Paying taxes as an independent contractor can be a pain. The purpose of this article is to make it easier for self-employed individuals (such as real estate agents, brokers, and investors) to understand, calculate and plan for paying Uncle Sam the self-employment tax he is owed.
An independent contractor is essentially a nonemployee, meaning a person or business entity that provides products or services to other businesses and is in business for themselves. This is in contrast to an employee, who works for an employer and is paid a certain wage or a salary.
Sounds pretty obvious, right?
According to the National Association of Realtors, there are about 2 million independent real estate agents and brokers in the United States. Each one of these individuals is a self-employed business owner, considered an independent contractor.
The Internal Revenue Service (IRS) has declared that real estate agents are "statutory nonemployees" for tax purposes. As such, they are considered self-employed and subject to self-employment tax, just like any other independent contractor.
Self-employment tax consists of Social Security and Medicare taxes for self-employed individuals. It is equivalent to the Social Security and Medicare taxes that employers are required to withhold from their employees’ paychecks.
Think of it this way: If you were working for an employer, you would have a certain amount of money withheld from your paychecks for Social Security and Medicare taxes. What you may not know is that your employer would also have to pay that same amount on the wages you receive.
Those required to pay self-employment tax include:
Independent contractors are responsible for paying both the employee's and the employer's portions of self-employment tax on their earnings. Also, rather than having the tax withheld from multiple paychecks throughout the year, independent contractors must pay self-employment tax as a lump sum, along with their income tax return in the spring, or by making estimated quarterly tax payments throughout the year.
Investing in real estate is one of the best ways to create wealth and enhance your cash flow. For passive income investors, your rental income is not subject to self-employment tax. However, if you do several real estate transactions in a year, the IRS might consider you to be doing active business or trade rather than simply enjoying passive income from your real estate investments.
While the IRS treats everything on a case-to-case basis, if you earn more than half of your total income through real estate investments, the IRS may consider your earnings to be a source of earned income rather than passive income. Earned income is subject to self-employment tax and higher income taxes.
How you legally structure your investment activities can also affect how your investment income will be taxed. For example, investing in real estate as a C corporation, and paying yourself a management fee or salary can also trigger self-employment tax and higher income taxes.
You calculate self-employment tax on Schedule SE (Form 1040). To do so, you must take 92.35% of your total net earnings (gross earnings minus any deductions) and multiply that figure by the current self-employment tax rate.
Currently, the self-employment tax rate is 15.3%, which is a combination of 12.4% Social Security tax plus the 2.9% Medicare tax. Therefore, the formula for self-employment tax is as follows:
SE Tax = (net earnings) x (92. 35%) x (15.3%)
For example, if you earn $10,000 in self-employment income in 2020, you will pay approximately $1,412 in self-employment tax ($10,000 x 0.9235 x 0.153 = $1,412.955). Likewise, if you earned $50,000, you would pay $7,064.775 in self-employment tax ($50,000 x 0.9235 x 0.153 = $7,064.775).
Self-employment tax can be a hefty price to pay for doing business as an independent contractor. The only way to reduce your self-employment tax is to reduce your self-employed income.
Shockingly, the IRS allows independent contractors to deduct a wide range of valid business expenses on Schedule C (Form 1040). Knowing what these deductions are and keeping good receipts and records can save you thousands of dollars.
Common expenses that can be deducted on Schedule C include:
Other expenses that individuals often forget to deduct on Schedule C are:
Your self-employed income and expenses are reported on Schedule C. The result of that form is the total self-employed income that gets transferred to the Taxable Income line on your 1040.
If you are an active real estate flipper or wholesaler, you are more than likely subject to self-employment tax. But you can save thousands in taxes by electing to be taxed as an S Corporation.
S Corporations (and LLCs that have elected S Corporation tax treatment) can be structured to minimize or avoid self-employment tax entirely. Also, as an S Corporation, you will not be obliged to pay federal income tax or corporate taxes.
For instance, you can structure your S Corp so that you only pay self-employment tax on a fair salary that you pay yourself, rather than on your corporation’s net earnings. Moreover, any distribution you pay yourself from the S Corporation will be completely exempt from self-employment tax.
As a rule, whenever you have income from sources other than a salary or wages, and you expect to owe $1000 or more when you file your tax return, you need to make estimated quarterly tax payments to the IRS to avoid penalties, interests, and a sizable tax bill at the end of the year. While it is best to consult with a tax professional to determine your quarterly tax payments, there are steps you can take to budget for your self-employment tax obligation:
After accounting for self-employment tax, set aside at least one-third or even as much as 45% of all your earnings in a dedicated savings account. This will help ensure that you have enough to make estimated tax payments each quarter.
Remember, self-employment tax is paid on your net earnings, meaning the amount you have left over after you have accounted for all your expenses. So, be sure to keep accurate records of all your expenses to ensure that you are not paying more taxes than necessary.
If you must submit estimated tax payments each quarter, make sure that you submit them on time to avoid penalties.
A qualified tax professional can help you determine what your self-employment tax liability will be and ensure that you pay your taxes on time. With the right preparation and advice, you will not be caught off guard when tax season rolls around.
Find out about the tax savings strategies that you can implement as a real estate investor or entrepreneur by taking our Tax Discovery quiz. We'll use this information to prepare to have a productive conversation. At the end of the quiz, you'll have an opportunity to schedule your consultation. TAKE THE TAX DISCOVERY QUIZ
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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