Self-Employment Taxes For Sole Proprietors
Sole Proprietors typically pay at least three different federal taxes. In addition to federal income taxes, they also are subject to 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
- 12.4 percent Social Security tax up to an annual income ceiling ($147,000 for 2022) and
- 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.
Self-employment taxes are based on earned income from a business you own as a sole proprietor or single-member LLC.
Self-employment taxes are based on 92.35 percent of the net business income. 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 affect self-employment tax.
Self-employment taxes are calculated on IRS Form SE and reported on your personal income tax return.
Some types of income are not subject to self-employment tax at all, including
- Gains from on the sale of capital assets such as stocks
- Gains from the sale of a personal residence
- Occasional items sold on ecommerce sites such as eBay.
- Hobby Income
- Most rental income,
- Most dividend and interest income,
- Gain or loss from sales and dispositions of business property, and
- S corporation distributions to shareholders.
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.
General partners in a general partnership must pay self-employment tax on their 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.”
Limited partners in a limited partnership do not pay self-employment tax on their share of the partnership’s profits. But they do pay self-employment tax on any guaranteed payments they 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.