If you own a business that isn’t incorporated, your business income likely triggers self-employment (SE) tax to cover Social Security and Medicare taxes. Self-employment tax is imposed on net earnings from self-employment, which is income derived from carrying on a trade or business, minus allowable deductions. A self-employed person pays what amounts to the employee and employer share of FICA. The SE rate is considerable—15.3%–but one half is a personal deduction. BLS reported that self-employed workers account for about 5.5% of U.S. workforce. And given the number of business owners with unincorporated entities, the overall number of individuals subject to SE tax is very high. Unfortunately, mistakes can be made.
Mistakes to avoid and what you can do:
1. Misclassifying gig income
Today, many people work in the gig economy. They are ride share or delivery drivers, freelancers, or influencers. These activities usually are considered to be a trade or business, even if done on a part-time basis or as a sideline hack for extra income. The earnings from these activities can’t just be reported as “other income” (a line on Schedule 1 of Form 1040) if are really a business. Earnings should be reported on Schedule C.
For example, in one case, a movie reviewer reported his income from writing reviews as well as the sale of movie memorabilia as “other income” and did not file a Schedule C to report this as business income. The Tax Court said he was in a business, which is something he’d done for 30 years. As a result, the “other income” minus allowable deductions was really net earnings from self-employment and was subject to SE tax.
What to do: Treat business income as business income, and take it into account for self-employment tax purposes.
2. Thinking all income for limited partners and LLC members are exempt
In general, limited partners are subject to self-employment tax only on guaranteed payments and not on their distributive share of partnership income. But courts and the IRS are increasingly looking at the true nature of limited partners’ activities.
Using a functional analysis test, courts look past labels of state law regarding limited partners for SE purposes. For example, the Tax Court said that hedge fund managers were subject to SE tax because of their business activities even though technically called limited partners under state law.
What to do: Analyze the activities of limited partners to determine their true status for SE tax purposes.
3. Not taking SE tax into account for retirement plans
Self-employed individuals with a qualified retirement plan—SEP, 401(k), profit-sharing plan, etc.—base contributions to the plan on net earnings from self-employment after a reduction for SE tax. The Deduction Worksheet for Self-Employed in Publication 560 takes into account the reduction in net earnings for SE tax.
What to do: Don’t ignore SE tax in figuring retirement plan contributions or face penalties for making excess contributions.
4. Not using the optional SE tax in bad years
Businesses are not always profitable. If you have a year with little or no net income from self-employment, you can obtain credits for Social Security coverage by using an optional method for figuring SE tax. In essence, you’re agreeing to pay more in SE tax than would otherwise be owed in order to gain Social Security credits (used to figure eventual Social Security benefits).
You can use the nonfarm optional method if net earnings from nonfarm self-employment in 2025 were less than $7,840 and also less than 72.189% of your gross nonfarm income. (The $7,840 may be increased for 2026.) The nonfarm optional method can only be used for 5 years; they don’t have to be consecutive. Different rules apply to the farm optional method.
What to do: Don’t pass up the opportunity to build Social Security credits, which can impact retirement benefits later on.
5. Failing to include SE tax in estimated taxes
Underpayments of federal income tax can result in penalties. Self-employed individuals typically pay their taxes through quarterly estimated taxes, which cover both income tax and self-employment tax (as well as some other taxes and amounts). The underpayment penalty is based on the quarterly IRS interest rate, which is 7% for the first quarter of 2026.
What to do: Take SE tax into account in figuring estimated taxes for the year.
Final thought
Predictions by MBO Partners expect half the U.S. workforce to be self-employed by 2027. This is because of the impact of AI, a growing skill gap, and other factors. Huge layoffs by major corporations, including Amazon, General Motors, Microsoft, Paramount, Procter & Gamble, Nestlé, Target, UPS, and Verizon, mean that former employees will need to find new jobs or become self-employed. Make sure that if you work for yourself (and don’t do so through a corporation), you avoid SE mistakes.
Additional information concerning self-employed individuals can be found in this list of blogs.
