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)
- 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
- 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 must also pay self-employment tax on 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.
New 62.5 Cents Mileage Rate
The IRS noticed that average gas prices across the United States exceeded $5.00 a gallon and took action.
Small businesses that qualify to use and do use the standard mileage rate can deduct 62.5 cents per business mile from July 1 through December 31, 2022. That’s up 4 cents a mile.
This brings up a practical question: what do you do if you track business mileage using the three-month sample method?
Three-Month Sample Basics
As a reminder, here are the basics of how the IRS describes the three-month test:
- The taxpayer uses her vehicle for business use.
- She and other members of her family use the vehicle for personal use.
- The taxpayer keeps a mileage log for the first three months of the taxable year, showing that she uses the vehicle 75 percent of the time for business.
- Invoices and paid bills show that her vehicle use is about the same throughout the year.
According to this IRS regulation, her three-month sample is adequate for this taxpayer to prove her 75 percent business use.
Sample-Method Solution to New July 1 Mileage Rate
To use the sample rate, you need to prove that your vehicle use is about the same throughout the year. Your invoices and paid bills prove the mileage part, and your appointment book can add creditability to consistent business and personal use.
Keep in mind that the sample is just that—a sample—it’s pretty exact for the three months but not that exact for the year, although it must adequately reflect the business mileage for the year.
If you have a good three-month sample, you take your business mileage for the year and apply the 58.5 cents to half the mileage and the 62.5 cents to the remaining half to find your deductions.
For example, say you drove 20,000 business miles for the year. Your deduction would be $12,100 (10,000 x 58.5 cents + 10,000 x 62.5 cents).
Mileage Record for the Full Year
If you have a mileage record for the entire year, no problem. Your record gives you the mileage for the first six months and the last six months.
Paying Your Child: W-2 or 1099?
Here’s a question I received from one of my clients: “I will hire my 15-year-old daughter to work in my single-member LLC business, and I expect to pay her about $12,000 this year. Do I pay her through payroll checks and file a W-2?”
Yes. And W-2 payment is essential. If you pay her on 1099, she will pay self-employment taxes.
When you pay her on a W-2, neither you nor your daughter pays any Social Security or Medicare taxes, and in most states, you also don’t pay any unemployment taxes.
Key point 1. Your single-member LLC is a “disregarded entity” for federal tax purposes. It’s taxed as a sole proprietorship (unless you elect corporate treatment). In this instance, you are the child’s parent, enabling “no Social Security or Medicare taxes” for both your child and your proprietorship.
Key point 2. Your daughter has a $12,950 standard deduction. This means she also pays zero tax on earned income up to that amount.
Tax Revenue For 2019 Broken Down Through The Key Findings From The Tax Foundation and IRS SOL Table 1.3
- Taxpayers reported nearly $12.1 trillion of total income on their 2019 tax returns.
- About 68 percent ($8.3 trillion) of the total income reported on Form 1040 consisted of wages and salaries, and 82 percent of all tax filers reported earning wage income.
- Retirement accounts such as 401(k)s and pensions are important sources of capital income for the middle class. Taxable IRA (Individual Retirement Account) distributions, pensions, and annuities (more than $1.1 trillion) and taxable Social Security benefits ($360 billion) accounted for about $1.47 trillion of income in 2018.
- Business income is another large component of reported personal income. Businesses that report income taxes through the individual income tax system, like S corporations, sole proprietorships, and partnerships, accounted for $1.1 trillion of income in 2018.
- Investment income consisting of net capital gains, taxable interest, and ordinary dividends accounted for nearly $1.2 trillion of income in 2018, more than business income and slightly less than taxable retirement income.
The individual income tax is the federal government’s largest source of revenue. More than 157 million individual income tax returns were filed for the tax year 2019, the second year under the changes made by the Tax Cuts and Jobs Act (TCJA).
Each household with taxable income must file a return to the Internal Revenue Service (IRS). On the IRS individual income tax form (Form 1040), all sources of taxable income are listed on the first page and added to reach total income. From there, the taxpayer’s deductions and credits are calculated on the tax return to determine tax liability and tax owed or refunded.
This report will focus on sources of reported total income in 2019, which amounted to more than $12.1 trillion. We will review the component parts of total income reported on lines 1 through 5 of the 2019 Form 1040 and on the 2019 Schedule 1. Reviewing reported income helps to understand the composition of the federal government’s revenue base and how Americans earn their taxable income. We divide income into four major categories—wages and salaries, business income, investment income, and retirement income—and review each category for the tax year 2019.
IRS Has Just Released Publication 3744
IRS Seeks Transformation in New 5-year Plan The IRS’s fiscal 2022–26 Strategic Plan sets out goals to modernize its operations and interactions with taxpayers while adapting to new challenges and threats. All of this is covered in a new 26-page IRS publication 3744. This is important as they have not finished processing the 2020 tax returns yet. They expect to have that completed by November 2022.
Chips And Tax Credits
semiconductors will join The Senate has begun debate on the so-called Chips bill, which would provide $52 billion in grants and $24 billion in tax credits to supposedly strengthen the production of semiconductors in the U.S. If this measure passes, U.S. wool, mohair, helium, soybeans, ethanol, steel, credit unions, and Amtrak as industries thought to be so important as to warrant taxpayer subsidies—forever.
As President Ronald Reagan once observed, “The closest thing to immortality is a government program.” So, lawmakers should think ahead 50 years from now and wonder if those in Congress might ask, “What were they thinking?” (source Tax Foundation)
What’s New For Individuals in 2022
Deductions – Effective for 2022, a taxpayer must itemize to deduct charitable contributions. The Tax Cuts and Jobs Act (TCJA) increased the 50% AGI limitation to 60% for cash contributions through 2025 in 2026 it goes back to 50%.
Earned income Credit Effective for 2022, a taxpayer with no qualifying children has to be at least age 25 and under age 65 to qualify for EIC.
Child Tax Credit Effective for 2022, the Child Tax Credit is $2,000 per qualifying child, of which $1,500 is refundable. A qualifying child is a dependent child who has not attained age 17 as of the close of the calendar year. The credit starts to phase out when AGI exceeds $400,000 for MFJ and $200,000 for all others.
Dependent Care Credit and Exclusion Effective for 2022, the dependent care expense limitation is $3,000 for one child and $6,000 for two or more children. The credit is not a refundable credit (it can only eliminate tax owed). The credit equals a percentage of dependent care expenses ranging from 35% for taxpayers with AGI not over $15,000, down to 20% for taxpayers with AGI over $43,000.
The Reconciliation Bill includes nearly $80 Billion for IRS including Enforcement and Audits: What that means for taxpayers
IRS Commissioner Charles Rettig said the $80 billion in funding would not increase audits of households making less than $400,000 per year. The bill passed the Senate and needs the House of Representatives to pass it and allow the President’s signature to make it law. Typically, tax legislation starts in the House of Representatives from the House Ways and Means committee then to the Senate Finance committee then to the Senate floor, then the conferees, then the president for signature. Remember this was not a tax law bill it was a Reconciliation bill with a funding portion for IRS. That being said, Senator Mike Crapo R-Idaho, ranking member of the Senate Finance Committee said, “My colleagues claim this massive funding boost will allow the IRS to go after millionaires, billionaires, and so-called rich ‘tax cheats,’ but the reality is a significant portion raised from their IRS funding bloat would come from taxpayers with below $400,000 in income.” Everyone expects this bill to pass now, and only time will tell us who it is correct.
In Next Month’s Issue, I will Discuss August Business Planning Ideas to Get Ready for Year End:
- Retirement Plans
- Bonus Depreciation
- Health Saving Plans
- Accountable Plans
- Meals Deduction
- Travel Rules
- S Corporation and Partnership K-2 and K-3 Rules
- Partnership Audit election
- Section 105 Plans
- Any many other issues
If You Haven’t reviewed or Revised Your Estate Planning Document In The Past Several Years Contact Your Estate Planner As Soon As Possible
The estate laws have changed many times in the past few years and are due to change again in the year 2026. Contact our office for more information.
It is an honor to assist you with all your questions and concerns.
Al Whalen, EA, CFP®