What counts as self-employment income

Self-employment income is net earnings from a trade or business carried on as a sole proprietor, as an independent contractor, or as a member of a partnership. The critical distinction the IRS draws is between someone performing services as an employee, where the employer withholds and remits payroll taxes, and someone performing services as an independent contractor, where the obligation falls entirely on the individual.

A person is generally self-employed for tax purposes if they work for themselves rather than for an employer who controls both what work is done and how it is done. The IRS applies a behavioral control test, a financial control test, and a relationship test when worker classification is disputed. Misclassification as an independent contractor when the working arrangement is economically equivalent to employment is a significant compliance risk for both the worker and the business engaging them.

Earnings from the following are treated as self-employment income: sole proprietor business activity reported on Schedule C; a partner's distributive share of partnership income from a trade or business; and certain guaranteed payments from a partnership. Rental income is not self-employment income in most circumstances, though a real estate dealer or someone providing substantial services to tenants may find that it is.

For 2025, net earnings from self-employment below $400 do not trigger a self-employment tax filing requirement. Above that threshold, a Schedule SE must be filed regardless of whether any income tax is owed.

Schedule C: reporting business income and expenses

A sole proprietor reports business income and deductible business expenses on Schedule C, which is attached to the individual Form 1040. The result, net profit or net loss, flows to the main return and is the figure on which self-employment tax and income tax are calculated.

Schedule C requires you to report gross receipts, subtract the cost of goods sold if you sell physical products, and then deduct allowable business expenses to arrive at net profit. The expenses most commonly reported on Schedule C fall into the following categories.

Advertising and marketing

Costs of promoting the business are fully deductible. This includes website costs, digital advertising, business cards, and promotional materials. For service businesses, this is often a modest line item. For e-commerce sellers or client acquisition-dependent businesses, it can be substantial.

Business use of vehicle

If a vehicle is used for business purposes, the deduction can be calculated using either the standard mileage rate or actual expenses. The standard mileage rate for 2025 is 70 cents per mile. Actual expenses include fuel, insurance, depreciation, repairs, and registration, prorated for the business use percentage. You cannot switch from actual expenses back to the standard mileage rate if you used actual expenses in the first year the vehicle was placed in service.

Commuting from home to a regular place of business is not a deductible business expense regardless of the distance involved. Travel between business locations, to client sites, or to temporary work locations is deductible.

Meals

Business meals are 50% deductible when the meal has a genuine business purpose and the taxpayer or an employee is present. The prior rule that allowed 100% deductibility for certain meals has not been extended, and the 50% limitation applies broadly. Entertainment expenses, such as sporting events or theater tickets, are not deductible even when a business discussion occurs.

Office and facilities

Rent for office space, utilities, telephone, and internet used for the business are deductible. Where a dedicated home office is used, different rules apply and are covered in the home office section below.

Professional services

Fees paid to accountants, attorneys, and other professionals for services related to the business are deductible. Legal fees for personal matters, such as estate planning or personal divorce proceedings, are not.

Salaries and wages

Amounts paid to employees are deductible as a business expense. The owner's own salary or draws are not deductible on Schedule C because the owner is not an employee of their sole proprietorship. This contrasts with the S corporation structure, where a reasonable salary paid to a shareholder-employee is a deductible expense.

Supplies and materials

Consumable items used in the business that are not inventory are deductible in the year purchased. Office supplies, packaging materials, and small tools fall into this category.

Depreciation and Section 179

Capital items, meaning equipment, machinery, furniture, and similar assets with a useful life of more than one year, are normally deducted over their depreciable life rather than in full in the year of purchase. Section 179 allows an immediate deduction for qualifying property up to $1,160,000 for 2025, subject to a phaseout when total property placed in service exceeds $2,890,000. Bonus depreciation, which allowed 100% first-year deduction for most assets, has been phasing down and stands at 40% for 2025 before being further reduced in subsequent years.

Example

Thomas is a freelance software consultant who purchased a new laptop for $2,800 and office furniture for $1,400, both used entirely for business.

Under Section 179, he can deduct the full $4,200 in the year of purchase rather than depreciating it over five or seven years.

This reduces his Schedule C net profit by $4,200, reducing both self-employment tax and income tax on that amount.

The home office deduction

The home office deduction allows self-employed individuals to deduct a portion of home expenses against business income when part of the home is used regularly and exclusively for business. It is one of the most commonly misunderstood and misapplied deductions in individual tax.

The regular and exclusive use test

The home office must be used regularly and exclusively for business. Exclusively means that the space is not used for personal purposes at any time. A bedroom that doubles as an occasional office does not qualify. A dedicated room used only for business activity qualifies. The IRS applies this test strictly, and taxpayers who cannot clearly establish exclusive use are denied the deduction on audit.

There is one exception to the exclusive use test: if the home is used for inventory storage or as a daycare facility, exclusive use is not required. The space still needs to be used regularly for that purpose.

Principal place of business

The home office must be the principal place of business, or a place where the taxpayer meets clients or customers in the ordinary course of business, or a separate structure not attached to the dwelling used in connection with the business. A taxpayer who has a dedicated office elsewhere and also works occasionally from home does not meet the principal place of business test for the home portion.

The principal place of business test is met if the home office is used for administrative or management activities and there is no other fixed location where the taxpayer conducts such activities. This allows a contractor who performs all their client-facing work on-site to still claim a home office deduction for the space where they do their invoicing, scheduling, and correspondence.

Calculating the deduction: two methods

The regular method calculates the deductible percentage as the square footage of the dedicated office space divided by the total square footage of the home. This percentage is then applied to deductible home expenses including mortgage interest or rent, utilities, insurance, and depreciation. The result is the home office deduction.

The simplified method allows a deduction of $5 per square foot of qualifying home office space, up to a maximum of 300 square feet, for a maximum deduction of $1,500. The simplified method requires no tracking of actual home expenses and is easier to administer, but produces a smaller deduction for most taxpayers with higher-cost homes or larger office spaces.

Example

Amara works as an independent consultant from a dedicated home office of 200 square feet in a 1,600-square-foot home. Her annual home expenses are: rent $24,000, utilities $3,600, renters insurance $600. Total deductible home expenses: $28,200.

Under the regular method: 200/1,600 = 12.5%. Home office deduction: $28,200 x 12.5% = $3,525.

Under the simplified method: 200 sq ft x $5 = $1,000.

The regular method produces a significantly larger deduction in this case.

The deduction limit

The home office deduction cannot exceed the gross income from the business after other deductions. In other words, the home office deduction cannot create or increase a net loss on Schedule C. Any excess deduction is carried forward to the following year.

Self-employment tax

Self-employment tax is the mechanism by which self-employed individuals contribute to Social Security and Medicare. It is calculated on Schedule SE and is separate from income tax.

The rate is 15.3% on net earnings from self-employment up to the Social Security wage base, which is $176,100 for 2025. Above that amount, the Social Security portion (12.4%) no longer applies and only the Medicare portion (2.9%) continues. There is an additional 0.9% Medicare surtax on earnings above $200,000 for single filers and $250,000 for married filing jointly, bringing the top marginal Medicare rate to 3.8% on high earners.

Net earnings from self-employment for Schedule SE purposes are calculated as 92.35% of net Schedule C profit. The reason for this adjustment is that employees pay payroll tax on gross wages, while employers deduct the payroll tax before paying the employee. The 92.35% factor replicates this adjustment for the self-employed.

Example

Kieran has net Schedule C profit of $80,000.

Net earnings for SE tax: $80,000 x 92.35% = $73,880.

SE tax: $73,880 x 15.3% = $11,304.

This amount appears on Schedule SE and flows to Form 1040 as an additional tax liability, separate from income tax.

Deduction for half of self-employment tax

Half of the self-employment tax paid is deductible as an above-the-line adjustment to income. This deduction reduces adjusted gross income without requiring itemization. It exists because the employer's half of payroll taxes is deductible by the employer as a business expense. The deduction for half of SE tax provides the equivalent benefit to the self-employed.

Using the Kieran example above: SE tax is $11,304. Half of that, $5,652, is deductible as an adjustment to income. This reduces Kieran's AGI and therefore reduces his income tax on the full amount of his business income.

Retirement contributions and self-employed individuals

Self-employed individuals can contribute to retirement accounts in ways that produce significant tax deductions. The three most relevant structures are the SEP-IRA, the SIMPLE IRA, and the solo 401(k).

SEP-IRA

A Simplified Employee Pension IRA allows a self-employed individual to contribute up to 25% of compensation, which in the self-employed context translates to an effective rate of approximately 20% of net self-employment earnings after the SE tax deduction. The contribution limit for 2025 is $70,000 and for 2026 is $72,000.

The reason the effective rate is 20% rather than 25% is the circular calculation involved. The contribution reduces self-employment income, which affects net earnings, which in turn affects the allowable contribution. The IRS provides a worksheet to calculate the exact figure, but 20% of net SE earnings (after the half-SE-tax deduction) is a reliable approximation.

SEP-IRA contributions are deductible as an above-the-line adjustment to income and do not require the business to have employees. They can be established and funded up to the tax return due date including extensions, making them one of the most flexible retirement vehicles available.

Solo 401(k)

A solo 401(k), also called an individual 401(k) or one-participant 401(k), is available to self-employed individuals with no employees other than a spouse. It allows contributions in two capacities: as an employee, contributing up to $23,500 for 2025 ($31,000 for those aged 50 and over with the catch-up), and as an employer, contributing up to 25% of compensation subject to the overall limit of $70,000 for 2025.

The employee contribution to a traditional solo 401(k) is deductible. The employer contribution is also deductible. The combined deduction potential of a solo 401(k) is therefore higher than a SEP-IRA for lower levels of self-employment income because the flat employee contribution is not limited by a percentage of earnings.

Example

Fatima has $60,000 of net self-employment income and is under 50.

SEP-IRA contribution: approximately 20% x $60,000 = $12,000.

Solo 401(k) employee contribution: $23,500. Employer contribution: 20% x $60,000 = $12,000. Total: $35,500, subject to the overall limit of $70,000.

The solo 401(k) allows Fatima to shelter more than twice as much income from current tax compared to the SEP-IRA.

The qualified business income deduction

The qualified business income deduction, known as the QBI deduction or the Section 199A deduction, was introduced by the 2017 Tax Cuts and Jobs Act and made permanent under the One Big Beautiful Bill Act signed in 2025. It allows eligible taxpayers to deduct up to 20% of qualified business income from a pass-through business, which includes sole proprietorships reported on Schedule C, partnerships, S corporations, and certain trusts.

The deduction is calculated at the individual level, not the business level. It reduces taxable income but does not reduce adjusted gross income, and it is not an itemized deduction. It applies whether or not the taxpayer itemizes.

Basic calculation

For taxpayers below the income thresholds, the deduction is simply 20% of qualified business income. Qualified business income is the net income from the business after deducting business expenses but before the QBI deduction itself. It does not include wages paid to the owner as an S corporation shareholder-employee, capital gains, dividends, or interest income.

Income thresholds and limitations

Above certain taxable income thresholds, the QBI deduction becomes more complex. For 2025, the phase-in range begins at $197,300 for single filers and $394,600 for married filing jointly. Above these thresholds, limitations based on W-2 wages paid by the business and the unadjusted basis of qualified property may reduce the deduction. Above the top of the phase-in range, the W-2 wage limitation fully applies.

The W-2 wage limitation restricts the deduction to the greater of 50% of W-2 wages paid by the qualified business, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. A sole proprietor who has no employees pays no W-2 wages and therefore may find the deduction significantly limited or eliminated once income exceeds the threshold.

Specified service trades or businesses

Certain professional service businesses are classified as specified service trades or businesses, known as SSTBs. These include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. For taxpayers whose income exceeds the phase-in threshold, the QBI deduction is gradually eliminated for income from an SSTB and is fully eliminated above the top of the phase-in range.

For self-employed advisors, consultants, and financial professionals, this limitation is material. A sole proprietor consultant with taxable income well above the threshold receives no QBI deduction on their consulting income, regardless of how the business is structured.

Below the income thresholds, however, an SSTB receives the full 20% deduction just like any other business. For a single consultant with taxable income of $150,000, the QBI deduction applies in full.

Example

Marcus is a self-employed marketing consultant, single, with Schedule C net profit of $120,000. He takes the standard deduction of $15,750, producing taxable income of approximately $104,250 after the half-SE-tax deduction.

His taxable income is below the $197,300 phase-in threshold.

QBI deduction: 20% x $120,000 = $24,000.

This deduction reduces his taxable income further, saving him approximately $5,280 in income tax at the 22% marginal rate.

The effective federal income tax rate on his self-employment income is meaningfully lower as a result.

Estimated tax payments for the self-employed

Self-employed individuals have no employer withholding from which the IRS can collect tax during the year. The full obligation falls on the individual to estimate and pay quarterly. This was covered in Part 1 in terms of the general mechanics, but for the self-employed the stakes are higher because the amounts owed are typically larger and the variability of income makes estimation more difficult.

The self-employed taxpayer is estimating not just income tax but also self-employment tax, which adds materially to the quarterly payment amounts. A consultant expecting $100,000 of net profit will owe approximately $14,130 in SE tax alone (15.3% on 92.35% of $100,000), in addition to income tax at their marginal rate. Dividing the expected combined liability across four unequal quarters and paying on schedule is the baseline minimum to avoid penalties.

The prior-year safe harbor described in Part 1 is particularly useful for the self-employed with variable income. Paying 100% of the prior year's total tax liability across the four quarterly dates, regardless of what this year looks like, satisfies the safe harbor and avoids any underpayment penalty. This is not optimal cash flow management if income turns out to be significantly lower than the prior year, but it eliminates penalty exposure entirely.

Contractor versus employee: why it matters

The classification of a worker as an independent contractor or an employee has significant consequences for both the worker and the business. For the worker, employee status means the employer pays half of FICA taxes, withholds income tax, and may provide benefits. Contractor status means the worker bears the full self-employment tax and is responsible for their own estimated payments.

For the business, misclassifying an employee as a contractor creates substantial liability: the business may owe the employer's share of payroll taxes, the employee's share that should have been withheld, plus interest and penalties. The IRS and the Department of Labor both pursue misclassification cases, and the dollar exposure in an audit can be severe.

The IRS applies a multi-factor test. Behavioral control factors include whether the business controls what work is done and how it is done, whether the business provides training, and whether the work must be performed by a specific person. Financial control factors include whether the worker has a significant investment in their own tools and facilities, whether the worker is available to work for multiple businesses, and whether the worker can realize a profit or loss. Relationship factors include whether there is a written contract, whether benefits are provided, and whether the relationship is permanent or project-based.

No single factor is determinative. A person with a written contractor agreement who nevertheless works exclusively for one business, follows that business's procedures, and has no other clients may still be classified as an employee based on the economic reality of the relationship.

Key figures for 2025 and 2026

Item

2025

2026

SE tax rate

15.3% up to $176,100; 2.9% above

Updated SS wage base applies

SS wage base

$176,100

Adjusted annually

Additional Medicare surtax

0.9% above $200K single / $250K MFJ

Same

QBI deduction

Up to 20% of qualified business income

Same

QBI phase-in threshold (single)

$197,300

$201,775

QBI phase-in threshold (MFJ)

$394,600

$403,550

SEP-IRA limit

$70,000

$72,000

Solo 401(k) employee contribution

$23,500 ($31,000 age 50+)

$24,500 ($32,500 age 50+)

Standard mileage rate

70 cents per mile

TBC

Section 179 expensing limit

$1,160,000

Indexed for inflation

Home office simplified method

$5 per sq ft, max $1,500

Same

Next: Part 4 covers investment income, capital gains, and property transactions, including the critical distinction between short-term and long-term gains, cost basis, the primary residence exclusion, and the specific complexity that arises when property is held across borders.

This article is published by Antravia Advisory. It is for informational purposes only and does not constitute tax advice. Individual circumstances vary and you should seek advice from a qualified practitioner before making decisions that affect your tax position.