If your net earnings from self employment are $400 or more don't forget that in addition to paying income taxes, the IRS requires that you also pay self employment tax, which is similar to the Social Security and Medicare that would be withheld from your pay if you had a 9-5 job. Currently, the self employment tax rate is 15.3%. However, you can deduct a portion of this tax when you file your tax return at the end of the year.
Nicole is a self employed yoga instructor who teaches at various studios around town. At the beginning of the year Nicole was advised by her accountant to calculate her estimated taxes and make quarterly payments, so she did exactly that. At the end of the year when she was preparing her tax return she found that she only owed an additional $87 to settle her federal tax liability, which included her income tax and 15.3% self employment tax. Since Nicole had made her estimated payments throughout the year paying the outstanding balance was easy and she wasn't blindsided by an additional 15.3% tax since it had been paid in advance with her estimated quarterly payments.
May is a sole practitioner lawyer who just completed her first year of business. She generated $100,000 of revenue and incurred $65,000 of expenses, resulting in a net income of $35,000 (line 31 of her Schedule C). To calculate her self employment tax May would do the following: $35,000 x 92.35% = $32,323 x 15.3% = $4,945, which she would report on line 57 of her from 1040. Additionally, May can deduct $2,474 (50% of her total self employment tax liability) on line 27 of her Form 1040 to help reduce her taxable income.
Maria rents the guest house in her backyard on a short-term basis through Airbnb. Maria's rental activity meets the requirements to be considered passive and she reports all of her rental activity on her Schedule E. Last year after all expenses Maria's Airbnb rental generated $15,000 of net income. Since this income was generated from the rental of real estate and she does not provide substantial services (like a hotel or bed and breakfast), her $15,000 of rental income would not be subject to self employment tax.
Curtis is a self employed plumber who sources most of his work from taskrabbit. This year Curtis calculated his self employment taxes to be $10,000. Since ordinarily an employer would pay for a portion of this tax through Social Security and Medicare, Curtis is allowed to deduct $5,000 (self employment tax liability x 50%) on line 27 of his Form 1040, effectively reducing his taxable income. Note that this deduction simply reduces the amount of income Curtis must pay federal income tax on. He still must pay the full $10,000 of self employment tax.
Gina Gogetter, a single Washington D.C. based realtor took home $400,000 in commissions last year net of all business expenses. Gina chose to celebrate her success by moving into a larger home, purchasing a sports car and flying her extended family to Monaco for a reunion. When Gina filed her taxes, her accountant told her that not only did she owe $140,000 thousand of income tax from her commissions, she also owed $28,371 of self-employment tax. Unfortunately, Gina had already spent all of her money and ended up paying penalties and interest on all of her unpaid taxes for the next two years while she worked hard to make enough money to pay down her balance.
