Author: Leon Clinton

Are you considering joining the Great Resignation and becoming self-employed to be in charge of yourself?

Yes?

Okay, but before leaping, consider the tax implications. This self-employment thing may not be as rosy as it appears.

Here’s the big picture.

Don’t Believe the Hype

Despite what some may believe, becoming self-employed won’t allow you to

• write off all your meals as a business expense,
• deduct the cost of taking your friends to sporting events,
• deduct all your transportation expenses, and
• write off the entire cost of owning or renting a residence that contains your home office.

Sorry about that.

While there are some tax advantages to being self-employed, they are underwhelming and should not be the main reason for deciding to go out on your own.

The big non-tax disadvantage is you’ll have to pay for things that were formerly provided by your employer, such as

• health insurance,
• retirement plan contributions,
• a company car (if you were lucky),
• company-paid business trips that included elements of pleasure,
• meals when you worked late at the office, and
• so forth.

And there is one big tax disadvantage: the dreaded self-employment tax.

Now, some details on the tax issues most likely to affect you as a self-employed taxpayer.

The Dreaded Self-Employment Tax Can Be Really Expensive

The self-employment tax is how our beloved U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income (e.g., net income from Schedule C multiplied by 92.35 percent).

That 15.3 percent rate is composed of:

• 12.4 percent for the Social Security tax component of the self-employment tax plus
• 2.9 percent for the Medicare tax component.

Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9 percent Medicare tax continues before rising to 3.8 percent at higher self-employment income levels (above $200,000 if you’re unmarried or $250,000 if you’re a married joint-filer). The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.

Side note. The additional Medicare tax applies to an employee’s W-2 income in the same manner that it applies to self-employment income. It kicks in at the $200,000/$250,000 levels.

Once you’re in the 3.8 percent bracket, it continues to hit your net self-employment income up “to infinity and beyond,” as Buzz Lightyear would say.

Key point. When you were an employee, your employer paid half of the 12.4 percent Social Security tax and half of the 2.9 percent Medicare tax. You paid the other half. Your employer took what you paid from your salary. But now that you’re self-employed, you cover both halves out of your own pocket.

Bottom line: If you make good money, the self-employment tax can be a big number. You’ll need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.

If, after reading the above, you are ready for self-employment, call me on my direct line at 408-778-9651, and let’s talk about getting you set up with some tax deductions to offset your tax bite.

• By Leon Clinton
• July 21, 2022

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 (Social Security and Medicare tax) 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 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.”

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.

If you have any questions about limited or general partners, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 16, 2022

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) and
• 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, and
• 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.

If you have questions about the self-employment tax, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 12, 2022