What is Self-Employment?

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Definition:

Being self-employed generally means that you are your own boss — You keep your own hours, cover expenses, and pay your own taxes.

🤔 Understanding self-employment

Self-employed people are generally individuals who work in a freelance or contractor capacity for other companies. They pay their own taxes, insurance, equipment, and other expenses. They’re typically not protected by labor laws that protect traditional employees, such as worker’s compensation, overtime, or minimum wage. The government defines self-employment in a specific way for tax-filing purposes. The term includes business structures like pass-through entities (aka businesses that pass its income and expenses directly to its owner). A self-employed person may provide a particular service or run a small private business. They are different from a W-2 employee or someone who owns a public corporation.

Example

Drivers who offer their services through ride-sharing apps, like Uber (UBER) and Lyft (LYFT), often do so as independent contractors for the app companies. In September 2019, California passed a landmark legislation (aka Assembly Bill 5, or AB5) to reclassify these drivers and other gig economy workers as W-2 employees. The state declared that these workers are employees because their services are controlled and directed by the company they work with.

Takeaway

Being self-employed is like adulting…

You get to choose when you work and when you play, but you’re also responsible for making sure the bills (aka taxes) get paid. As an employee, you’re required to be at the workplace for an assigned number of hours. Your employer handles the taxes and operations. It’s kind of like living with your parents. You play by their rules; they keep the lights on and the water running. When you’re self-employed, you make your own rules, and pay your own bills.

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What are the different types of self-employment?

The IRS considers you self employed when you own and operate a business that isn’t structured as a C corporation. This includes sole proprietors, LLCs, S-Corps, and partnerships.

A sole proprietor is an owner-operator — They own their small business, and they’re the sole employee of that business. This could include an e-commerce shop on eBay, or a jewelry maker who sells out of their own store.

Freelancers and independent contractors are also self-employed, and they typically work with multiple people or companies as their clients. Freelancers and contractors often provide a specific service, like web design, software programming, writing, wedding photography, auto repairs, and so on.

Self-employed individuals pay their own taxes, typically on a quarterly basis. The Internal Revenue Service (IRS) allows them to claim deductions for expenses that are related to the business.

You are also considered self-employed if your business is structured as a LLC (Limited Liability Company). For example, if you and your spouse own a small store in town, you may structure it as an LLC and a limited general partnership so that you split the profits. Since these are pass-through entities, you (and your partner, if applicable) would be considered self-employed.

What are some examples of being self-employed?

There are many different ways a person can be self-employed. Essentially, any small business that involves working for yourself is generally considered self-employment. Here are a few examples:

  • A jewelry maker who sells handmade items online through a marketplace (think Etsy or a booth at your local arts and crafts fair)
  • A reseller who buys products at a discount (whether from thrift stores or the clearance aisle at your local shopping center) and flips them in person or online for a profit
  • A driver that offers ride services through apps (like Uber or Lyft), or delivers food through apps like Doordash or GrubHub
  • A caretaker for children, pets, houses, or campgrounds
  • A manual laborer or handyman who cuts grass, hauls away unwanted items, or cleans windows
  • Someone who offers creative services, including a wedding or portrait photographer, website programmer, and desktop publisher

What is the self-employment tax?

When you work for yourself, you’re responsible for paying taxes that would otherwise be paid by your employer, such as Medicare and Social Security. When you work as a W-2 employee, your employer pays half of the Social Security and Medicare taxes you owe, and withholds the other half from your paycheck. As a self-employed person, you pay these taxes on your own, in addition to income taxes. The good news is that if you’re self-employed you can deduct half (the portion that an employer would pay) when filing your income tax return. The Internal Revenue Service requires self-employed individuals to file income taxes and pay self-employment taxes when their individual net income meets or exceeds $400 annually.

How much in taxes will I pay if I’m self-employed?

As of January 2020, the self-employment tax rate is 15.5% of net income. Social security makes up 12.4% of that rate, and the remaining 2.9% goes toward Medicare taxes. The Social Security tax rate, however, may only apply to a specific amount of your income.

For 2020, the Social Security portion of the self-employment tax applies to the first $137,700 of your combined wages, tips, and net earnings. The Medicare rate applies to all of your earnings.

As a self-employed person, you’re allowed to deduct a variety of expenses from your earnings, such as office space, gas, phone bills, equipment, and meals directly related to your business. You’re also allowed to deduct half of your self-employment taxes when calculating your adjusted gross income.

Self-employed individuals pay self-employment and income taxes based on their net income — The amount left after taking out deductions from your gross income. Unlike self-employment tax rates, which is a flat percentage, income tax rates vary based on your level of taxable income, filing status, and the tax year. For example, if you filed as a single taxpayer in 2019 and earned a taxable income between $39,476 and $84,200, your income tax rate is 22%.

Am I required to pay the self-employment tax?

If you’ve earned $400 or more in a given year from self-employment sources, then you’re required to pay the self-employment tax, regardless of your gross income amount. Let’s say you’re a W-2 employee who sells handmade jewelry through Etsy, and you made $500 in sales one year. You would be required to pay the self-employment taxes on that $500 in addition to paying your standard taxes for the W-2 income.

For tax year 2019, an individual single taxpayer is not required to file income taxes if their taxable income was under $12,200. However, if you earned $500 from a side gig like an Etsy shop (more than the $400 minimum), then you’re required to pay self-employment taxes on the Etsy income, even if your W-2 income was under $12,200.

When you do earn more than the minimum $400 in self-employment income, the IRS expects you to file estimated income tax payments on a quarterly basis, using the Form 1040-ES. If you expect to owe $1000 or more in taxes for the year and don’t submit quarterly tax payments, you may owe the IRS a penalty at the end of the tax year.

The Form 1040-ES includes a worksheet to help you estimate your income taxes and deductions. If this is your first year working as a self-employed individual, you’ll estimate based on your growth and profit predictions.

At the end of the year, you’ll file a Schedule C and itemize your deductions, earnings, and quarterly payments made through the year. Depending on how complicated your taxes are, you may want to consider hiring a tax accountant.

How do I become self-employed?

There are many ways to be self-employed. You might earn self-employed income by driving Uber in your free time outside of your full-time job. You might earn most or all of your income through self-employed means, like providing a specialty or professional service on your own, or you might choose to open a small store and sell a product.

Keep in mind that the process for becoming self-employed will vary by person and business. For example, if your business is providing a specialized service, like hair styling, you may need to acquire a license or build a work portfolio before you can begin to take on customers. If you’re opening a shop, you may need to first save up capital.

Here are a few common steps that a self-employed person may take to form their business:

  • Determine what type of tax entity (Sole proprietor, LLC, S-Corp) is best suited for their type of business.
  • Call or visit their local city’s county clerk office (or check for online applications) to obtain any licenses that may be required for their business. For example, a bar owner may need to acquire a license to sell alcohol. A home repair shop may require special permits and insurance.
  • File for an Employer Identification Number (EIN) with the Internal Revenue Service.
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