Small business people, entrepreneurs, and independent contractors should know before they start that they will probably have to pay self-employment taxes on their net income. But just in case you hadn’t heard the news, you have to pay self-employment taxes on your net income! So what is self-employment tax anyway?
First, it is not income tax, it is in addition to income tax. It is FICA and Medicare taxes on your net earnings from your small business. However it’s different from the FICA and Medicare taxes you may have noticed being withheld from your paycheck because you are paying both the employee and the employer share of FICA and Medicare taxes.
How It Works
Here’s how the tax works:
- FICA employer and employee portions of 12.4% (6.2% + 6.2%) up to the FICA income limit ($113,700 in 2013).
- Medicare employer and employee portions of 2.9% (1.45% + 1.45%)
- Total self-employment tax rate is 15.3% on the net income of your business (generally Schedule C income or certain types of partnership income) multiplied by 92.35%.
You get a deduction for half of the calculated self-employment tax for the year, just as you would if you were an employer paying your share of your employees’ FICA and Medicare taxes.
Here’s an example. Carl is a master mechanic who now makes sculptures from old car parts. His business, Carl’s Crankshaft Creations, made a profit last year of $45,000. Carl will have self-employment tax of $6,358 ($45,000 X .9235 X 15.3% = $6,358) on those earnings, plus income tax of $4,008.
Unfortunately Carl did not plan for these taxes and he is shocked that he owes so much money. Last year, when he worked as an employee at the Chrysler dealership and made only $32,000, he always had a refund. He was planning to spend this year’s refund on a new set of tires for his truck. His life is ruined!
Carl has forgotten that he owes self-employment tax, as well as income tax, on his business income. When he was an employee, the Chrysler dealership withheld FICA, Medicare and income taxes from his $32,000 paycheck. Carl was not taking home $32,000. He was paying taxes every time he got paid, and he actually paid more than he needed to, hence the big refund.
Carl was very upset about his taxes, and has vowed that this will never happen again. But how can he avoid the same problem next year?
- File and pay this year’s taxes as soon as you can. If you have to stretch out the payments, there are options that the IRS and the states will accept. The worst option is to not file or not attempt to pay your taxes. Taxes do not go away if you do not file a return, they just linger and grow with interest and penalties on the unpaid balance. It’s best to face up to your taxes and just get them paid off.
Carl had been saving some money for a business trip, so he used that money to make a big dent in his taxes with the first payment. He paid the rest of the tax balance within two months of filing his tax return. He didn’t get to go to the American Association for Appreciation of Automobile Aesthetics Convention in Arizona, but at least he doesn’t have that old balance hanging over his head.
- Set up a personal withholding account which is separate from your business or personal checking account. Make monthly deposits equal to 14% plus your effective income tax rate on the net income from your business each month (usually 20-30 percent). Make your quarterly payments from this account, and resist the temptation to tap if for other purposes if at all possible!
Carl set up a savings account and began funding it every week from April 15th on. Money was tight because he was also trying to pay off his last year’s taxes at the same time, but once that was done with that, it was pretty easy. He paid his first quarterly payment for the current year in May, which was late, but was able to make the rest of the quarterly payments on time.
- Plan your business income for this year and take action as appropriate to get to your target business income. Consider setting up a small business retirement fund (a 401K or SEP) as a strategy for lowering your income taxes. If your business is very profitable consider converting it to an S-Corporation and paying yourself through payroll, so you have no self-employment income and you can withhold taxes through the company. Monitor your business and other income throughout the year to ensure the amount you’re paying in quarterly is sufficient.
Carl consulted with an accountant to consider options for his business. He decided he was not yet ready to become an S-Corporation, but he settled on a target income for his business and set up a simple budget to keep his spending in line with the target. His accountant prepared financial statements for Carl each quarter to review actual results versus the target. When the accountant prepared Carl’s tax return for this year, he had already paid most of the balance through quarterly payments, so the balance due was minor.
Planning Is Better Than Surprising
Carl sounds a little like that goody-two-shoes kid you wanted to beat up in third grade because he’s so perfect. We don’t always live in the same world as Carl, and unexpected expenses or downturns in your cash flow do happen from time to time. The point is that you’re probably going to have to pay taxes, whether they are paid today, next year, or over the next 5 years. It’s best to just plan on it now and just do it. If you want to feel better, just remember that if you have to pay taxes, that means you’re profitable, which is a good thing.