http://turbotax.intuit.com/tax_help/the_self_employment_tax/articleI'm starting a new business. Do I need to pay the self-employment tax?

Yes, if you make any money. The self-employment tax (officially known as the SECA tax for Self-Employment Contributions Act tax) is the self-employed person's version of the FICA (Federal Insurance Contributions Act) tax paid by employees to pay for Social Security and Medicare. It's due on your net earnings from self-employment.

This article defines the self-employment tax, explains how it is calculated, and tells you how to report the tax on your income tax return. There is also a brief introduction to paying estimated taxes

Many newly self-employed people — sole proprietors, independent contractors and the like — are surprised at their tax bills at the end of the year because they notice they're suddenly paying a lot more in tax as a self-employed person than as an employee. That's because they're carrying the full burden of paying for Social Security and Medicare. Employees share that cost with their employers, with each paying the 7.65% FICA tax. When you're self-employed, though, you're stuck with the full 15.3% levy.

The tax is divided into two parts:

• 12.4 percent for Social Security. For 2006, this part of the tax applies to the first $94,200 of earnings. If you earn more than (from your business or, if you also have a job, from the combination of your job and your business), then the 12.4% part of the tax that pays for Social Security stops. (The dollar limit will be a few thousand dollars higher in 2007.)
• 2.9 percent for Medicare. The Medicare portion of the self-employment tax is unlimited. No matter how much you earn, you'll pay the 2.9% Medicare tax. Even if you have investment losses that offset part of your self-employment income for income tax purposes, such losses will not effect the amount of self-employment tax you owe. For more information on this tax, see IRS Tax Topic 554: The Self-employment Tax.

When you start a small business and you do not incorporate or form a partnership, you report the results of your operations on Schedule C and file that with your Form 1040. The result of netting your revenues and expenses is a net profit or loss.

You calculate your self-employment tax on Schedule SE and report that amount in the "Other Taxes" section of Form 1040. In this way, the IRS differentiates the SE tax from the income tax.

Good news: When figuring self-employment tax you owe, you get to reduce self-employment income by 7.65% before applying the tax rate. Say, for example, that your net self-employment income is $50,000. That's the amount you report as taxable for income tax purposes on Form 1040. But when figuring your self-employment tax on Schedule SE, Computation of Social Security Self-Employment Tax, the taxable amount is $46,175. Not paying the 15.3% tax on $3,825 difference in this example saves you $585.

(The savings evaporate at higher income levels. When 2006 self-employment income hits $102,003, for example, even after the 7.65% reduction, the 15.3% rate applies to the maximum $94,200 to which the full self-employment tax applies in 2006 Above that level, then, the reduction saves not the full 15.3% but only the 2.9% Medicare portion of the tax which applies to all self-employment income.)

More good news: You can claim 50% of what you pay in self-employment tax as an income tax deduction. A $1,000 self-employment tax payment reduces taxable income by $500, for example. And, in the 25% tax bracket, that saves you $125 in income taxes. This deduction is an adjustment to income claimed on the Form 1040 and is available whether or not you itemize deductions.

You run a catering business as a sole proprietor. In 2006 your net profit as reported on Schedule C is $35,000.Your net earnings as calculated on Form SE would be $32,323 ($35,000 x 0.9235). Your self-employment tax would be $4,945 (32,323 x 0.153) and you would report that amount on Form 1040 in the "Other Taxes" section. Then you would report one half of your self-employment tax, $2,473, ($4,945 X .50) on the 1040 as an adjustment to income, which reduces your adjusted gross income and thus the amount of income tax you owe.

If you have worked as an employee, you know that the net earnings on your paycheck are much less than your gross earnings. Why? Because your employer withheld money for social security, Medicare, and income tax, and sent that money to the government.

When you are self-employed, the entire burden for paying employment taxes and prepaying estimated income tax liability is left to you. That's why you need to pay estimated taxes in quarterly installments to the U.S. Treasury; otherwise, you may be subject to underpayment penalties.

If you're not sure whether you meet the definition of being self-employed, see IRS Tax Topic 554: The Self-Employment Tax.

For more information on estimated taxes, see IRS Tax Topic 355: Estimated Tax.