As a self-employed individual or partner in a business, you may not understand self-employment (SE) tax, how it’s calculated, or how it affects you.
As an employee SE tax doesn’t affect you at all. While you can stop reading at this point, I suggest you continue in case 1) you plan on starting your own business, 2) become partner, or 3) want to understand the tax consequences of your boss (assuming (s)he’s a sole proprietor or partnership).
When an employee gets a paycheck they are required to have Social Security (6.2%) and Medicare (1.45%) taxes withheld. This amount is held by the employer and deposited with the IRS either immediately or on a monthly basis, depending on certain factors. When this amount is deposited with the IRS, the employer is required to match this amount (7.65%) for a total of 15.3%. (There are limits on the amount withheld and matched for Social Security but we won’t get to that here.)
As a self-employed individual you are considered both employee and employer. And while you don’t receive a “paycheck” per se, you are still responsible for contributing to Social Security and Medicare. This is done via the SE tax calculated on your tax return each year and paid along with your quarterly estimated payments. Another way to look at it is your business profit is your salary and you, the employEE, have Social Security and Medicare tax withheld. Then you, the employER, match it.
What really gets people is if they have enough other losses or deductions to reduce their taxable income to $0 but still have a balance due. Wait. What? That’s possible? Yes it is. Let’s say you have $50,000 of business profit either from a Schedule C business or a partnership. You also have a $15,000 loss from a rental property and itemized deductions – R/E taxes, mortgage interest, charitable contributions – totaling $25,000. A family of 4, for 2014, will have an exemption amount of $15,800 ($3,950 x 4). Just like that your taxable income is $0 ($50,000-$15,000-$25,000-$15,800). But the return is showing a balance due of $7,064! The $50k is still subject to SE tax to cover Social Security and Medicare taxes. If that $50k was on line 7 as Salaries and wages, your portion of the Social Security and Medicare taxes would have already been withheld and matched by your employer. In this care you are both.
“OK, that’s fair. But your math is off, $50,000 x 15.3% = $7,650, $600 more than what you show above.” That is absolutely correct. Let me show you how. Typically the matching portion of employment taxes submitted by an employer is a deduction on their return. This is no different on a self-employed individual’s return, it’s just calculated differently. First the profit, $50,000 in this example, is multiplied by 92.35% (100% – 7.65%) then that result is multiplied by the 15.3% to calculate your SE tax thus giving you a “deduction” for the employer matching portion.