When you're self-employed, you don't deal with net profits -- the term you find on IRS forms is net earnings. Net earnings equal your gross business income, less any business expenses you can claim, and they're what you pay Social Security taxes on. As of 2012, the self-employment tax is 13.3 percent. Of that total, 2.9 percent of your income goes to Medicare. The rest is for Social Security.
You calculate your net earnings on Schedule C, the tax schedule for independent contractors. First, you report your gross income -- your total income from the business, less the cost of goods sold and the return of any merchandise. Subtract whatever you spent on advertising, office expenses, equipment, transportation, employee salaries and so on to determine net earnings. Your standard deduction, exemptions and above-the-line deductions on your 1040 don't affect your earnings or the self-employment tax you owe.
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If your net income is under $400, you don't pay self-employment tax. The exception is if you're a minister in a religious group that doesn't pay Social Security on its employees. In that case, you have to pay self-employment tax if you earn more than $108.28. As of 2012, you only pay Social Security on income up to $110,100: when you earn above that, you pay the 2.9 percent Medicare tax, but no added Social Security. If you have wages as well as self-employment income, your wages count first toward the cap.
When you figure your self-employment tax payment, you don't pay on your entire net earnings: the tax affects 92.35 percent of your net self-employment income. After you calculate the tax on Schedule SE, you can subtract half of the total you have to pay as a deduction on your 1040. You do this as part of determining your adjusted gross income. Your self-employment tax becomes part of your total tax obligation for the year -- if you have a balance due, you send a single payment to the IRS when you file your tax return.
Some income doesn't trigger Social Security taxes because the IRS distinguishes between self-employment and supplemental income. If you're self-employed as an inventor, for instance, constantly working on new gadgets or improving old ones, you pay self-employment tax on this income -- it's treated as if it's earnings from a job. If you come up with one good idea, patent it and collect royalties, but never try for another invention, the IRS doesn't see you as self-employed. You report your royalties as supplemental income on Schedule E and don't pay self-employment tax.
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