Self – Employment & Taxes

A question on a lot of minds is "What does it mean to be self-employed for tax purposes?"

There are several factors that you must be aware of when you decide to open that business or strike out on your own.

  1. For income tax purposes, you will report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses will be deductible against gross income (i.e., "above the line," and not as itemized deductions subject to the 2%-of-adjusted-gross-income floor). If you have any losses, the losses will generally be deductible against your other income, subject to special rules relating to hobby losses, passive activity losses and losses in activities in which you weren't "at risk."

 

  1. If you will be working from an office in your home, performing management or administrative tasks from a home office, or storing product samples or inventory at home, you may be entitled to deduct an allocable portion of certain of the costs of maintaining your home. And if you have a home office, you may be able to convert nondeductible commuting expenses (of going from your residence to another work location) into deductible transportation expenses. See an additional blog on deductible miles.

 

  1. You will also be required to pay self-employment taxes: a social security tax at a 12.4% rate on your net earnings from self-employment of up to $118,500 (reduced by any wages that you earn from employment), and a Medicare tax at a 2.9% rate on the excess. A portion of your self-employment taxes will be deductible as a trade or business expense (that is, as a deduction against gross income, not subject to the limits that apply to itemized deductions). Note: no SE taxes will be assessed on self-employment income under $400.

 

  1. You may be allowed to deduct your health insurance costs as a trade or business expense. This means your deduction for medical care insurance won't be limited by the normal 10%-of-AGI floor on itemized medical expenses. Your health care insurance can include your spouse and your children and still qualify for a deduction.

 

  1. Your income won't be subject to withholding tax. However, you will be required to pay estimated taxes quarterly. You should work with your tax advisors to minimize the amount of your estimated tax payments while avoiding any underpayment penalty.

 

  1. You will have to maintain complete records of your income and expenses. In particular, you should pay attention to recording your expenses in order to be able to take the full amount of the deductions to which you are entitled. Certain types of expenses, such as automobile, travel, entertainment, meals, and home office expenses, are subject to special recordkeeping requirements or limitations on their deductibility and require special attention. See our blog on record keeping for more information.

 

  1. If you hire any employees, you will have to get a taxpayer identification number and will have to withhold and pay various payroll taxes. Hiring employees and other independent contractors can lead to additional accounting obligations. The first of which is to decide whether the person should be hired as an employee or an independent contractor.  To determine if a person should be an employee or contractor please see the following client letter:  Employee – contractor letter.  If you hire someone as an independent contractor and pay them $600 or more, you may be required to send them and the IRS Form 1099 in the following year reporting the amount you paid them.  When you consider hiring, it is important to contact your tax advisor to discuss the matter in detail.

 

  1. You should consider establishing a qualified retirement plan. The advantage of a qualified retirement plan is that amounts contributed to the plan are deductible at the time of the contribution, and aren't taken into income until the amounts are withdrawn. Because of the complexities of ordinary qualified retirement plans, you might consider a simplified employee pension (SEP) plan, which requires less paperwork. Another type of plan available to sole proprietors that offers tax advantages with fewer restrictions and administrative requirements than a qualified plan is a "savings incentive match plan for employees," i.e., a SIMPLE plan. If you don't establish a retirement plan, you may still be able to make a contribution to an IRA.

 

This list is simplified and far from exhaustive, if you have additional questions or you are considering starting your own business.  Please consult your advisors and see our blog “Starting a biz”

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