In General: Self-employment tax is imposed on a self-employed individual’s self-employment income (Code Section 1401). Self-employment income generally means the net earnings from self-employment an individual. However, an individual’s self-employment income does not include:
- for purposes of the OASDI portion of the tax, that part of the net earnings from self-employment that exceeds the contribution base for the year reduced by the amount of any FICA wages paid to the individual during the tax year (Code Section 1402(b)(1)); or
- the individual’s net earnings from self-employment for the tax year, if that amount is less than $400 (Code Section 1402(b)(2)).
An individual’s net earnings from self-employment are equal to:
- the gross income the individual derives from any trade or business he or she carries on, less the same deductions that are generally allowed for income tax purposes and that are attributable to that trade or business; plus
- the individual’s distributive share (whether or not distributed) of partnership income or loss from any trade or business carried on by the partnership; with
- certain adjustments (Code Section 1402(a); Regulation Section 1.1402(a)-2(a)).
Observation: This is the regular method for figuring net earnings from self-employment.
The trade or business must be carried on by the individual, either personally or through agents or employees (Berger v. Commissioner, Tax Court Memo. 1996-76; Moorhead v. Commissioner, Tax Court Memo. 1993-314; Price v. Commissioner, Tax Court Memo. 1993-265). Accordingly, income derived from a trade or business carried on by an estate or trust is not included in determining the net earnings from self-employment of the individual beneficiaries of such estate or trust (Regulation Section 1.1402(a)-2(b); Revenue Ruling 59-162).
If an individual has two or more businesses, the individual’s net earnings from self-employment are the combined net earnings from all of his or her businesses. A loss in one business reduces the income from another (Regulation Section 1.1402(a)-2(c)).
If a taxpayer successfully “mines” virtual currency (for example, the taxpayer spends computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger, and receives new bitcoins in exchange) and if the taxpayer’s mining of virtual currency constitutes a trade or business and the taxpayer does not engage in the mining activity as an employee, the net earnings from self-employment resulting from those activities constitute self-employment income and are subject to self-employment tax. Also, the fair market value of virtual currency an individual receives for services he or she performs as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax (Notice 2014-21).
Whether a payment is derived from a trade or business carried on by an individual depends on whether, under all the facts and circumstances, a nexus exists between the payment and the carrying on of the trade or business (Revenue Ruling 91-19). Generally, the required nexus exists if it is clear that a payment would not have been made but for an individual’s conduct of a trade or business. For example, in Peterson v. Commissioner, 2016 PTC 181 (11th Circuit 2016), Tax Court Memo. 2013-271, the court held that post-retirement deferred compensation payments to a Mary Kay beauty consultant were subject to self-employment tax because the payments were based on past services. However, in Newberry v. Commissioner, 76 Tax Court 441 (1981), the Tax Court held that business interruption proceeds from an insurance policy, which were intended to compensate for earnings lost as a result of a fire which suspended operation of the taxpayer’s grocery store, did not constitute earnings from self-employment because they were not derived from a trade or business “carried on.” Similarly, unemployment benefits and strike benefits are not subject to self-employment tax because no services are being performed (Revenue Ruling 58-139, Revenue Ruling 60-330, Revenue Ruling 68-424).
The fact that a payment represents compensation for lost income of a trade or business rather than income generated directly by the day-to-day conduct of the trade or business is generally irrelevant in determining whether this required nexus exists (Revenue Ruling 60-32; Notice 87-26). In Revenue Ruling 76-500, for example, a farmer suffered an $8,000 crop loss resulting from a drought. The farmer received an $8,000 loan from the Farmers Home Administration, of which $5,000 of the principal was immediately canceled. The IRS concluded that the amount of the canceled portion of the loan represents a replacement of a portion of the farmer’s lost profits, and must be taken into account in computing net earnings from self- employment.
Observation: The IRS stated in Revenue Ruling 91-19 that it does not agree with the Tax Court’s decision in Newberry v. Commissioner, 76 Tax Court 441 (1981), to the extent the decision holds that the required nexus cannot exist if an individual is not currently engaged in the day-to-day conduct of the trade or business, e.g., is unemployed.
S corporation pass-through items do not constitute net earnings from self-employment to the S corporation’s shareholders because those items are not derived from a trade or business carried on by the shareholder (Ding v. Commissioner, Tax Court Memo. 1997-435; Revenue Ruling 59-221).
Generally, an individual’s gross income and deductions attributable to a trade or business for self-employment tax purposes are determined under the same rules that apply in determining his or her income and deductions for income tax purposes. Thus, if the individual uses the accrual method in computing taxable income from a trade or business for income tax purposes, he or she must use the same method in determining net earnings from self-employment (Regulation Section 1.1402(a)-2(a)). An individual’s gross income from a trade or business includes gross income he or she received (in the case of a cash method taxpayer) or accrued (in the case of an accrual method taxpayer) in the tax year from a trade or business, even though that income may be partly or entirely attributable to services rendered or other acts performed in an earlier tax year in which the individual was not subject to self-employment tax (Regulation Section 1.1402(a)-1(c)).
If, in addition to self-employment income, the taxpayer has wages that are subject to FICA tax, the OASDI contribution base is reduced by the amount of those wages. This rule is important only if the taxpayer’s total earnings (wages and net earnings from self-employment) for the year are greater than the OASDI contribution base.
Example: Karen has $30,000 in wages and $40,000 in net earnings from self-employment in 2017. Thus, her total earnings ($70,000) are not greater than the 2017 OASDI contribution base ($127,200). Karen’s employer will withhold 7.65 percent in OASDI and Medicare taxes on her $30,000 of wages. Karen must pay 13.3 percent in OASDI and Medicare taxes on her $40,000 of net earnings from self-employment.
Example: Karl has $90,500 in wages and $50,000 in net earnings from self-employment from a business in 2017. Karl does not pay dual OASDI tax on earnings of more than $127,200. Karl’s employer will withhold 7.65 percent in OASDI and Medicare taxes on Karl’s $90,500 of wages. The $90,500 of wages reduces his self-employment tax OASDI contribution base to $36,700 ($127,200 − $90,500 = $36,700). Thus, Karl must pay 13.3 percent in OASDI and Medicare taxes on the first $36,700 of his $50,000 of net earnings from self-employment, and then 2.9 percent in Medicare tax on the remaining $13,300.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 03/06/2021 09:49)