Self-employment tax is the pair of charges chapter 2 of the Internal Revenue Code imposes on an individual’s self-employment income, one for old-age, survivors, and disability insurance and one for hospital insurance, with a third charge added on top above a threshold. It is not a payroll tax, because nothing is withheld and no employer owes a matching share, and it is not income tax, because it is measured against self-employment income rather than against taxable income.
The Charges, and Their Rates
In addition to other taxes, there is imposed for each taxable year, on the self-employment income of every individual, a tax equal to 12.4 percent of the amount of the self-employment income for that year, for old-age, survivors, and disability insurance (26 U.S.C. 1401(a)). In addition to that tax, there is imposed for each taxable year, on the same self-employment income, a tax equal to 2.9 percent of it, for hospital insurance (26 U.S.C. 1401(b)(1)).
A third charge sits above both. In addition to the tax imposed by paragraph (1) and the preceding subsection, there is imposed on every taxpayer other than a corporation, estate, or trust, for each taxable year beginning after December 31, 2012, a tax equal to 0.9 percent of the self-employment income for that year which is in excess of $250,000 in the case of a joint return, one half of that amount in the case of a married taxpayer as defined in section 7703 filing a separate return, and $200,000 in any other case (26 U.S.C. 1401(b)(2)(A)). That charge is coordinated with wages rather than stacked on them, and how the threshold is shared between wages and self-employment income is set out in additional Medicare tax.
The hospital insurance side of this pair, and its counterpart on wages, are worked through in Medicare tax.
The Base Is Not the Business’s Profit
The tax is imposed on self-employment income, and that term is built in two steps from a third one. Neither step is the net profit a Schedule C produces.
Step one, net earnings from self-employment. The term means the gross income derived by an individual from any trade or business carried on by that individual, less the deductions allowed by this subtitle which are attributable to that trade or business, plus his distributive share, whether or not distributed, of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member, except that in computing that gross income and those deductions and that distributive share, a list of adjustments applies (26 U.S.C. 1402(a)).
That closing “except that” is not decoration. It introduces a numbered list of exclusions and substitutions that reshapes the figure, and two of them matter to almost every return. Rentals from real estate and from personal property leased with the real estate, together with the deductions attributable to them, are excluded, unless such rentals are received in the course of a trade or business as a real estate dealer. That exclusion then has an exception of its own, and the exception has two limbs that both have to hold: the preceding provisions of the paragraph do not apply to income derived by the owner or tenant of land if, first, the income is derived under an arrangement between the owner or tenant and another individual providing that the other individual shall produce agricultural or horticultural commodities on the land and that there shall be material participation by the owner or tenant in the production or the management of the production of those commodities, and second, there is material participation by the owner or tenant with respect to any such commodity, in each case determined without regard to any activities of an agent of the owner or tenant (26 U.S.C. 1402(a)(1)). So farm rental income can sit inside the base rather than outside it, and the distributive share of any item of income or loss of a limited partner, as such, is excluded, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent those payments are established to be in the nature of remuneration for those services (26 U.S.C. 1402(a)(13)).
The reduction that produces the familiar percentage. In lieu of the deduction provided by section 164(f), there is allowed a deduction equal to the product of the taxpayer’s net earnings from self-employment for the taxable year, determined without regard to that paragraph, and one half of the sum of the rates imposed by subsections (a) and (b) of section 1401 for that year, determined without regard to the rate imposed under paragraph (2) of section 1401(b) (26 U.S.C. 1402(a)(12)).
Read that formula against the rates above and the reason for the reduction becomes visible: it is half of the two ordinary rates combined, and the 0.9 percent charge is deliberately left out of the sum. The Code never prints the resulting percentage, and the form does. How the reduction is applied line by line on Schedule SE is set out in independent contractor.
Step two, self-employment income. The term means the net earnings from self-employment derived by an individual, other than a nonresident alien individual except as provided by an agreement under section 233 of the Social Security Act, during any taxable year, except that the term does not include two things (26 U.S.C. 1402(b)):
- The part above the wage base, and only for one of the two taxes. In the case of the tax imposed by section 1401(a), that part of the net earnings from self-employment which is in excess of an amount equal to the contribution and benefit base, as determined under section 230 of the Social Security Act, which is effective for the calendar year in which the taxable year begins, minus the amount of the wages paid to that individual during that taxable year (26 U.S.C. 1402(b)(1)).
- Anything under the floor. The net earnings from self-employment, if those net earnings for the taxable year are less than $400.
Two things in the first bullet are routinely lost. It is written only for the section 1401(a) tax, so the 2.9 percent hospital insurance charge has no cap at all. And the cap is a subtraction, not a ceiling: wages already paid to the individual in the year consume the base first, which is why a person with a job and a side business does not get a second full base.
Trade or Business Means Something Narrower Here
The chapter borrows the phrase and then cuts it. The term trade or business, when used with reference to self-employment income or net earnings from self-employment, has the same meaning as when used in section 162, relating to trade or business expenses, except that the term does not include the performance of the functions of a public office, subject to a fee-basis carve-out for State and local offices, and does not include the performance of service by an individual as an employee, subject to a list of named exceptions (26 U.S.C. 1402(c)).
The employee exclusion is why classification decides this tax before any arithmetic starts, and the statutory categories that are treated as self-employed despite looking like employment are set out in statutory nonemployee.
The Deductible Half, and the Part That Is Not Deductible
In the case of an individual, in addition to the taxes described in subsection (a), there is allowed as a deduction for the taxable year an amount equal to one half of the taxes imposed by section 1401, other than the taxes imposed by section 1401(b)(2), for that year (26 U.S.C. 164(f)(1)). The exclusion in that sentence is the whole of the difference between a correct figure and a slightly generous one: the 0.9 percent charge imposed by that paragraph (26 U.S.C. 1401(b)(2)(A)) is not halved and not deducted.
The deduction has a character rule of its own. For purposes of that chapter, the deduction allowed by paragraph (1) is treated as attributable to a trade or business carried on by the taxpayer which does not consist of the performance of services by the taxpayer as an employee (26 U.S.C. 164(f)(2)). Where a deduction of this kind sits relative to adjusted gross income is set out in above the line deductions.
What Self-Employment Tax Is Confused With
Payroll Tax
Payroll tax is triggered by paying wages for employment and is owed by two taxpayers at once, the employee and the employer, on the same wages. Self-employment tax is one taxpayer’s own charge on business earnings, with no withholding and no matching share. The FICA machinery on the wage side is set out in payroll tax.
Income Tax
Different base, different chapter. Self-employment tax is measured on self-employment income under chapter 2; income tax is measured on taxable income, and the separation is worked through in federal income tax liability.
The Qualified Business Income Deduction
It does not reach this tax. The deduction under subsection (a) shall only be allowed for purposes of this chapter (26 U.S.C. 199A(f)(3)), and the chapter that provision is speaking from is chapter 1, while self-employment tax is imposed by chapter 2 (26 U.S.C. 1401).
Common Questions
Yes, and it is written as an exclusion from the base rather than as an exemption. Self-employment income does not include the net earnings from self-employment if those net earnings for the taxable year are less than $400 (26 U.S.C. 1402(b)(2)). Church employee income has its own special rule for that paragraph (26 U.S.C. 1402(b)).
The chapter answers this by what it reaches rather than by naming the entity. The tax is imposed on self-employment income, built from net earnings from a trade or business carried on by the individual plus the distributive share of partnership income described in section 702(a)(8) (26 U.S.C. 1402(a)). The character of an S corporation shareholder’s income and the compensation question that goes with it are set out in S corporation.
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