Taxes, Business

Understanding Self-Employment Tax: Who Needs to Pay and Why It Matters

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Arin Gregoryona, CPA

July 20, 2024

Navigating the world of taxes can be complex, especially when it comes to self-employment tax. Unlike traditional employees who have Social Security and Medicare taxes automatically deducted from their paychecks, self-employed individuals must handle these taxes on their own. Here’s a clear breakdown of who needs to pay self-employment tax, who is exempt, and why understanding this is crucial for your financial health.

What is Self-Employment Tax?

Self-employment tax is governed by the Self-Employment Contributions Act (SECA). It applies to individuals who earn income directly from their business activities, rather than as employees. This tax encompasses Social Security and Medicare contributions, which self-employed individuals must pay in full, unlike employees who split these contributions with their employers.

For the year 2024, the self-employment tax rate is 15.3%. This includes 12.4% for Social Security on the first $168,600 of net earnings and 2.9% for Medicare on all net earnings. Additionally, an extra 0.9% Medicare tax applies to those with self-employment income exceeding $250,000 for married couples filing jointly, $125,000 for married individuals filing separately, and $200,000 for all others.

Who Must Pay Self-Employment Tax?

Here are the primary groups required to pay self-employment tax:

  • Sole Proprietors and Independent Contractors: Those running their own businesses or providing services as independent contractors must pay self-employment tax if their net earnings exceed $400 in a tax year.
  • Partners in a Partnership: Members of a partnership engaged in a trade or business must pay self-employment tax on their share of the partnership’s income.
  • Members of a Limited Liability Company (LLC): Depending on how the LLC is classified for tax purposes, members may need to pay self-employment tax on their share of the LLC’s profits.
  • Clerics: Clerics must pay self-employment tax on income from ministerial services unless they have taken a vow of poverty. This includes:
    • W-2 Income: Income from a church, which is subject to income tax and self-employment tax.
    • Self-Employment Income: Income from non-church activities, such as weddings or funerals, is subject to self-employment tax.
    • Schedule C: Clerics use this IRS form to report self-employment income, which can be offset by related expenses.
    • Housing Allowance: Income received as a housing (parsonage) allowance is subject to self-employment tax, even if not subject to income tax.

Who is Exempt from Paying Self-Employment Tax?

Not everyone has to pay self-employment tax. The following are typically exempt:

  • Employees: Individuals receiving a W-2 from their employer are not subject to self-employment tax as their employers handle Social Security and Medicare tax withholding.
  • Rental Income: Generally, rental income is not subject to self-employment tax unless the rental activity involves significant services provided to tenants.
  • Limited Partners: Limited partners in a partnership are usually exempt from self-employment tax on certain income distributions due to their passive involvement.
  • Corporation Owners: Shareholders of corporations, including S corporations, are not subject to self-employment tax on their share of corporate profits but must receive reasonable compensation that is subject to FICA taxes.
  • Probate Commissions: Fees granted to nonprofessional fiduciaries by probate courts are typically not considered self-employment earnings unless they involve extensive business management.
  • Termination Payments for Insurance Salespeople: Payments received by former insurance salespeople for past services are not considered self-employment income under specific conditions.
  • Religious Exemptions: Ministers, Christian Science practitioners, and certain religious order members who have taken a vow of poverty may be exempt from self-employment tax, provided they file Form 4361 with the IRS.
  • Notary Public Fees: Fees for notary public services are exempt from self-employment tax.
  • Nonresident Aliens: Nonresident aliens engaged in U.S. trade or business may be subject to self-employment tax, with specific treaty exemptions.
  • Occasional Income: Income from occasional acts or transactions, without a regular pattern, is not subject to self-employment tax. For instance, managing an estate casually for a relative is not considered self-employment.

Special Situations

  • Self-Employment Tax Deduction: Self-employed individuals can deduct half of their self-employment tax when calculating their adjusted gross income. This helps offset the burden of paying both the employer and employee portions of Social Security and Medicare taxes.
  • Optional Methods: There are special methods for farmers and nonfarmers with low net self-employment earnings, allowing them to maintain Social Security coverage credits even in years of low or no profit. These methods can also affect eligibility for certain credits.

Understanding and managing self-employment tax is essential for anyone earning income outside traditional employment. If you have questions about how self-employment tax applies to your situation, or need assistance with tax planning, don’t hesitate to contact us for personalized guidance.

Arin Gregoryona, CPA

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