically a percentage of your net income from self-employment activities. The only way to reduce your self-employment tax is to increase your business-related expenses, as this will reduce your net income, and correspondingly reduce your self-employment tax. Regular deductions, such as the standard deduction or itemized deductions, won't reduce your self-employment tax.
Similarly, above-the-line deductions for health insurance, SEP-IRA contributions, or solo 401(k) contributions will not reduce your self-employment tax either; those deductions only reduce the federal income tax. One tactic to examine when preparing your tax return: the impact of taking the Section 179 deduction or bonus depreciation for fixed assets. This will impact both the income tax and the self-employment tax.
Increase the Self-Employment Tax During Years With Losses or Low Income
Sometimes a person wants to increase their self-employment tax to maintain their eligibility for Social Security retirement or disability benefits. In general, people need at least forty Social Security credits over their lifetime to be eligible for retirement benefits, and at least five years of credits out of ten to be eligible for disability benefits.
Self-employed people who are facing a year in which they have lost money (expenses greater than income) or years in which their income is vastly lower, and who still want to build up Social Security credits towards their retirement or disability benefits, can use a special method to increase their self-employment tax. This is called the "Optional Method" and the rules are spelled out in the Instructions for Schedule SE.
What's important to remember is this: self-employed persons who are not farmers or fisherman are limited to using this optional method only five times in their lifetime.