If your income exceeds the annual filing thresholds, you must file a federal income tax return no matter where the money is coming from. However, the Internal Revenue Service treats income from self-employment or independent contracting sources slightly differently than employee income for the purpose of payroll taxes and certain tax deductions.
Who is Self-Employed?
The Internal Revenue Service sets up guidelines to determine whether you are treated as an employee or as an independent contractor (self-employed) by the people and companies that you do business with. The more independent you are in doing your job, the more likely you are to be self-employed. The IRS looks at how much control the person you work for has over when and how you do the work, how the person you work for controls the business aspects of your work such as who provides the supplies and pays various expenses and what types of contracts and employee benefits like vacation time or pension plans are offered by the person you work for.
The most significant difference between the taxes paid by self-employed individuals and employed individuals is the FICA tax, also known as payroll taxes, and the self-employment tax. These taxes include the Social Security tax and the Medicare tax. As an employee, you split the cost of the Social Security tax and the Medicare tax with your employer. As of 2010, this means that each party pays 7.65 percent. However, self-employed individuals have no employer to split the taxes with so they must pay the entire amount themselves, which is 15.3 percent as of 2010.
The Medicare tax applies to all of your income, regardless of how much you make. The Social Security tax only applies to a certain amount of income per year. This cap varies each year for inflation and as of 2010 was set at $106,800. If you work as an employee and are self-employed and your total income exceeds the annual limit, the Social Security tax applies to your employee income first. For example, if in 2010 you make $120,000 as an employee and $20,000 from self-employment, you would split the Social Security tax with your employer on the first $106,800 of your employee income and would not have to pay any Social Security tax on your self-employment income.
Deducting Social Security and Medicare Taxes
As a self-employed individual, the IRS allows you to deduct 50 percent of the self-employment taxes that you pay from your income taxes to account for the extra costs that you must pay for since you do not have an employer. For example, if you are self-employed and made $50,000, using the 2010 tax rates, you would pay $7,650 in self-employment taxes. If you were employed, you would split those taxes with your employer so you would pay only $3,825. Therefore, the IRS allows you to deduct $3,825 from your taxable income because of the self-employment taxes that you pay.
Paying FICA and Self-Employment Taxes
When you work as an employee, the money for your FICA taxes is automatically withheld from your paycheck by your employer and you do not have to file additional tax forms to calculate your FICA taxes when you file your income taxes. When you are self-employed, you must file schedule SE with your income tax return to determine how much you owe in self-employment taxes. During the year, the IRS expects you to make estimated payments on a quarterly basis.
- Internal Revenue Service. "Self-Employment Tax (Social Security and Medicare Taxes)." Accessed Jan. 28, 2020.
- Internal Revenue Service. "About Schedule SE (Form 1040), Self-Employment Tax." Accessed Jan. 28, 2020.
- Internal Revenue Service. "Who Is Self-Employed?" Accessed Jan. 28, 2020.
- Internal Revenue Service. "Topic No. 751 Social Security and Medicare Withholding Rates." Accessed March 14, 2020.
- Internal Revenue Service. "Questions and Answers for the Additional Medicare Tax." Accessed Jan. 28, 2020.
- Internal Revenue Service. "Topic No. 554 Self-Employment Tax." Accessed March 14, 2020.
- U.S. Senate Committee on Finance. "DIVISION A – KEEPING WORKERS PAID AND EMPLOYED, HEALTH CARE SYSTEM ENHANCEMENTS, AND ECONOMIC STABILIZATION: Section 2302. Delay of payment of employer payroll taxes." Accessed March 30, 2020.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."