When you're self-employed, things can get complicated around tax season. A self-employed individual will need to deal with income taxes (federal and state), self-employment tax, and possibly employment or excise taxes all without the administrative support provided by a more traditional work arrangement. As with many financial matters, there’s a lot to it, but it doesn’t need to be overwhelming. Let’s look at taxes for the self-employed, one piece at a time.
Income Tax
If you're self-employed you will report the profit or loss from your self-employment activities on their 1040 Schedule C. This form is used to report your income, cost of goods sold, and business expenses to the IRS and may include information from one or more 1099 forms. Your profit or loss carries to your personal income tax return.
Your income (profit) as a self-employed person is taxable to you individually. The advantage of this is that you are taxed only once on the income, at the personal level. You are not taxed as a business and then again on any distributions made to you.
Most states — all but eight — also levy income tax on individuals, as do some localities. Self-employed individuals will need to follow state and local rules as well.
And you’ll likely need to make estimated tax payments, which we’ll discuss shortly.
Self-Employment Tax
Self-employment tax is how the self-employed pay Social Security and Medicare taxes. These can be a bit of a surprise for the newly self-employed; they take a bite out of your income.
When you work for an employer, you, as an employee, pay half the Social Security taxes and your employer pays half. When you are self-employed, you are both the employer and employee, so you pay both halves. What was 7.65 percent as an employee becomes a combined 15.3 percent for the self-employed.
You calculate the tax using form 1040 SE and pay the tax along with your income taxes. Which, we mentioned above, need to be paid through estimated payments.
Estimated Tax Payments
The income tax system in the United States is a pay-as-you-go system; the taxes need to be paid as you make the income, or you may be subject to penalties. Most people would prefer not to get themselves into that situation, so they make their payments and avoid the penalties.
Usually, you make quarterly estimated tax payments based on your anticipated taxable income for the year. Many self-employed people find that making quarterly estimated tax payments is a lot easier than producing an entire year’s worth of tax payments all at once.
The general rule for not having a penalty is that your payments need to be at least the lower of 90 percent of this year’s tax liability or 100 percent of last year’s tax liability. Unless your business income is flat, and hopefully it’s growing, you should try to figure the actual liability and make appropriate payments. Many people have their tax advisor run the numbers for them.
As a business owner, you need to be aware of the dates the estimated payments are due, and whether you need to make a payment.
Employment Taxes
Often you don’t do it all yourself. You may hire others to help you, either other self-employed individuals or people you employ.
If you hire other self-employed individuals, subcontracting work to them, they will be responsible for their taxes just as you are responsible for yours.
If you employ other people, you’ll need to deal with employment taxes. You’ll need to make appropriate withholding of income taxes from your employee’s wages, as well as their Social Security and Medicare taxes, and your Social Security and Medicare taxes as their employer.
This isn’t really complicated, and many business owners, especially with only one or two employees, take a few minutes each week and do the calculations themselves. Or they use readily available programs or engage one of the many payroll companies to take care of this for them. If you have a few employees, using a payroll company may be the easiest option, and allow you to keep your focus on the business of the business and not on administration.
Excise Taxes
Some businesses also pay excise taxes.
Excise taxes are legislated taxes on specific goods or services. For example, there are excise taxes on airline tickets, gasoline, alcohol and tobacco products, and self-tanning. Though many self-employed persons will never deal with excise taxes directly, some will, and all self-employed individuals need to know where they stand. This is a pretty simple question for your tax advisor.
Better safe than sorry.
Employer Identification Number
The IRS provides a nice checklist to see if you need to have an Employer Identification Number (EIN). If you have employees, you definitely need one, as you likely will with any form of business other than sole proprietorship. The process is straightforward; you’ll just want to determine if you need an EIN, and get one if you do. For those who don’t need an EIN, you’ll want to be aware of what might change that — such as bringing on your first employee.
The Bottom Line
There are many reasons people start their own business, having a more complicated tax situation isn’t one of them.
Though it may seem like a lot, it’s just a shift in responsibility. When you’re an employee, it’s someone else’s business to take care of the taxes; when it’s your business, it’s all on you. The taxes were there before, but now you’re responsible.
And the responsible thing to do is to have at least a basic understanding of the taxes so you can make sure they get handled, by you or by someone else, and that you avoid unnecessary penalties or other problems. It’s not super simple, but it doesn’t need to be complicated either.
There are many resources out there. The IRS website is a wealth of information. Many business owners, however, would prefer to put their energies into the business of the business and farm out the tax work to qualified professionals. That’s fine, often an excellent choice. But even when you farm it out, as a business owner you’re still responsible, and it behooves you to have at least a basic understanding.
