Business, Legal & Accounting Glossary
Self-employment can be referred to a person who works for himself/herself instead of as an employee of another person or organization, drawing income from a trade or business.
In the United States, self-employed workers are paid directly by clients or by their business, and some proportion of these payments will be due to the government as income tax.
In the United States, a person running a business as a sole proprietorship or a limited liability company is considered self-employed for tax purposes, but the sole shareholder of an S Corporation is not considered self-employed. Such a person is considered an employee of the corporation and does not pay self-employment tax, but instead pays FICA tax (matched by the corporation) at half the tax rate at which the self-employment tax is imposed — 7.65% each by employer and corporation, instead of the 15.3% self-employment tax.
The self-employed in the United States are usually required to pay estimated income taxes quarterly. They pay both the employee and employer portions of the FICA tax (which pays for Social Security and Medicare) since they are considered both the employer and the employee. An employed person pays 7.65% (6.2% for Social Security and 1.45% for Medicare) through a paycheck deduction, and the employer pays the other 7.65%. The self-employed person pays both sides of this tax, or 15.30% total. However, since half of the hypothetical self-employment tax is allowed as a deduction against self-employment income, only 92.35% of the self-employment income is taxable at 15.30%, an effective tax rate of about 14.13%. This tax is reported on Schedule SE of the IRS Form 1040.
Many self-employed choose to incorporate to reduce this tax. Before incorporation, a self-employed person making $100,000 in business profit would pay 15.30% of that profit in self-employment tax, or $15,300. But with an incorporated business, the business can pay the owner $50,000 in salary and $50,000 in dividends (called “distributions”). The owner pays 7.65% of the $50,000 in salary and his/her corporation pays the other 7.65%, for $7650 total. Distributions are not subject to self-employment tax, so there is no FICA/Medicare tax on the $50,000 in distributions. Thus the business owner may save $7,650 in taxes. However, tax laws can be tricky, and do change, so it is usually advisable to seek the advice of a competent accountant in taking the decision to incorporate for the purpose of saving tax. (Note, however, that the above example is slightly over-simplified — the 12.4% OASDI portion of the self-employment tax, or the 6.2% OASDI portion of the FICA tax applies only to the OASDI wage base, which is the first $94,200 of self-employment income in 2006, or $97,500 in 2007. The 2.9% Medicare portion of the self-employment tax and the 1.45% Medicare portion of the FICA tax applies to all self-employment income.)
Self-employed persons are sometimes eligible for more deductions than an ordinary employee. Travel, uniforms, computer equipment, cell phones, etc., can be deducted as legitimate business expenses. However, again, the advice of an expert may be worth the money it costs.
Self-employed persons report their business income or loss on Schedule C of IRS Form 1040 and calculate the self-employment tax on Schedule SE of IRS Form 1040.
Self-employed workers cannot contribute to a 401k plan of the type with which most people are familiar. However, there are various vehicles available to self-employed individuals to save for retirement. Many set up a Simplified Employee Pension Plan (SEP) IRA, which allows them to contribute up to 25% of their income, up to $44,000 (2006) per year. There is also a vehicle called the Self-Employed 401k or SE 401k for self-employed people. The contribution limits vary slightly depending on how your business is organized but are generally higher than the other types of plans.
A self-employed person in the United Kingdom can operate as a sole trader or as an incorporated limited liability company. It is also possible for someone to form a business that is run only part-time or concurrently while holding down a full-time job. This form of employment, while popular, does come with several legal responsibilities. When working from home clearance is required from the local authority to use part of the home as business premises. Should the business hold records of customers or suppliers in any electronic form it is required to register with the Data Protection Registrar. Other legal responsibilities include statutory public liability insurance cover, modifying premises to be disabled-friendly, and the proper recording and accounting of financial transactions. Free advice on the range of responsibilities is available from government-operated Business Link centres.
Self-employed may be subject to more taxes than the average employee. In addition to both the employee and employer National Insurance contributions, there may be VAT, business rates and other taxes payable to central and local governments.
Both in the US and the UK governments are cracking down on disguised employment, often described as the presence of a contractual intra-business relationship to hide what is otherwise a simple employer-employee relationship.
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This glossary post was last updated: 11th August, 2022 | 0 Views.