Tax Hacks 2016: What You Need to Know if You're Self Employed
By Marilyn Lewis
Being your own boss definitely has its advantages — flexibility, upward mobility, the chance to take your business in the direction you choose — but at tax time, being self-employed can be a challenge. Here's a look at what's expected of you when you go to work for yourself.
Like everyone else, if you're self-employed, you'll pay personal income taxes by filing Form 1040 on or before April 15. In addition, however, the self-employed also have to pay self-employment (SE) tax, which is a combination of Social Security and Medicare taxes.
You probably know that when you're an employee, 6.2 percent of your gross pay is withheld from your paycheck for Social Security. What you may not know: Your employer also pays the government another 6.2 percent, bringing the total contribution for Social Security to 12.4 percent of your pay, up to $118,500.
Your employer is also responsible for paying another 2.9 percent of your pay into Medicare, with no limit.
When you're self-employed, however, you're covering all this yourself. You pay the entire 12.4 percent of Social Security, plus the 2.9 percent for Medicare. So while employees pay 6.2 percent of their earnings for Social Security, the self-employed pay more than 15 percent.
If your business earned $400 or more in net profit, you'll owe SE tax. If your business netted less than $400, you may not need to even file a 1040. You may owe tax on your self-employment income even you aren't self-employed full time or if your solo work is just a sideline. To know if you owe SE tax, subtract your business expenses (more on this below) from your business income using IRS Schedule C (Form 1040), Profit or Loss From Business.
If you owe self-employment tax, use a different 1040 form, Schedule SE (Form 1040), to report your income. Transfer your bottom line amount from Schedule C to the SE 1040.
The IRS explains the details at IRS Self-Employed Individuals Tax Center.
You might be able to use the simplified Schedule C-EZ if you meet the following criteria:
You earn a profit.
You have expenses of $5,000 or less.
You have no employees.
You have no inventory.
You are not using depreciation or deducting your home's cost.
The IRS has help deciding between Schedule C and C-EZ.
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Quarterly tax payments
Self-employed workers estimate how much Medicare, Social Security and income tax they owe and pay it in quarterly installments. Use Form 1040-ES, Estimated Tax for Individuals (PDF) to calculate and pay quarterly taxes. It has a worksheet that helps estimate what you owe and vouchers to submit with your quarterly tax payments.
You'll need last year's tax return to complete it. If this is your first year of self-employment, you'll estimate, making up any difference in subsequent quarters.
In addition, there are other requirements. Your specifics will depend on the type of corporate structure you've chosen.
Depending on how your business is incorporated you may have other tax reporting requirements. The IRS describes business structures and their tax filing requirements here.
Typically, self-employed workers, including contractors, operate as "sole proprietors." Few one-person and small businesses become corporations as these have more complex tax and legal requirements.
Some small or one-person businesses use the S Corporation (S Corp) structure, though. The Small Business Administration, comparing incorporation options for businesses, says that "one of the best features of the S Corp is the tax savings for you and your business." However, forming and operating an S Corp requires strict operating and reporting procedures that not every small business wants to undertake.
If you are curious about an S Corp, ask a tax adviser with expertise in this area to help you weigh the pros and cons.
You may be thinking, "Uh oh, I didn't incorporate at all." Breathe easy. The most common structure used by small-business people is a sole proprietorship. You don't need to do anything special to declare yourself a sole proprietor, as long as you are the only owner.
Tax-wise, this is the easiest approach. For details on IRS filing requirements see the IRS forms for sole proprietors.
Limited Liability Companies (LLCs)
An LLC is a business structure established by your state that may give you some advantages, including some protection from personal liability. (The SBA has more on LLCs.) But having an LLC doesn't affect how you file taxes — you just file as a sole proprietorship, an S Corporation or whatever business structure you've chosen to use.
Paying state and local taxes is another obligation of self employment. Each state and local government has its rates and rules. The IRS offers links to each state's tax authority. Check with your city government for local rules.
You can deduct "ordinary" and "necessary" business expenses by subtracting them from your income. Here's the test, from IRS' section on deducting business expenses:
An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business.
Independent workers' deductions can include costs for travel, retirement savings, entertainment, insurance, license fees, taxes, and office equipment and software. These articles have the details on taking deductions:
Tax Hacks 2016: Don't Overlook These 8 Deductions and Credits
Some of your business expenses can be deducted only partially — your costs for a car used for both personal and business transportation, for example. If 30 percent of your car's use is for business, you'll deduct 30 percent of the vehicle's costs.
As an alternative, you can deduct all of your business mileage, so keep a record with odometer readings for the start and end of each business trip and consult this chart for mileage rates the IRS allows.
Some business costs — investments that become business assets — are treated differently. They are capitalized, deducted over a number of years. Nolo explains deductions versus capital expenses.
Do you have experience paying taxes as a self-employed person? Share with us in comments below or on our Facebook page.