Being your own boss and calling the shots makes self-employment very appealing. However, self-employment also comes with additional responsibilities, like being fully responsible for your taxes.
Before you start your self-employment adventure, understand how self-employment taxes work and make a plan to pay them.
Here are five things tax experts suggest considering when becoming your own boss.
Key Takeaway: Know your responsibilities.
- Understand your full tax liability
- Consider incorporating
- Pay taxes quarterly
- Know what the penalties are
- Keep good records
Understand your full tax liability
If you’re transitioning from being a W-2 worker to self-employment as a sole proprietor or in a partnership, your tax liability changes. You’ll also need to become familiar with Schedule C (Form 1040) to report on your business’s gains and losses.
You’re still responsible for state, local, and federal taxes, including FICA taxes. FICA taxes are the Social Security and Medicare taxes that workers pay.
“For those who are self-employed, they bear the entire tax burden of paying taxes into Medicare and Social Security. For those not self-employed, their employer is responsible for half of the FICA taxes due,” says Chane Steiner, CEO of Crediful.
Since you’ll be responsible for your full FICA tax obligation instead of splitting it with your employer, you need to figure out how they’re determined.
“There may be ways to see how you should handle FICA taxes because they’re are assessed on self-employment income, but not profits. Accordingly, if you were to incorporate your self-employed business and pay yourself a salary, any profits would not be subject to self-employment taxes, but the wages you pay yourself would be subject to self-employment taxes. You should contact a qualified CPA or attorney who may help you with this distinction,” advises Paul T. Joseph, attorney and CPA with Joseph & Joseph Tax & Payroll.
It’s also important to keep a good financial record, especially if you haven’t incorporated.
“They are not being paid a wage and instead, a self-employed individual must keep a set of books showing income and expenses associated with their self-employed business allowing them to determine taxable profits (or losses).
While an employer and an employee each pay half of the FICA taxes due on an employee’s wages, the self-employed person pays 100 percent of these taxes — termed the self-employment tax (SE tax for short) — on their self-employment profit. If the individual has more than one self-employment activity, the net profits and losses from all the self-employed activities are combined to determine the amount of the SE tax,” says Lee Reams, Sr., BSME, EA and Chief Content Officer with TaxBuzz & CountingWorks.
If both you and your spouse are self-employed, you are not allowed to combine your self-employment income when calculating taxes.
“If married and both spouses have self-employment income, the couple cannot combine their SE incomes when figuring their individual SE tax,” says Reams.
While ensuring that your federal tax obligations are met, it’s also important to understand what your tax obligations are for your state and in states you offer services to.
“In addition to paying the federal government, business owners need to remember to pay estimated taxes to the states in which they do business. If the business provides goods and services to clients in multiple states, the business may need to pay estimated taxes to all of those states based on the revenue from each state,” says Beth Logan, EA, Kozlog Tax Advisers.
The amount you pay in taxes is calculated differently depending on whether you’ve formed a corporation or just operate as a sole proprietor.
If self-employment is going to be your main source of income, it can be a good idea to form an S-corporation for tax purposes.
An S-corporation is an entity that gives its total income, losses, deductions, and credits to its shareholders, which means that shareholders can report the income on their personal taxes to be taxed at their normal income rate. If you’re self-employed and form an S-corporation, the S-corporation would pay you a salary for the work you do.
“Self-employed people should begin by setting up a company taxed as an S-corporation. By setting up this business entity, it allows self-employed to minimize their FICA taxes since income earned through an S-corporation is not subject to FICA taxes — only the salary they pay themselves (which must be reasonable) is subject to FICA.
An S corporation, reported properly, will also minimize the chance of an IRS audit. Keeping good documentation, including receipts, for all income and deductions is essential as well,” advises Tom Wheelwright, CPA, CEO of WealthAbility and author of Tax-Free Wealth.
When deciding whether or not to incorporate, it’s a good idea to meet with a tax professional to get advice specific to your situation.
Pay taxes quarterly
W-2 filers have their taxes withheld throughout the year and may only think about paying taxes when it’s filing time in April.
“To manage their tax liability, self-employed should make estimated payments each quarter so they don’t get a big surprise in April. Most importantly, these individuals should hire a qualified tax advisor and an attorney to help them get everything set up properly and to minimize tax liabilities,” suggests Wheelwright.
If you’re self-employed, you’re taking full responsibility for your taxes. Whether or not you’ve incorporated, you’ll need to make quarterly tax payments.
“These estimated taxes are paid with an IRS Form 1040-ES and include the taxpayer’s income and SE taxes. In lieu of filing Form 1040-ES and sending a check to the U.S. Treasury, the payments can be made online through the IRS’s website or by using the government’s Electronic Federal Tax Payment System (EFTPS), which allows payments to be scheduled up to a year in advance, by having payments automatically withdrawn from the individual’s bank account at specified dates,” suggests Reams.
Looking at the IRS’s schedule and deadlines for quarterly payments will help you make sure you’re paying on time.
“Since self-employed taxpayers need to pay estimated taxes quarterly based upon their taxable profits for the quarter and, after the first quarter of the year, taking into account prior quarterly profits and estimated taxes already paid for the year,” says Reams.
To make quarterly payments, you’ll need to estimate the taxes you owe. Be sure to include all of your income when making this estimate.
“Remember tax pre-payments are not just based on the self-employment income and must factor in all other taxable income including investment income, retirement income, the self-employed individual’s wages from other work, and a spouse’s wages or self-employment income, as well as account for withholding from other sources,” adds Reams.
How you calculate an estimate will vary depending on how you’re filing.
Tiffany Powell, Sapphire Bookkeeping & Accounting Inc Owner, has tips for S-corp and Schedule C filers:
- “If you are self-employed filing as an S-corp, we want to make sure that the required salary is reasonable and has the necessary withholding to cover all the taxable income at year-end so that payments are made throughout the year in smaller payments.
- If a client is being taxed as a Schedule C, we plan using estimated tax payments or increasing a spouse's withholding to cover the taxes owed on the additional income. The state you are located in will determine what amount of money should be set aside for taxes. You always want to use your effective tax rate plus about 10 percent to cover the Self Employment tax for Social Security and Medicare after adjustment.”
Working with a tax professional can help you navigate this process successfully. A tax professional can also give you advice tailored to your situation.
You can also work through the process yourself. However, it’s important to be sure that you know what you’re doing because you want to make sure you’re paying your taxes correctly.
“You can always fill out the tax form and pay by check. You can also use https://www.officialpayments.com or services like these to pay by credit card or bank transfer,” says Aalap Shah, 1o8 Founder and a former accountant.
Know what the penalties are
If you’re paying estimated taxes quarterly, it’s important to have good estimations to avoid penalties.
“If a self-employed taxpayer pre-pays less than 90 percent of their current year’s tax liability, including Social Security and Medicare taxes for the year, they can be subject to a penalty which assesses interest on underpayments by the quarter,” says Reams.
While it’s important to be aware of this penalty, it’s also important to realize when there are exceptions.
“The underpayment penalty does not apply where the final amount due on an individual’s tax return is less than $1,000. The penalty also does not apply where a taxpayer, for a full 12-month year, did not have a prior year tax liability,” Reams continues.
Self-employed taxpayers can make estimates based on the current year’s revenue or use safe harbor methods to avoid these penalties. Reams identifies two safe harbor methods:
- “100 percent of the prior year’s tax liability paid evenly for each quarter provided the prior year’s adjusted gross income was $150,000 or less ($75,000 if using the filing status married filing separate).
- 110 percent of the prior year’s tax liability paid evenly for each quarter if the prior year’s adjusted gross income was greater than $150,000 ($75,000 if filing married filing separate).”
The safe harbor methods may make more sense in some situations and can be less advantageous in others.
“One thing to consider when deciding whether or not to use the safe harbor method is that since the safe harbor estimates are not based on current year’s profits, a self-employed individual could be in for an unexpected substantial tax liability at tax time.
Or, if their current year income is significantly less than it was in the prior year, they could be overpaying their current year tax and be eligible for a large refund when they file their current year return. If an overpayment results, all or part of it can be applied to the next year’s estimated taxes instead of receiving a refund payment,” says Reams.
As you evaluate your self-employment income and projections for the current tax year, you’ll be better able to weigh your options and determine how you’re going to calculate your quarterly tax payments. If you have specific questions, it’s always worthwhile to talk to an accountant or attorney who specializes in taxes.
Keep good records
Taxpayers who are self-employed have a higher chance of getting audited, so it’s even more important to be sure you have good financial records if you’re self-employed.
“We recommend keeping separate bank accounts for business and personal so that income and expenses are easily traceable. It is also recommended that you keep some kind of bookkeeping whether an app or by paper so that you can verify your income and expenses,” offers Powell.
Shah has done this for his expenses:
“The best and easiest way that I handle keeping track of my records is to use one credit card and bank account that records my income and expenses. I have connected it to Quickbooks for ease of record keeping and use my google calendar to record travel expenses or milage when the need arises. You can use Evernote to keep receipts and other docs on the go but I find that having limited options to spend and record income keeps everything centralized and easier to manage at tax time,” he suggests.
Having good records and keeping your business expenses separate from your personal ones will help you be prepared in the event of an audit.
Working with a tax professional and following these five tips will help ensure that you are meeting your tax obligations and are prepared in the event of an audit.