There are several big advantages to living the self-employed life. You don’t have anyone to answer to, you can set your own hours, and you control your own career destiny in ways most traditional wage earners never dream of. However, self-employment isn’t all a bed of roses.
One aspect of self-employment that isn’t talked about enough is the heavy burden of self-employment taxes. All self-employed individuals in the United States — including limited liability company (LLC) owners — are subject to this 15.3% tax rate. What is self-employment tax, and where does this money go?
In this article, we’ll discuss what goes into the self-employment tax and who has to pay it. Let’s dive into all the details you need to know about this important tax.
What Is Self-Employment Tax?
Self-employment tax is the combination of an employer and employee’s shares of Medicare and Social Security taxes. Typical wage earners only pay the employee share, but because a self-employed person does not have an employer, they are on the hook for the entirety of these taxes.
The tax breaks down as follows: 12.4% for Social Security, and 2.9% for Medicare. It’s important to note that taxpayers only need to pay the Social Security portion of this tax for the first $147,000 of “combined wages, tips, and net earnings” they earn in a year. However, all income is subject to the Medicare portion of this tax.
Who Needs to Pay Self-Employment Tax?
In general, everyone who fills out a Form 1040 with the Internal Revenue Service in any given year is subject to self-employment tax, as long as they earned $400 or more through their self-employment ventures. In addition, church employees who bring in at least $108.28 will need to pay this tax as well.
All business owners in companies that use pass-through taxation models — including sole proprietorships, general partnerships, and most LLCs — are required to pay self-employment tax. The only exception to this rule is for LLCs categorized as S corporations for tax purposes. In this situation, the LLC’s owners only need to pay self-employment taxes on the salary they pay themselves, while the rest of the LLC’s income is exempt.
One advantage of the corporation over the LLC is the fact that corporations typically do not have to pay self-employment tax. However, the most popular form of corporation (the C corp) has a “double taxation” requirement that often exceeds the tax burden of self-employment tax.
With double taxation, the business income is taxed first at the 21% corporate rate, and that same income is taxed again on the individual level when paid out as dividends. For most small business owners, this ends up being more expensive than paying self-employment taxes through the LLC’s pass-through model.
To learn more about the differences between the LLC and the corporation, take a look at our comprehensive comparison guide. In addition, you can find further information regarding the taxation options of an LLC in our article on that topic.
How Should Self-Employment Taxes Be Paid?
To be able to pay your self-employment taxes, you will need to have either a Social Security Number or an Employer Identification Number (EIN), also known as a federal tax ID number. Regarding when you should pay your self-employment taxes, the vast majority of self-employed individuals need to pay estimated taxes on their business income, so this is the preferred way to pay your self-employment taxes as well.
When and how can you make estimated tax payments? Estimated taxes are due four times a year, typically on the 15th day (unless that day is a weekend or federal holiday) of the following months:
- 1st quarter – April 15
- 2nd quarter – June 15
- 3rd quarter – September 15
- 4th quarter – January 15
One unusual wrinkle about self-employment tax due dates is that the second “quarter” is only two months long, whereas the fourth “quarter” lasts for four months. To be honest, we have tried for years to get an answer regarding why the IRS sets up the due dates in such an uneven fashion, but to this point we have still never figured it out.
We’ve heard all kinds of horror stories from entrepreneurs who didn’t understand how self-employment taxes work, and those stories often end with a rude awakening when tax season rolls around. If you fail to plan ahead for the impact of self-employment taxes on your overall tax bill, you could end up owing thousands more dollars than you expect.
Overall, self-employment tax is something you need to carefully consider when planning out any business venture. Depending on your financial situation, it could be worth forming a corporation instead of an LLC to avoid self-employment tax — although this option comes with its own tax issues that can make it counterintuitive.
We hope this article helped you develop your understanding of self-employment taxes! If you have any further questions on this topic, consulting with an attorney or accountant should be your next move.