In the realm of taxes, understanding who is required to pay self-employment tax and who is exempt is crucial for individuals navigating their financial responsibilities. Whereas employees have Social Security and Medicare taxes withheld from wages–often referred to as FICA taxes– individuals who work for themselves are subject to self-employment (SE) tax, which they pay in lieu of the Social Security and Medicare taxes employees pay via payroll withholding. Employees and employers share the employee’s liability, while self-employed individuals pay both the employer and employee liability. 

Understanding Self-Employment Tax - Before diving into the specifics of who must pay self-employment tax, it's essential to understand what it entails. Self-employment tax is governed by the Self-Employment Contributions Act (SECA), under which individuals who earn income directly from their business activities, rather than as employees, are required to contribute to Social Security and Medicare. This tax is calculated as a percentage of net earnings from self-employment. 

For 2024, the self-employment tax rate is 15.3%, comprised of 12.4% for Social Security contributions on the first $168,600 of net earnings and 2.9% for Medicare contributions on all net earnings. Unlike employees, who share these tax responsibilities with their employers, self-employed individuals bear the full burden. An additional Medicare tax of 0.9% of net self-employment income applies for those with SE income above the following thresholds: $250,000 married joint, $125,000 married separate and $200,000 all others 

Who is Required to Pay Self-Employment Tax? – Generally the following are subject to self-employment tax:

• Sole Proprietors and Independent Contractors - Individuals operating their businesses or offering services as sole proprietors or independent contractors are required to pay self-employment tax on their net earnings if they exceed $400 in a tax year.
  

• Partners in a Partnership - Members of a partnership that conducts a trade or business are subject to self-employment tax on their share of the partnership's income.
  

• Members of a Limited Liability Company (LLC) - Depending on the election made by the LLC, members may be treated as sole proprietors or partners for tax purposes and thus be required to pay self-employment tax on their share of the LLC's profits.
  

• Clerics - A cleric is required to pay self-employment tax on income from services as a minister unless the individual has taken a vow of poverty. The following are examples of common situations related to the self-employment income of clerics:
  
  o   W-2 Income - from the Church is subject to income tax, and self-employment tax. It's important to note that the church does not withhold FICA taxes for this income.
  
  o   Self-employment Income - Clerics who do not work for a specific church or who receive income for presiding over weddings, funerals, etc., have non-employee income that is taxable and subject to self-employment tax, based on the net profit from the self-employment activity.
  
  o   Schedule C – This is the IRS form on which clerics report their SE income, which can be offset by associated expenses, resulting in the net profit that’s subject to SE taxes.
  
  o   Most clerics receive a Housing (Parsonage) Allowance from the church they work for. To the extent allowed by law, this income is not subject to income tax but is subject to self-employment tax.

Who is Exempt from Paying Self-Employment Tax? - While the scope of self-employment tax is broad, there are specific exemptions and special cases:

• Employees: Individuals who work as employees and receive a W-2 form are not subject to self-employment tax on their wages, as their employers withhold Social Security and Medicare taxes throughout the year that the employer pays over to the government.
  

• Rental Income: Generally, income derived from renting out property is not subject to self-employment tax unless the individual is engaged in a rental business that provides services for the convenience of tenants. This generally includes rents paid in crop shares.
  

• Limited Partners: Limited partners in a partnership may be exempt from self-employment tax on certain income distributions, as their involvement in the business is typically passive, i.e., more in the nature of an investment.
  

• Certain Business Owners: Owners of corporations, including S corporations, may not be subject to self-employment tax on their share of the corporation's profits, though they must pay themselves reasonable compensation subject to the FICA employment taxes.
  

• Commissions Allowed by the Probate Court – Commissions (fees) allowed to nonprofessional fiduciaries (such as an estate executor or trustee) by a probate court under local law generally aren't considered self-employment earnings. However, if the fees relate to active participation in the operation of the estate's business, or the management of an estate that required extensive management activities over a long period of time, the fees would be SE income to the extent they represents a special payment for operating the business.
  

• Termination Payments of Former Insurance Salespeople -The law provides that net earnings from self-employment don’t include any amounts received from an insurance company for services performed by an individual as an insurance salesperson for the company if certain conditions are met.
  

• Religious Exemptions - Ministers, Christian Science practitioners, and members of religious orders who have taken a vow of poverty may get an exemption from self-employment tax on their earnings if certain requirements are met. To get the exemption, Form 4361 must be filed with the IRS. Retired clergy receiving parsonage or rental allowances are not subject to self-employment tax.
  

• Notary Public – The fees for the services of a notary public are exempt from the self-employment tax.
  

• Nonresident Aliens - Nonresident aliens engaged in a trade or business within the United States may be subject to self-employment tax, with specific exemptions based on tax treaties.
  

• Miscellaneous Income from an Occasional Act or Transaction – Income from an occasional act or transaction, absent proof of efforts to continue those acts or transactions on a regular basis, isn't income from self-employment subject to the SE tax. An example is a nonprofessional fiduciary who manages the estate of a relative or friend. However, professional fiduciaries are subject to self-employment tax

Special Situations

• Self-employment Tax Deduction - Self-employed individuals can deduct half of their self-employment tax when calculating their adjusted gross income, providing some relief. The purpose of this deduction is to make up for the self-employed person having to pay both sides of the Social Security and Medicare taxes. However, this is not a deduction on the individual’s business form, such as Schedule C. It is deductible whether the individual itemizes their deductions or claims the standard deduction.
  

• Optional Methods – There are two methods – one for farmers and another for nonfarmers – that can be used when net self-employment earnings are less than $400 and paying SE tax isn’t required. Use of these methods allows a taxpayer to continue accruing credit toward their Social Security coverage in years when profits are small (or even when there is a loss). Using the optional method may also allow the individual to qualify for the earned income credit and certain other credits, or to receive a larger credit. These individuals are subject to special rules for self-employment tax, with different thresholds and rates applying to their net earnings.

 Understanding the intricacies of self-employment tax is vital for anyone earning income outside of traditional employment. While the responsibility to pay rests on many self-employed individuals, exemptions and special cases exist.

 Contact this office with questions regarding self-employment tax and how it may apply in your specific circumstances.

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Under U.S. Treasury regulations, any tax advice in this communication is not intended or written to be used to avoid IRS penalties. Tzinberg & Associates provides this newsletter for general guidance only. It does not constitute tax advice, accounting services, investment advice, or professional consulting. Consult a professional adviser before making decisions or taking action, as the information is provided "as is" without any warranties regarding its completeness, accuracy, or timeliness.