Are you about ready to join the “Great Resignation” and become self-employed? If so, you need to consider the federal tax implications, which may not be as rosy as you think. Here are what we think are the most important things to know to make a good decision.
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, or write off the costs of owning or renting a residence that contains your new home office.
While there are some tax advantages to being self-employed, they can be underwhelming and should not be a main reason for deciding to go out on your own.
The big nontax disadvantage is you’ll have to pay for things that were formerly provided by your employer. These could include 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.
Big Disadvantage: Self-employment (SE) Tax
The SE tax is the way the U.S. Treasury collects Social Security and Medicare taxes on nonwage 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). The 15.3% rate is composed of (1) 12.4% for the Social Security tax component of the SE tax plus (2) 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 (above $200,000 if you’re unmarried or $250,000 if 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.
On the other hand, 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 100% of both taxes out of your own pocket. 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.
Partial Deduction for SE Tax. In a 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.
Consider an S Corporation. If you’re willing to go to some trouble to potentially manage the SE tax bite, consider operating your new shop as an S corporation. Contact us for information on this strategy.
Potential tax advantages for the self-employed
Tax-wise, being self-employed is not all bad news. Here are some significant federal tax advantages of self-employed status.
Deductible 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. 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. Contact us for details on self-employed retirement plan options.
Deduction for Self-employed Health Insurance Premiums. If you qualify, you need not itemize to claim this deduction. Contact us for details.
Deduction 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% write-off deal.
Qualified Business Income (QBI) Deduction. The QBI deduction was the centerpiece of the 2017 Tax Cuts and Jobs Act (TCJA). Through 2025, the QBI deduction is available to eligible self-employed individuals. The deduction can be up to 20% of net income earned from certain pass-through businesses, including a sole proprietorship 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. Contact us for details.
Conclusion
There you have it: Most of what you need to know about the federal tax implications of self-employed status. You also can check out the IRS’ Self-Employed Individuals Tax Center.
There is much more, including many factors that depend on your individual circumstance. We would welcome the opportunity to discuss the full story with you. Contact the tax experts at KM&M CPAs if we can be of help. To set up an appointment to review any tax or accounting issue, call us at 419-756-3211, send an email to kmm@kmmcpas.com, or by fill out our contact form at this link.