Individuals whose businesses are incorporated do not have to think about self-employment tax. Any salary they take from their corporations as owner-employees are subject to FICA taxes. In contrast, those with other types of business entities—sole proprietorships, partnerships, and limited liability companies (LLCs)—are not employees; they are self-employed individuals. As such they meet their Social Security and Medicare taxes obligation through the payment of self-employment tax.
Self-employed individuals pay what amounts to the employer and employee share of FICA tax; the employer share is deductible. In other words, they pay 15.3% (comprised of 12.5% for Social Security tax and 2.9% for Medicare tax). The self-employment tax is applied to net earnings from self-employment, although only net earnings up to an annual threshold ($118, 500 for 2016; $127, 200 for 2017) are taken into account for the Social Security tax portion. In basic terms, net earnings from self-employment are income minus expenses. It sounds simple enough, but there are some ins and outs that may impact your payments.
$400 threshold
While FICA taxes apply to the first dollar of wages paid to an employee, there is no self-employment tax due if net earnings from self-employment are less than $400.00. So a self-employed individual with only losses for the year, or someone with a modest sideline business, may be below the threshold for self-employment tax.
However, if net earnings are $400.00 or more, then the tax applies to all net earnings. There’s no exemption for this amount.
Optional payments
Self-employed individuals who have modest earnings may want to voluntarily pay self-employment tax. The reason: This enables such individuals to earn Social Security credits, which translate into higher benefits in retirement.
There are two optional methods for figuring earnings: one for farmers and one for all other self-employed individuals (nonfarm optional method). The farm optional method applies for 2016 returns if gross farm income was not more than $7, 560 or net farm profits were less than $5, 457. The nonfarm optional method can be used if net nonfarm profits were less than $5, 457 and also less than 72.189% of gross nonfarm income but you had net earnings from self-employment of at least $400 in two of the prior three years. The nonfarm income optional method cannot be used more than five times by a self-employed individual
Determining self-employment income
In most cases, it’s easy to know what is or is not self-employment income for purposes of the self-employment tax. But there continues to be confusion about certain types of payments. Here are some recent matters concerning this issue:
- Payments for past performance. A former employee received a payment resulting from 34 years of services for a company. The IRS said it is subject to self-employment tax because there is a nexus between the income received and a trade or business. A court said the same thing for retirement payments made to a former Mary Kay sales person.
- Separate lines of work. A plastic surgeon who conducted his medical practice through a single-member professional limited liability company (PLLC) also had a minority interest in a limited liability company that ran a surgery center. The Tax Court said that his earnings from the surgery center were not subject to self-employment tax because he was a mere investor here; the activities did not have to be grouped as a single activity. He did not manage the center or have any day-to-day responsibilities there.
It should be noted that the IRS has yet to issue regulations explaining the extent to which a member’s distributive share from an LLC is subject to self-employment tax. This issue is on the IRS’s Priority Guidance Plan for 2016-2017.
Final thoughts
Self-employment tax must be taken into account in figuring estimated tax payments, and the first estimated tax payment for 2017 is due by April 18, 2017. Self-employed individuals should work with a tax professional to make sure this tax obligation is being handled properly.
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