Self-Employment Tax: What It Is and How to Reduce It

Self-Employment Tax: What It Is and How to Reduce It

Self-employment tax is one of the biggest surprises for new business owners. On top of income tax, you owe an additional 15.3% on your net self-employment earnings. That is the combined employee and employer share of Social Security and Medicare taxes that W-2 employees split with their employer.

How Self-Employment Tax Works

When you work for someone else, your employer pays half of your Social Security and Medicare taxes (7.65%), and the other half (7.65%) is withheld from your paycheck. When you are self-employed, you pay both halves -- the full 15.3%.

The breakdown:

• Social Security: 12.4% on net earnings up to the annual wage base (this threshold adjusts annually — check IRS.gov for the current year's limit)
• Medicare: 2.9% on all net earnings with no cap
• Additional Medicare Tax: 0.9% on net earnings exceeding $200,000 ($250,000 for married filing jointly)

Who Pays Self-Employment Tax

You owe self-employment tax if your net self-employment earnings are $400 or more per year. This includes:

• Sole proprietors
• General partners in a partnership
• Members of an LLC taxed as a sole proprietorship or partnership
• Independent contractors and freelancers
• Gig workers

S corporation shareholders and C corporation shareholders do not pay self-employment tax on their distributions or dividends. However, S corp shareholders who work in the business must pay themselves a reasonable salary, which is subject to employment taxes.

Calculating Self-Employment Tax

1. Start with your net self-employment income (gross income minus business expenses)
2. Multiply by 92.35% (this adjustment accounts for the "employer" portion of the tax)
3. Apply the 15.3% tax rate (12.4% Social Security + 2.9% Medicare) on the adjusted amount
4. If the adjusted amount exceeds the Social Security wage base, only the 2.9% Medicare tax applies to the excess

Report self-employment tax on Schedule SE, which you file with your Form 1040.

The Deduction You Should Not Miss

You can deduct the employer-equivalent portion of your self-employment tax (half of the total SE tax) as an adjustment to income on your Form 1040. This reduces your adjusted gross income, which can lower your income tax. It does not reduce your self-employment tax itself, but it is a meaningful deduction that some business owners overlook.

Strategies to Reduce Self-Employment Tax

1. Elect S Corporation Status

The most impactful strategy for established businesses. When your business is taxed as an S corporation, you pay yourself a reasonable salary (subject to employment taxes) and take remaining profits as distributions (not subject to self-employment tax).

Example: Your business earns $150,000 in profit. As a sole proprietor, you pay SE tax on the entire amount. As an S corp, you pay yourself a $70,000 salary (employment taxes apply) and take $80,000 as a distribution (no SE tax). The savings can exceed $10,000 per year.

The IRS requires the salary to be "reasonable" for your role and industry. Setting it too low invites scrutiny.

2. Maximize Business Deductions

Every legitimate business deduction reduces your net self-employment income, which directly reduces your SE tax. Common deductions include:

• Business equipment and supplies
• Vehicle expenses for business use
• Home office deduction
• Health insurance premiums (for self-employed individuals)
• Retirement plan contributions
• Professional development and education
• Business travel and meals (50% for meals)

3. Hire Your Spouse

If your spouse works in your business, you can hire them as an employee. Their wages are subject to employment taxes, but they reduce your self-employment income. This can also qualify them for Social Security benefits and allow the business to provide tax-free fringe benefits.

4. Contribute to Retirement Plans

Contributions to a SEP IRA, SIMPLE IRA, or Solo 401(k) reduce your net self-employment income. A SEP IRA allows contributions up to 25% of net self-employment earnings (after the SE tax deduction), with a maximum of $66,000 for 2023. A Solo 401(k) allows even larger contributions through the combination of employee deferrals and employer contributions.

5. Time Your Income and Expenses

If you are close to the Social Security wage base, timing income or expenses across tax years can affect how much SE tax you owe. Accelerating deductions into the current year reduces this year's SE tax liability.

When S Corp Election Makes Sense

The S corp strategy is not free. You will have additional costs for payroll processing, potentially higher accounting fees, and state filing requirements. Generally, the S corp election makes financial sense when your net business income consistently exceeds $50,000-$60,000 per year and the SE tax savings outweigh the administrative costs.

Talk to a CPA who specializes in small business tax before making this election. The analysis is specific to your situation.