Harvey & Parmelee LLP
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Tax Tips

Do I Need to Pay Self-Employment Tax? - May 2001
Richard Scrivanich - Partner

The self-employment tax (SE tax) is a Social Security and Medicare tax for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of wage earners. It can apply even if the work is only part-time, or doesn't generate enough income to support the individual.

Who must pay.
You must pay SE tax if: 1) You were self-employed and your net earnings from self-employment were $400 or more (excluding certain income described below); or 2) you performed services for a church as an employee and received income of $108.28 or more. The SE tax rules apply even if you are fully insured under Social Security or have started receiving benefits. For 2001, the maximum net self-employment earnings subject to the social security part of the self-employment tax has increased to $80,400.

Definition of self-employed.
You are self-employed if you carry on a trade or business as a sole proprietor, an independent contractor, a member of a partnership, or are otherwise in business for yourself. The definition of a trade or business is an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The IRS will look at factors such as the regularity of activities and transactions and the production of income to determine if you have a trade or business. You don't need to actually make a profit to be considered in trade or business, but you do need to have profit motive, and make ongoing efforts to further your business.

Sole proprietors, partners and spouses.
If you own your own business as a sole proprietor, the income from your business is SE income. If only one spouse has an interest in a business, then it is a sole proprietorship.

If you are a member of a partnership that carries on a trade or business, the general rule for SE tax is that your distributive share of the income or loss from the trade or business is included in the calculation of your SE income.

If a husband and wife are partners (that is, they both have an interest in the business), then the partnership must report the business income and expenses on a separate return, and the spouses must file a Schedule K-1 with their regular tax return, showing each partner's share of the net income or loss, and file separate Schedules SE to report each partner's individual SE tax.

Note: If your spouse is your employee and not your partner, then you must pay Social Security and Medicare taxes for him or her as the employer.

Independent contractors.
Independent contractors are generally not employees and therefore usually pay SE tax. (This assumes the independent contractor is not incorporated. If he or she is, then no SE tax is paid.) Such persons have an independent trade, business, or profession in which they offer their services to the general public. However, whether someone is an employee or independent contractor depends on the facts of each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done and how it will be done.

You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed. If an employer has the legal right to control the details of how the services are performed. If an employer-employee relationship exists (no matter what the relationship is called), you are not an independent contractor.

What is SE income?
Different types of income can be SE income. The source of your income and your involvement in the activity from which your income is derived will determine whether it is SE income.

Gains and losses. A gain or loss from the disposition of property that is neither stock in trade nor held primarily for sale to customers is not SE income. It does not matter whether it was a sale, exchange, or involuntary conversion. The following are examples of gains or losses from the disposition of types of property that do not create SE income.

• Investment property.
• Depreciable property or other fixed assets used in your trade or business.
• Livestock held for draft, dairy, breeding, or sporting purposes and not held mainly for sale, regardless of how long the livestock were held or whether they were raised or purchased.
• Standing crops sold with land held more than one year.
• Timber, coal, or iron ore held for more than one year, if an economic interest was retained, such as a right to receive coal royalties.

Interest. Interest is not SE income unless you receive it in your trade or business. This includes interest on accounts receivable, bonds, notes or other debt, unless you are a dealer in stock or securities. (Remember, if the stocks or securities are held for speculation or investment by a dealer, the interest is not SE income.)

Part-time business. Income from a part-time business can be SE income. (Again, this will not apply if you are incorporated.) For example, you do woodworking and carpentry in your spare time. You have your own shop equipment and tools. You get your customers from advertising and word-of-mouth. The income you earn from this activity may be SE income.

Real estate rent. Rent from real estate and personal property leased with real estate is not SE income, unless either of the following applies:

1. You are a real estate dealer, or
2. You provide services for your tenants. You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making profits from those sales. Rents received for using or occupying a hotel or apartment house are SE income if services are provided for the occupants. Something is a service if it is provided for the convenience of the occupants, such as maid service. But heat, light, cleaning of stairways and lobbies, and the collection of trash are not services primarily for the occupants' convenience.

Determining net SE income. Net SE income usually includes all business income minus all business deductions allowed for income tax purposes, and is shown on either a Schedule C, F, or K-1 of your individual tax return. You must determine your net income from self-employment by using the same accounting method you use for income tax purposes. When calculating your net SE income, you do not reduce it by any of the following:

1. personal exemptions for yourself, spouse, or dependents;
2. the standard deduction or itemized deductions;
3. the net operating loss deduction;
4. the self-employed health insurance deduction;
5. the deduction for half of your SE tax; or
6. nonbusiness deductions (including contributions to pension or retirement plans, such as SEPs, Keoghs, or SIMPLE plans).

If you have any questions concerning the self-employment tax, or any other question for that matter, please feel free to give me a call at (562) 698-9891.

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All rights reserved. For personal use only. Do not duplicate or distribute without permission. All information in this article is for informational purposes only. Some of the articles included here were written in a prior year or before a current tax law change. Therefore some of the information in the older articles may not still be valid. Any dollar thresholds indicated relate only to the year for which the article was written and could be different for the current year. Please discuss with us your personal situation before acting on any of the information provided. If you have any questions, please give us a call at (562) 698-9891.