Ecommerce Know-How: Self-Employment Tax Requirements

Ecommerce businesses that operate as sole proprietorships, partnerships, and even limited liability companies frequently pass tax liability from the company to the owners and contractors of the business. These owners and contractors must then pay self-employment tax, which is typically a higher rate than what would have been withheld from a paycheck if those individuals were employees (versus owners and contractors) of the company.

Ecommerce has been one of the great social and business levelers in recent times. To some extent, small merchants with very little capital have been able to sell right alongside massive corporations. While that trend may be changing (a topic for a later article), it has meant that a significant number of online retailers and wholesalers are actually small businesses operated as sole proprietorships, partnerships, or limited liability companies (LLC).

Survey Says . . .

As an example, 70.7 percent of Practical eCommerce readers operate businesses with total annual sales of less than $500,000, according to a November 2008 survey. While I could find no statistically significant industry-wide data regarding what percentage of overall ecommerce businesses are formed as proprietorships, partnerships, LLCs, or corporations, the relatively modest sales levels disclosed in the Practical eCommerce survey mentioned above does offer anecdotal evidence that many of these businesses are organized in less complex ways (i.e. a sole proprietorship).

These sorts of business structures have special U.S. tax requirements, and in this edition of “eCommerce Know-How,” I will (1) briefly describe self-employment tax, (2) explain who is likely to be required to pay it, (3) discuss “pay-as-you-go,” and (4) offer a few resources (links) to help affected ecommerce business owners and contractors get more information.

What is Self-Employment Tax?

The U.S. self-employment tax represents both halves (the “employer portion” and the “employee portion”) of Social Security and Medicare taxes. For the 2008 tax year, the rate was 15.3 percent of a self-employed taxpayers total taxable income.

In the more common employer and employee relationship, both the employer and the employee pay Social Security and Medicare taxes, splitting the total tax bill, if you will. But when a person is self-employed, he must pay both halves or the total Social Security and Medicare tax liability.

Of the 15.3 percent tax, 12.4 percent is destined for Social Security and 2.9 percent is reserved for Medicare. There are a few breaks for the self-employed related to the self-employment tax. First, like all American taxpayers, there is a limit. In the 2008 tax year, self-employed workers only had to pay Social Security tax on the first $102,000 of taxable income. (There’s no such upper limitation on the 2.9% Medicare tax.) That Social Security limit has been steadily rising for years. It was $76,200 in 2000. For the 2009 tax year it will to $106,800.

The self-employed can also deduct one-half of their self-employment tax from their adjusted gross income, which does help to offset the cost a bit.

Who Has to Pay the Self-Employment Tax?

Basically, anyone that operates a business that is organized as a sole proprietorship, a partnership, or an LLC that files its taxes on Form 1065 (like a partnership) or who works as an independent contractor (i.e. a web designer or developer), must pay this tax if they earned more than $400 from the venture.

The U.S. Internal Revenue Service (IRS) offers several good resources regarding who must pay the self-employment tax.

Federal Income Taxes Are Pay-As-You-Go

If you worked as an employee, each pay period your employer would withhold a portion of your income and pay it to the IRS. When you’re self-employed it is your responsibility to pay estimated taxes. But don’t take my word for it, here is exactly what the IRS had to say, “You must pay the tax as you earn or receive income during the year. You generally have to make estimated tax payments if you expect to owe tax, including [self-employment] tax, of $1,000 or more when you file your return. There are two ways to pay as you go: withholding and estimated taxes. If you are a self-employed individual and do not have income tax withheld, you must make estimated tax payments.”

The IRS offers Publication 505, which helps to explain your payment responsibilities.

Resources

• US IRS Self-Employment Tax
• The IRS’s Self-Employment Individual’s Tax Center
• The US Social Security Administration’s Contribution and Benefit Base Table, which shows tax liability limits.
• The IRS’s Who is Considered Self-Employed?
• Publication 505, Tax Withholding and Estimated Tax
• Publication 334, Tax Guide for Small Business