Self Employment Tax 101

In the United States, the federal tax authorities put almost no bureaucratic barriers to an enterprising person that wants to set up his own instant business. For instance, consider a lawn mowing service. Perhaps you have a lawnmower and a truck. You put out some ads and distribute some flyers and soon enough you have a growing client base of satisfied suburbanites that are only too happy to exchange some cash in return for keeping their lawns neat and tidy without taking on the risks of sunburn or exposure to the heat and humidity of the great outdoors.

Don’t forget your silent partner, otherwise known as the federal government. In this brief blog post, we’ll leave aside Uncle Sam’s little brother – state tax. If you permanently live outside of the U.S. (as is the case of most of our clients), then you may not have to file state taxes.

Here’s what Uncle Sam (via our friends at the IRS) expect from you – diligently keep track of your income and expenses. That’s pretty much it. You might need an accountant to determine exactly what a business expense is and how to do tricky stuff like depreciation. The accountant might also give you helpful tips about tracking business mileage on your truck etc. Don’t accidentally forget to include some of your income that got paid in cash and immediately was spent as if it never happened. The sleuths at the IRS have their ways of finding hidden income. You will also likely need to make quarterly estimated payments.

Now we’ll talk about self employment tax. This is an issue that salaried employees need not be concerned with. Your employer will conveniently deduct your social security and medicaid taxes directly from your pay slip without any effort on your part. Self employed individuals also play the role of employer, so they have some extra work to do. This is done on the schedule C, which is attached to your annual form 1040 tax filing. The long form is a bit involved and is liable to cause severe headaches and/or accounting fees. If you have a simple cash business, then the EZ schedule might very well suffice. Schedule C will generate “self-employment tax” (or SE tax for short), which consists of social security and medicaid. These taxes are separate and in addition to your income tax assessment.

For many self-employed Americans living abroad, you may avoid SE tax by invoking a totalization agreement. The idea of a totalization agreement is simple enough. That is, it is sufficient to pay into the national insurance of one country and thereby avoid double taxation just as you expect to avoid double taxation on income tax. Unfortunately for Americans living in Israel, Israel and the United States have failed to execute this agreement. Therefore, you will indeed pay both social security/medicaid and Israeli national insurance if you are American and self employed in Israel.

Here are the nitty-gritty numbers. They are taken from the 2016 schedule SE.

  • SE tax is 15.3% of 92.35%, or 14.13% of your SE profit (income less expenses).
  • SE tax has two components:
    • 12.4% for social security
    •   2.9% for medicaid
  • 12.4% Social security tax is applied to a maximum of $118,500 grossed up at 92.35% to $128,316. This means that the social security tax is capped at $14,694, or 12.4% of $118,500. There is no social security tax on SE income in excess of $128,316.
  • 2.9% medicaid has no maximum.

Example 1 (standard)

Your SE business turns a profit of $50,000.  Your SE tax is (12.4% + 2.9% = 15.3% of 92.35% of $50,000 = $7,065.

Example 2 (high income)

Your SE business turns a profit of $500,000.  You have exceeded the maximum base for social security, so we’ll need to calculate social security and medicaid taxes separately.

  • Social security tax is the maximum amount of $14,694.
  • Medicaid tax is 2.9% of 92.35% of $500,000 = $13,391
  • SE tax total is $28,085=$14,694+$13,391

For information about the personal benefits of social security, see our blog “Social Security for XPAT’s“.