Self-Employment Tax Considerations

Tax tips when you’re self-employed

Perhaps you are considering starting your own business or working for yourself in today’s fluctuating economy and remote work environment. Before deciding to embark on such an undertaking, you should understand that being self-employed, as compared to being treated as an employee, comes with its own set of advantages and disadvantages from a tax perspective.

Tax disadvantages to self-employment

Payroll taxes enacted under the Federal Insurance Contributions Act (FICA) include a 12.4% Social Security tax and a 2.9% Medicare tax. Additionally, there is a 0.9% additional Medicare Tax assessed on earnings over $200,000. Wages/earnings subject to Social Security taxes are capped at an annual amount each year, adjusted for inflation ($147,000 in 2022), while the Medicare tax has no wage limits. Half of the FICA taxes owed are due from the employee and the other half are due from the employer. As an employee, you can expect about 7.65% of each paycheck to be withheld for FICA taxes. Since self-employed individuals are considered to be both the employee and the employer, these individuals must be prepared to pay FICA taxes of up to 15.3% of net earnings. And remember, this tax is in addition to federal and state income taxes on net earnings. As such, self-employed individuals in the highest tax brackets should expect to have up to 50-60% of their net earnings set aside for taxes.

Self-employed individuals in the highest tax brackets should expect to have up to 50-60% of their net earnings set aside for taxes.

Employer paid FICA tax is not the only employer provided benefit that one should consider before deciding to take the leap into the self-employed world.  The following benefits commonly offered by employers would need to be individually funded once making the move from employee to self-employed:

• Health Insurance: Employers are typically able to offer lower premiums to employees by being a part of a large group plan. Additionally, employers often subsidize the cost of premiums as an added employee benefit. As a self-employed individual, health insurance premium costs could be substantial, and you could spend considerable time shopping plans to make sure it meets your family’s needs.
• Disability/Life Insurance: Like health insurance, employers can typically offer plans with low-cost premiums for both short-term and long-term disability coverage by being part of a large group plan. Such premiums under a single individual plan could be substantial.
• Gym memberships: To encourage fitness and overall healthier lifestyles, many employers subsidize the cost of gym-memberships or contribute to employee’s Health Savings Accounts for meeting certain fitness goals. As a self-employed individual, these would all be out of pocket costs and would not be tax deductible unless considered ordinary and necessary for business operations.
• Continuing Professional Education (CPE): The cost of continuing education as well as licensing fees are typically covered by employers but are out of pocket costs for self-employed individuals. However, these costs are typically deductible for self-employed individuals.
• Home Office/Technology: Expenditures for getting a home office up and running and keeping on-going IT support/resources should be considered as well.
• Estimated Tax Payments: Since federal and state taxes are not being withheld from wages by your employer, you must be more disciplined to set aside the requisite amount of cash needed to pay taxes each quarter. Additionally, you will need to monitor your income and expenses throughout the year to determine the proper amounts to pay each quarter.

Tax advantages to self-employment

There are several tax advantages for self-employed individuals not available for employees:

• Retirement plans: As a self-employed individual, one can often contribute much higher amounts to retirement plans than under employer sponsored plans. Self-employed individuals may be eligible to contribute up to $61,000 to a retirement plan such as a Simplified Employee Pension (SEP), Solo 401(k) plan, SIMPLE IRA, or Keogh profit-sharing plan (maximum contribution amounts adjusted yearly for inflation). Contributions to retirement plans are fully deductible regardless of whether you take the standard deduction or itemize.
• Home Office: Self-employed individuals who use part of one’s primary residence as a principal place of business or a place to meet with clients can deduct a portion of their mortgage interest, real estate taxes, and maintenance costs against their self-employment income.
• Business mileage: When commuting to and from one’s home office to various work locations, self-employed individuals can take a standard mileage rate deduction (62.5 cents/mile after July 1, 2022, up from 58.5 cents/mile for the half of the year due to increased fuel prices nationwide).
• Health Insurance: While premiums payments could be more substantial for the self-employed, they are fully deductible for plans covering the taxpayer, taxpayer’s spouse, and dependents, regardless of whether the taxpayer takes the standard deduction or itemizes.
• Other business expenses: Since the Tax Cuts & Jobs Act in 2017 was enacted, employees have not been able to take certain deductions for unreimbursed employee business expenses such as travel, CPE costs, business gifts, and auto mileage to name a few. Prior to 2017, these expenses were typically allowed to the extent they exceeded 2% of Adjusted Gross Income (AGI), but after TCJA, the deduction was eliminated completely. However, a self-employed individual can claim all such expenses in arriving at AGI (the extent they are ordinary and necessary business expenses)
• Qualified Business Income Deduction (QBI): For self-employed taxpayers who qualify, a deduction of up to 20% of the net business earnings is allowed as a deduction against the taxpayer’s ordinary income.

When considering becoming a self-employed individual, one must take into consideration the potential for additional taxes as well as the loss of certain employer paid benefits typically enjoyed by employees. However, in some cases, the combination of the enhanced retirement plan deduction, the QBI deduction, and the deduction for employee business expenses can mitigate the cost of the additional taxes and losing employer sponsored benefits.

A final word of caution: It is not elective as to whether you are considered an employee or self-employed individual (i.e. independent contractor). Rather, your worker classification is determined by your facts and circumstances. Worker classification is a hot topic with the IRS so correctly identifying your status is very important. Learn more about worker classification: Worker Classification 101: employee or independent contractor | Internal Revenue Service (irs.gov)

Questions on self-employment taxes for your unique business situation? Contact your Keiter Opportunity Advisor.