Many individual business owners often choose to keep it simple and consider themselves as “self-employed” instead of forming a corporation. The IRS defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed”. An activity qualifies as a business if your primary purpose for engaging in the activity is for income or profit, and you are involved in the activity with continuity and regularity.
Many taxpayers question whether they are considered self-employed just because they received compensation during a tax year. The answer to that question makes a big difference. In addition to income tax, an individual could also be subject they could be subject to self-employment tax (“SE tax”) as well. Self-employment tax is similar to the Social Security and Medicare payroll taxes withheld from the pay of most wage earners. The total cost of these taxes for an employee is split between the employer and their worker, i.e. each pays a 7.65% tax rate on eligible wages. However, a self-employed taxpayer must pay up to 15.3% on eligible wages for 2013 (12.9% Social Security tax of the first $113,700 of net self-employment income and 2.9% Medicare tax on all net self-employment income.
It can be unclear whether an activity is considered to be a trade or business for SE tax purposes. Sometimes an activity is considered “sporadic” and not subject to SE tax. There are no clear-cut rules and the IRS will look at the facts and circumstances to make a determination. In one case an officer of a company was paid a commission by another corporation to negotiate the sale of the officer’s company to the corporation. The IRS ruled the payments to the officer were not self-employment income even though he received four installment payments during the tax year. The IRS did not consider this to be an activity conducted with continuity and regularity. That ruling contrasts a different case where a member of Congress was paid to deliver speeches. During the tax year in question, the congressman made 10 speeches and received $1,500. There was no pattern to the number of speeches given, the time required to speak or amount of compensation received for each speech. But the IRS ruled that the Congressman did earn self-employed income because the frequency indicated a degree of recurrence, continuity and availability for regular speech giving.
The IRS says certain types of activities are not self-employed income:
• Investment income from stocks, bonds, etc. that you own and manage
• Most prize and awards received
• Jury duty pay
• Shareholder distributions from S Corporations
• Gambling winnings
• Cancelled debt
• Income from the rental of personal property if you engaged in the rental for profit but were not in the business of renting such property
Self-employment tax is a hot issue for the IRS. Gary Kaplan, CPA can help if you have doubts about whether you are subject to self-employment tax.
