Self-Employment Tax Basics
If you own an unincorporated business, you likely pay at least three different federal taxes. In addition to federal income taxes, you must pay Social Security and Medicare taxes, also called the self-employment tax.
Self-employment taxes are not insubstantial. Indeed, many business owners pay more in self-employment taxes than in income tax. The self-employment tax consists of
- a 12.4 percent Social Security tax up to an annual income ceiling ($147,000 for 2022) and
- a 2.9 percent Medicare tax on all self-employment income.
These amount to a 15.3 percent tax, up to the $147,000 Social Security tax ceiling. If your self-employment income is more than $200,000 if you’re single or $250,000 if you’re married filing jointly, you must pay a 0.9 percent additional Medicare tax on self-employment income over the applicable threshold for a total 3.8 percent Medicare tax.
You pay the self-employment tax if you earn income from a business you own as a sole proprietor or single-member LLC, or co-own as a general partner in a partnership, an LLC member, or a partner in any other business entity taxed as a partnership. (There is an exemption for limited partners.)
You don’t pay self-employment tax on personal investment income or hobby income. For example, you don’t pay self-employment tax on profits you earn from selling stock, your home, or an occasional item on eBay.
The tax code bases your self-employment tax on 92.35 percent of your net business income.
That means your business deductions are doubly valuable since they reduce both income and self-employment taxes. In contrast, personal itemized deductions and “above-the-line” adjustments to income don’t decrease your self-employment tax.
Some types of income are not subject to self-employment tax at all, including
- most rental income,
- most dividend and interest income,
- gain or loss from sales and dispositions of business property, and
- S corporation distributions to shareholders.
You calculate your self-employment taxes on IRS Form SE and pay them with your income taxes, including your quarterly estimated taxes.
Self-Employment Taxes for Partners and LLC Members
Here’s a question: Does a member of a limited liability company (LLC) or a partner in a partnership have to pay self-employment taxes on the member’s or partner’s share of the entity’s income?
Incredibly, the answer is not always clear.
If you are a general partner in a general partnership, you must pay self-employment tax on your entire distributive share of the ordinary income earned from the partnership’s business. General partners also must pay self-employment tax on any guaranteed payments for services rendered to the partnership.
Partnerships generally are not required to pay guaranteed payments to the partners. Guaranteed payments are like employee salaries; the partnership pays them without considering the partnership’s income. They are often incorrectly called “partner salaries.”
If you’re a limited partner in a limited partnership, you don’t pay self-employment tax on your share of the partnership’s profits. But you do pay self-employment tax on any guaranteed payments you receive.
That’s all well and good. But what about LLCs? They are the most popular business entity in the U.S. today, with an estimated count of 21 million. It is not always clear when LLC members (owners) pay self-employment tax.
LLCs are state law entities not recognized for federal tax purposes. In other words, they are always taxed as something else. The tax code taxes the single-member LLCs as a sole proprietorship unless the owner elects taxation as a corporation (which is rare). Thus, owners of single-member LLCs file Schedule C and pay self-employment tax on their net profit. It couldn’t be simpler.
LLCs with multiple members are treated as partnerships for tax purposes unless they elect taxation as a corporation. If a multi-member LLC is taxed as a partnership, should its members be treated as general or limited partners?
Under proposed IRS regulations:
- Members of member-managed LLCs cannot be treated as limited partners and must pay self-employment tax.
- Members of manager-managed LLCs can qualify as limited partners, provided they work no more than 500 hours per year in the LLC business.
- Members of service LLCs engaged in health, law, engineering, architecture, accounting, actuarial science, or consulting must be classified as general partners.
Fortunately, you don’t have to follow the proposed regulations. The IRS has not finalized them and says it won’t enforce them. You can look at U.S. Tax Court rulings instead. The leading case says an LLC owner may be treated as a limited partner only if he is a passive investor who does not actively participate in the LLC business.
If you have questions about self-employment taxes, let us know. We would love to help you navigate through these waters.