Updated: Nov 10, 2021
Starting a new business is exciting and nerve-racking. The freedom of ownership is thrilling but it comes with the stress of finding your first customers.
Everywhere you turn to, you find more and more people starting a business using a skill they already have. From crafting jewelry to being an event coordinator, it is easy to say that entrepreneurship is in.
What is not as exciting is the idea that starting a business leads to understanding self-employment taxes. When we own our business, we are ultimately responsible for paying self-employment taxes on our earnings. There is no one to withhold taxes from our income so having a clear understanding of how taxation works is critical.
Today, we will focus on the most common type of business ownership, the Sole Proprietorship. A sole proprietor is someone who starts a new business without anyone else and without forming a corporation/LLC. This is the same as acting as an independent contractor/freelancer.
Focusing on the taxation aspect of Sole Proprietorships proves to be very straightforward. Self-Employment Tax is 15.3% of Net Profits. So what are net profits? This is the final income/loss based on your total self-employed income less your business expenses.
Here is an example:
Joe starts a new Sole Proprietorship called “Joe’s Services” and earns $50,000 from customers. While operating his new business, Joe had to spend $30,000 on advertising, supplies, software, and other expenses. The remaining amount of $20,000 is called his Net Profits.
What is Joe’s Self-Employment tax owed to the IRS?
We simply take 15.3% of $20,000 to find his Self-Employment tax of $3,060 that will need to be paid to the IRS.
You might be asking, why 15.3%? Self-Employment tax can be broken up into two parts, FICA and Medicare taxes. Out of this 15.3%, 12.4% goes towards Social Security and 2.9% goes to Medicare. By paying into these taxes, you will be able to claim Social Security benefits at retirement age and Medicare age at your applicable Medicare eligibility date.
The takeaway: Self-Employment taxes are 15.3% of your business income after you remove expenses from total sales.