Sole Proprietor Guide To Self-Employment Taxes
By Terri M. Blair
Most small businesses start out as sole proprietorships – single owners of a company with no employees. They know that they’re required to pay federal income taxes on their profits. But what comes as a big surprise is the self-employment taxes they must pay on their earnings.
Self-employment taxes are similar to the FICA (Federal Insurance Contributions Act) taxes that employees pay on their wages from an employer. These taxes include Social Security and Medicare.
But self-employment taxes take a much bigger chunk of your earnings as a sole proprietor. That’s because you’re responsible for paying the whole share of the tax. When you were an employee, your employer paid half of the tax.
So get ready for sticker shock when it’s time to pay your self-employment taxes. Prepare yourself by understanding who pays, when and how. Follow this guide.
Who Pays Self-Employment Taxes
For 2004, any sole proprietor who earns $400 or more in net profit in a year must pay self-employment taxes.
This includes:
Independent contractors and consultants Part-time sole proprietors who are also employees of another company Retirees who are receiving Social Security and also operating a sole proprietorship
As long as your business isn’t incorporated, it’s likely that your net business profit will be subject to self-employment taxes. There’s simply no escape.
The Self-Employment Tax Rate
The self-employment tax rate is 15.3 percent of your net income. The tax is broken down as follows:
However, there is an earnings limit that applies to Social Security. The earnings limit is adjusted each year for inflation. For 2004, the limit for sole proprietors is $87,900. That means that only the first $87,900 of your net business profits is subject to the 12.4 percent Social Security tax.
No such luck on the Medicare tax. Regardless of how much net profit you earn, all of it is subject to the 2.9 percent Medicare tax.
Calculating Self-Employment Taxes
Use IRS Schedule SE to calculate and report your self-employment taxes. File this schedule with Schedule C or C-EZ, whichever you use to report your net earnings from self-employment.
If you operate more than one sole proprietorship, you must file a Schedule C or C-EZ for each separate business. But for payment of self-employment taxes, the net income from each business is combined and reported together on a single Schedule SE.
You may have a loss in one business that offsets your profit in another business. If so, the loss will help reduce your self-employment taxes.
For example, your first business shows a net profit of $20,000. But your second business suffers a loss of $2,000. When you complete Schedule SE, you will only pay self-employment taxes on your net profits of $18,000 (your $20,000 profit less your $2,000 loss).
If your business (or multiple businesses) shows a net loss, you won’t owe any self-employment taxes.
Self-Employment Tax Tip
Remember that the amount of self-employment tax you pay is based on your net profit. Your net profit is calculated by subtracting all of your legitimate business expenses from your revenue.
To reduce your self-employment tax, deduct every legal business expense on your Schedule C or C-EZ. Study the schedule to learn exactly what is and isn’t tax deductible for your type of business.
Get in the habit of filing receipts for business purchases. Develop a recordkeeping system that accounts for all of your expenditures. Every penny you can legitimately deduct will help take the bite out of your tax bill.
Get Expert Advice
You might be the best ever architect or graphic artist. But meeting your tax obligations requires a whole different set of skills and knowledge.
Don’t guess about your tax responsibilities. Get expert advice from a tax professional when questions arise. As an AFS Member, you can always tap the online services of the CPAs at ProTax. They’ll answer your tax questions via e-mail within one business day.
For More Information
To get more detailed information about your self-employment taxes, download these items from the IRS Web site at www.irs.gov:
Form 1040, Schedule SE, Self-Employment Tax Form 1040, Schedule C, Profit and Loss from Business IRS Publication 533, Self-Employment Tax IRS Publication 334, Tax Guide for Small Business
(Posted December 2004)
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