Chapter 12: Self-Employment and Small Business Taxes

This post is Chapter 12 of 14 of the book Keep More of What You Earn — a plain-English guide to US taxes.

Nadia’s first year as a freelance marketing consultant went beautifully — $92,000 in client payments, working from her spare bedroom, no boss. Then April arrived. Her tax software delivered the news: $24,700 owed, due immediately, plus quarterly payments going forward. “Nobody told me I’d owe that much. Where did it all go?”

It went to the tax employees never see: self-employment tax — both halves of Social Security and Medicare, 15.3% on top of income tax — with zero withheld during the year. Nadia’s shock is the most common self-employment story in America, and it’s entirely preventable.

The 15.3%: the tax employees never see

Employees pay 7.65% in payroll tax; their employer pays the other 7.65%. Self-employed? You pay both halves: 15.3% total, computed on 92.35% of your net business profit. The two pieces for 2026:

Social Security: 12.4% on net earnings up to the $184,500 wage base.
Medicare: 2.9% on all net earnings, no cap. Plus 0.9% additional Medicare tax above $200,000.

Consolation prize: half of your SE tax is deductible above the line.

Nadia’s $92,000 profit: SE tax base $92,000 × 92.35% = $84,962; SE tax ≈ $13,000; deductible half $6,500 → AGI ≈ $85,500; income tax (single, standard deduction $16,100) ≈ $10,100. Total ≈ $23,100 — and nothing was withheld. There’s your April shock.

The quarterly rhythm (and the penalty for ignoring it)

Nadia should have been paying roughly $5,775 per quarter (April 15, June 15, September 15, 2026; January 15, 2027). She paid $0 — so she owed the $23,100 plus an underpayment penalty.

Year-one freelancer’s autopilot: use the prior-year safe harbor — pay 100% of last year’s total tax (110% if AGI exceeded $150,000) in four installments; penalty-proof while you learn the rhythm.

The 25–30% rule of thumb: set aside 25–30% of every payment you receive in a separate savings account — immediately, before you spend a dollar.

Deductions: the freelancer’s toolkit

Every legitimate business expense reduces both income tax and SE tax — a double benefit. The major categories:

Home office. Simplified: $5/sq ft up to 300 sq ft = max $1,500. Actual-expense: percentage of rent, utilities, insurance. The space must be used regularly and exclusively for business. Simplified wins for most.

Vehicle. 2026 split rate: 72.5¢/mile (Jan–Jun) and 76¢/mile (Jul–Dec). Requirements: a contemporaneous mileage log. Commuting from home to a regular workplace is never deductible.

Health insurance. Self-employed premiums (medical, dental, vision) are deductible above the line — but not if you’re eligible for an employer’s subsidized plan.

Retirement. Solo 401(k) / SEP IRA: a freelancer netting $100,000 can shelter ~$40,000+.

The rest: business meals (50%), business travel (100%), phone/internet, software, professional development, business insurance, preparer fees, startup costs (up to $5,000 in year one).

What isn’t deductible: commuting, personal meals, fines and penalties, and the “business” that’s really a hobby — no profit in 3 of 5 years and the IRS can disallow all losses.

The QBI deduction: 20% off the top

Section 199A (QBI) lets eligible business owners deduct up to 20% of qualified business income — on top of all other deductions. Nadia’s $92,000 profit could generate an $18,400 deduction, saving ~$4,000 at 22%. The catch: it phases out for specified service businesses at higher incomes — 2026 phaseout $201,750–$276,750 (single) / $403,500–$553,500 (MFJ). Below the range: full 20%, simple.

Entity choice: sole proprietor → LLC → S corporation

You start as a sole proprietor (or single-member LLC — same tax treatment by default; the LLC is legal protection, not tax magic). As profit grows: S corporation?

The S corp’s trick: you become an employee, paying yourself a reasonable salary (payroll tax applies) and taking remaining profit as distributions (no payroll tax). At $100,000 profit: sole proprietor SE tax ≈ $14,130; S corp ($60k salary + $40k distribution): payroll tax ≈ $9,180. Savings: ~$4,950/year — but the S corp costs ~$2,000–$4,000/year in admin. Rule of thumb: consider the S election around $60,000–$80,000+ in consistent net profit. This is a “with a professional” decision.

Paperwork the self-employed forget

1099-NECs you issue: pay any contractor $600+? File by January 31st — penalties per form.
Separate everything: a dedicated business bank account — commingled funds are how deductions die in audits.
Bookkeeping rhythm: reconcile monthly. Fifteen minutes a week beats fifteen hours in April.

Nadia’s full year: the capstone example

Single filer, 2026, freelance marketing. Revenue $98,000; expenses $17,570 (software, home office, mileage, phone, development, insurance, health premiums) → net profit $80,430.

SE tax ≈ $11,366; deductible half $5,683
AGI: $80,430 − $5,683 − $7,200 = $67,547
QBI deduction: 20% × $80,430 = $16,086
Taxable income: $67,547 − $16,100 − $16,086 = $35,361
Income tax ≈ $4,010; total tax ≈ $15,376 — versus the $24,700 shock from doing nothing. Deductions and QBI saved her ~$9,300.

Quarterly payments: ~$3,844 each. The 28%-of-every-payment habit covers it with room to spare.

Hiring help: contractor or employee?

The IRS uses three control tests — behavioral, financial, relationship. Misclassification means back payroll taxes, penalties, and interest. When in doubt: file Form SS-8, or just treat them as an employee.

The self-employed benefits stack

Solo 401(k): $24,500 employee + ~25% of profit employer-side, to $72,000 (2026).
HSA: fully available — same $4,400/$8,750 limits, deductible above the line.
Health insurance: deducted above the line.
The stack: retirement + HSA + premiums can shield $50,000+ before the standard deduction — if you set them up deliberately, before December 31st.

Key takeaways

SE tax is 15.3% on 92.35% of net profit (12.4% SS to $184,500 + 2.9% Medicare, 2026) — on top of income tax. Half is deductible above the line.
Pay quarterly or pay penalties. Prior-year safe harbor in year one; 25–30% of every payment to a tax account.
Deductions do double duty — home office ($1,500 simplified), mileage (72.5¢/76¢ split 2026), health insurance, retirement are the big four.
QBI: 20% of business income deductible, phasing out $201,750–$276,750 single / $403,500–$553,500 MFJ (2026).
S corp election makes sense around $60k–$80k+ in steady profit — savings must beat ~$2k–$4k in admin, and the salary must be reasonable.
Look like a business: separate accounts, monthly books, issue your 1099s, profit 3 years in 5.
Build your own benefits stack — Solo 401(k) + HSA + deductible premiums can shield $50,000+ before the standard deduction.

Next: Chapter 13 — Tax-Smart Investing.