If you’re a small business owner, you may have heard about the self-employment tax deduction, but maybe you’re not clear about how it works or why it matters. This deduction is a built-in tax break that helps lower your taxable income. In this post, I’ll walk you through what the self-employment tax deduction is, why it exists, and how you can use it to keep more of your hard-earned money in your pocket.

What is the self-employment tax?

Self-employment tax is not the same as your regular income tax. Here’s how it works: When you work as an employee, your employer automatically withholds taxes from your paycheck to pay for Social Security and Medicare taxes (together known as FICA). 

Currently, the self-employment tax rate totals 15.3%. Half of that is taken from your wages on your paycheck and the other half is paid by your employer on your behalf. But, when you’re self-employed, you are the employer, so instead of splitting the tax, you are responsible for all of it. 

By the way, for a full breakdown of everything you need to know about the self-employment tax, including how to prepare for it and when to pay it, read my free article Self-Employment Taxes Explained and Simplified.

Who has to pay self-employment tax?

In general, if you are self-employed and your net earnings from self-employment are at least $400 (profit minus expenses), then you’ll owe self-employment tax. 

All of these types of business owners typically need to pay self-employment tax unless they have elected to have their business taxed as an S-Corporation:

• Sole proprietor
• Independent contractor
• Freelancer
• Side hustler
• Gig worker
• Member of a partnership 

What is the self-employment tax deduction?

The good news is that you get to deduct the employer half of your self-employment tax on your tax return. This is because the IRS lets you treat the employer portion as a business-related deduction.

The other good news is that you don’t have to itemize your deductions or keep any special records to use the self-employment tax deduction. It’s an automatic deduction on your Form 1040, Schedule 1, which means that your tax software or your CPA will automatically handle it.

Can you give an example of how the self-employment tax deduction works using real numbers?

Sometimes the best way to illustrate how a tax works is by seeing it using real numbers, so here you go:

• Ginny has a business selling handcrafted and personalized bows. Last year, her business brought in $72,000. After subtracting expenses, Ginny’s business profit was $50,000.
• $50,000 x 15.3% = $7,650 self-employment tax owed
• $7,650 ÷ 2 = $3,825 self-employment tax deduction

What’s important to remember here is that the self-employment tax reduces your taxable income, but it doesn’t reduce the self-employment tax that you owe. You can think of this deduction like a coupon because lowering your taxable income does save you money on your income tax bill, but it doesn’t lower your self-employment tax bill itself.

Why does the IRS give a self-employment tax deduction?

Sometimes taxpayers hear about the self-employment tax deduction and think that business owners are getting an extra tax break, but that’s not the case. Here’s how to look at it: If self-employed people couldn’t deduct the self-employment tax, then they’d be taxed more heavily than employees earning the same amount.

In other words, the self-employment tax deduction helps even the playing field so that small business owners aren’t penalized for owning their own business.

If I have an LLC, does this change how my self-employment taxes work?

If you have an LLC, it does not change how you are taxed. A single-member LLC is taxed as a sole proprietorship by default, so you’ll still pay self-employment tax and qualify for the self-employment tax deduction.

The only time this would change is if you elect to be taxed as an S-Corporation, which is a completely different conversation.

If I have a regular W-2 job and a side business, do I still have to pay self-employment taxes?

Yes, even if you have a job where an employer is withholding FICA taxes from your paycheck, you still owe self-employment tax on any net profit over $400 that you bring in from a side gig or small business that you own.

Abridged by Amy

The self-employment tax deduction can seem confusing until someone explains it in plain language. And that’s how it is with lots of tax rules! Once you invest a little time in learning tax basics, then this part of your business becomes a lot less stressful. 

If you’re ready to spend some time learning about taxes and bookkeeping so you can stop second guessing your financial decisions, work with and learn from a CPA who specializes in working with small business owners like you.