Legal Definitions - Self-employment tax

Self-employment tax refers to the contributions that individuals who work for themselves must pay towards Social Security and Medicare.

These contributions are mandated by the Federal Insurance Contributions Act (FICA). Unlike traditional employees, whose employers split the cost of FICA taxes with them, self-employed individuals are responsible for paying both the employee and employer portions of these taxes on their business profits. However, they are permitted to deduct a portion of these taxes as a business expense when calculating their taxable income.

Here are a few scenarios illustrating how self-employment tax applies:

• Scenario: A Freelance Graphic Designer

  Maria operates her own graphic design studio as a sole proprietor. She works with various clients, designing logos, websites, and marketing materials. At the end of the year, after accounting for all her business expenses (like software subscriptions, office supplies, and professional development), Maria calculates her net profit. On this profit, she must pay self-employment tax, covering both her Social Security and Medicare contributions, which she remits directly to the government, typically through estimated tax payments throughout the year.

  This example demonstrates self-employment tax because Maria is working for herself, earning income directly from clients, and is therefore responsible for the full FICA tax burden that would normally be split between an employer and employee.

• Scenario: A Small Coffee Shop Owner

  David owns and operates a small, independent coffee shop. He manages the business, serves customers, and handles all the administrative tasks. While he might hire part-time baristas, David himself does not receive a traditional salary from his business. Instead, his income comes from the shop's profits. When David files his personal income tax, he calculates his net earnings from the coffee shop and then pays self-employment tax on those profits, ensuring his contributions to Social Security and Medicare are made.

  This illustrates self-employment tax as David, as the owner-operator, is considered self-employed. His income from the business's profits is subject to self-employment tax, reflecting his dual role as both the "employer" and "employee" for FICA purposes.

• Scenario: A Ride-Share Driver

  Sarah works as a driver for a popular ride-sharing application. She sets her own hours, uses her own vehicle, and is not considered an employee of the ride-share company. Each year, the company provides her with a summary of her earnings. After deducting her business expenses, such as fuel, vehicle maintenance, and a portion of her car insurance, Sarah determines her net income. She then calculates and pays self-employment tax on this net income, fulfilling her obligation to contribute to Social Security and Medicare as an independent contractor.

  This example highlights self-employment tax in the context of the gig economy. Sarah is an independent contractor, not an employee, meaning she is solely responsible for paying the entire FICA tax amount on her earnings from driving.