Are you about ready to join the Great Resignation and become self-employed? Yes? OK, but you need to consider the tax implications, which may not be as rosy as you think. Here’s what you need to know to make a good decision.
First and foremost, don’t buy the hype
Becoming self-employed won’t allow you to write off all your meals as business expenses, deduct the costs of taking your friends out for drinks and to sporting events, deduct all your transportation expenses, and write off the costs of owning or renting a residence that contains your new home office. Sorry about that.
While there are some tax advantages to being self-employed, they are underwhelming and should not be a 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. That includes health insurance, retirement plan contributions, a ride if you were lucky enough to have a company car, 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 (SE) tax.
Now for some details on the tax issues.
The dreaded self-employment tax
The SE tax is the way our beloved U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the SE tax rate is 15.3% on the first $147,000 of net SE income (gross income from self-employment minus expenses allowed for SE tax purposes).
That 15.3% rate is comprised of:
* 12.4% for the Social Security tax component of the SE tax plus
* 2.9% for the Medicare tax component.
* Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9% Medicare tax continues before rising to 3.8% at higher SE income levels ($200,000 if you’re unmarried or $250,000 of you’re a married joint-filer). The 3.8% rate consists of the “regular” 2.9% Medicare tax plus the 0.9% Additional Medicare tax on higher earners.
As long as you’re an employee, your company pays half of the 12.4% Social Security tax and half of the 2.9% Medicare tax. The other half is withheld from your salary.
But if you’re self-employed, you have to cover both halves out of your own pocket. Bottom line: if you make good money, the SE tax can be a big number. You’ll need to include what you owe for SE tax with your quarterly estimated federal income tax payments to avoid an IRS interest charge penalty.
Example: Say you make a net profit of $200,000 from being self-employed in 2022. You’ll report your business income and deductible operating expenses on Schedule C of Form 1040. Take the net income from Schedule C and multiply that figure by .9235. The result is $184,700, and that’s the net SE income amount that’s subject to the SE tax. For 2022, your SE tax bill will be a whopping $23,584. [($147,000 x 12.4%) + ($184,700 x .029%)]. Oof!
Sadly, in calculating your net SE income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your SE tax, or the deduction for self-employed health insurance premiums.
The self-employment tax hit will only get worse
Every year, the Social Security tax ceiling goes up based on an inflation adjustment. In turn, your SE tax bill goes up. Last August, the Social Security Administration issued its latest projected ceilings for future years.
* $156,000 for 2023.
* $162,900 for 2024.
* $168,600 for 2025.
* $173,300 for 2026.
* $180,600 for 2027.
Ugh! These numbers are bad enough, but, if you would like to bet me that the actual ceilings won’t be significantly higher, I’ll take that bet. How much are you willing to lose?
Key point: One proposed tax-law change that has been floated would restart the 12.4% Social Security tax on net SE income above $400,000. This is the so-called donut hole approach to increasing the Social Security tax. Over the years, the donut hole would gradually close as the lower edge of the hole is adjusted upward for inflation while the $400,000 upper edge of the hole remains static. Will this unfavorable change get made? Who knows?
Partial deduction for self-employment tax
In a wee bit of good news, you can deduct half of the 12.4% Social Security tax component of the SE tax and half of the 2.9% Medicare tax component. You need not itemize to claim this deduction. However, you can’t deduct any of the additional 0.9% Medicare tax that’s imposed on higher levels of net SE income.
Set up S corporation to mitigate SE tax
If you’re willing to go to some trouble to potentially minimize the SE tax bite, consider operating your new shop as an S corporation. I covered this strategy in an earlier column.
Deduction for contributions to self-employed retirement plan
For the 2022 tax year, a self-employed individual can potentially make a deductible contribution of up to $61,000 to a tax-favored retirement plan. Maybe more if you set up a defined benefit pension plan. Available options include a simplified employee pension (SEP), a Keogh profit-sharing plan, a solo 401(k) plan, a SIMPLE-IRA, and a defined benefit pension plan. Stay tuned for a future column on this subject.
Deduction for self-employed health insurance premiums
This write-off was also covered in a previous column. See here. If you qualify, you need not itemize to claim this deduction.
Deductions for business meals
For 2022, you can deduct 100% of business meals provided by restaurants. After this year, the deductible percentage will fall back to 50% unless Congress extends the 100% deal. For details, see this previous Tax Guy column.
Combine heavy SUV, pickup, or van with home office for double tax savings
I covered this strategy in another earlier column. See here.
Qualified business income (QBI) deduction
The qualified business income (QBI) deduction was a centerpiece of the 2017 Tax Cuts and Jobs Act (TCJA). For 2018-2025, the QBI deduction is available to eligible individuals, trusts, and estates, but it’s not available to C corporations or their shareholders.
The QBI deduction can be up to 20% of: (1) QBI earned from a sole proprietorship or single-member LLC (SMLLC) that’s treated as a sole proprietorship for federal income tax purposes plus (2) QBI passed through from a pass-through business entity, meaning a partnership, LLC classified as a partnership for federal income tax purposes, or S corporation. Pass-through business entities report their tax items to their owners who then take them into into account on their owner-level returns. The QBI deduction, when allowed, is then written off at the owner level.
Key Point: In this article, we will focus on individual taxpayers who can claim QBI deductions, with the understanding that essentially the same considerations apply to trusts and estates.
Through 2025, the QBI deduction is available to eligible self-employed individuals.
The deduction can be up to 20% of net income earned from a sole proprietorship business or single-member LLC business that’s treated as a sole proprietorship for federal income tax purposes. Great, but the QBI deduction rules are complicated, and the deduction can be phased out at higher income levels. Let me get back to you with details in a future column.
The bottom line
There you have it: most of what you need to know about the tax implications of self-employed status. If you’re still game, go for it. Years ago, I did, and I should have done it sooner.