Self-employed individuals, unlike employees, don’t have someone withholding Social Security or Medicare (FICA) taxes along with pre-payments toward their federal (and state, where applicable) income tax from their wages during the year.
They are not being paid a wage; instead, a self-employed individual must keep a set of books showing income and expenses associated with their self-employed business that will allow them to determine their taxable profits (or losses). While an employer and an employee each pay half of the FICA taxes due on an employee’s wages, a self-employed person pays 100% of these taxes, termed the self-employment tax or SE tax for short, on his or her self-employment profit.
If the individual has more than one self-employment activity, the net profits and losses from all of the self-employment activities are combined to determine the amount of the SE tax. However, two spouses have self-employment income, the couple cannot combine their SE incomes when figuring their individual SE tax.
Estimated Taxes – Since self-employed taxpayers don’t have taxes withheld on their self-employment income, they need to pay estimated taxes quarterly based upon their taxable profits for the quarter and, after the first quarter of the year, taking into account prior quarterly profits and estimated taxes already paid for the year. These estimated taxes are paid with an IRS Form 1040-ES and include the taxpayer’s income and SE taxes. In lieu of filing Form 1040-ES and sending a check to the U.S. Treasury, the payments can be made online through the IRS’s website or by using the government’s Electronic Federal Tax Payment System (EFTPS), which allows payments to be scheduled up to a year in advance, by having payments automatically withdrawn from the individual’s bank account at specified dates.
The payments are due April 15, June 15, September 15, and January 15. If the due date falls on a weekend day or legal holiday, the due date will be the next business day. And if you didn’t notice, the second “quarter” is two months, and the third one is four months: one of many quirks in our tax system.
Self-Employment Tax – All self-employed taxpayers who have more than $400 in net profit from their self-employment must pay self-employment tax, which is made up of Social Security tax of 12.4% on the first $132,900 (2019) of profit from the business and a 2.9% Medicare tax on all of the profits. In addition, there is an additional 0.9% Medicare tax to the extent the profits exceed $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. In addition, half of the self-employment tax can be deducted from gross income. There are special rules for determining the self-employment taxes for farmers and fishermen.
If a self-employed taxpayer pre-pays less than 90% of his or her current year’s tax liability, including Social Security and Medicare taxes for the year, then the taxpayer can be subject to a penalty that assesses interest on underpayments by the quarter.
Estimated-Tax Safe Harbors – However, rather than having to determine their quarterly profits and estimate their income tax and SE tax liabilities, some self-employed individuals instead opt to use a quarterly safe-harbor-payments method allowed by the IRS, which avoids the underpayment penalty if used correctly. There are two safe harbors available:
1. 100% of the prior year’s tax liability paid evenly for each quarter, provided the prior year’s adjusted gross income was $150,000 or less ($75,000 if using the filing status of married filing separate).
2. 110% of the prior year’s tax liability paid evenly for each quarter if the prior year’s adjusted gross income was greater than $150,000 ($75,000 if filing married filing separate).
The underpayment penalty does not apply if the final amount due on an individual’s tax return is less than $1,000. The penalty also does not apply if a taxpayer did not have a prior year tax liability for a full 12-month year.
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Regina H Rudolph, CPA