Small Business Taxes - What is Self-Employment Tax and Why Must You Pay It?

If you are new to the world of self-employment, it's time for you to meet an old nemesis known as Self-employment tax.

Self-employment (SE) tax is the sole proprietor's version of the social security and Medicare tax paid by employees.

In case you didn't realize it, in 2008 employees were required to pay 6.2% social security tax on the first $102,000 of wages or salary. In 2009, the amount subject to social security tax increases to $106,800. And they were also required to pay 1.45% Medicare tax on all their wages or salary, regardless of the amount.

And since most employees earn less than $102,000, the end result is that most employees paid 7.65% of their compensation to the IRS. Both the social security and Medicare tax are deducted "off the top" - the employee never sees this money because it is taken out of their pay and sent directly to the IRS by their employer.

(Keep in mind that we are talking only about social security and Medicare tax, which are separate from and different than federal income tax, which employees must pay, too.)

The employer must then match the 7.65% employee payment. The employer's share is an unavoidable business expense that reduces the employer's profit (or increases a loss). There is no way around it.

So both the employer and employee pay the same amount. The end result is a hefty 15.3% total tax: 12.4% social security tax plus 2.9% Medicare tax.

Well, self-employed folks (sole proprietors, independent contractors, and the like) have to pay social security and Medicare tax, too. The government has given it a different name: Self-employment tax. But it is really the same thing as social security and Medicare tax.

And the rules are basically the same: 15.3% total, 12.4% social security tax on the first $102,000 of wages and 2.9% Medicare tax on an unlimited wage amount.

But here comes the bad news - for purposes of the social security and Medicare tax, the sole proprietor must pay both the employer's share and the employee's share - or the entire 15.3%. Ouch!

And so the sole proprietor ends up paying twice as much as the employee.

Technically, there is a small reduction in the amount of Self-Employment tax paid because the sole proprietor gets to deduct the SE tax from his/her gross income.

But the fact remains: the SE tax paid by the sole proprietor is almost double the social security/Medicare tax paid by the employee.

If you're a sole proprietor and you didn't know about SE tax prior to reading this, I may have just ruined your day. And for that I am sincerely sorry.

And if you're a sole proprietor and did know about the SE tax prior to reading this, I may have just ruined your day, too, because things haven't changed in this area for many years. I wish I had better news for sole proprietors on this topic, but unfortunately, I don't.

That is our system and it is was it is.

What's a sole proprietor to do? The SE tax will be a thorn in your side as long as you remain a sole proprietor. This is one of the main reasons you should consider incorporating your small business and forming an S Corporation. There are legal tax strategies available to the S Corporation that can reduce the SE tax. Do some research in that area, or consult with your tax professional to get the details.