If you’re self-employed already or considering joining our ranks, you need to understand how self-employment taxation works. Here are six topics you’ll want to investigate. Consider these a starting point rather than a comprehensive guide, because within each area there are all sorts of gotchas.
In the U.S., tax day is April 15th, so it’s time to start thinking about filing 2006 taxes if you haven’t already. These topics are written with U.S. Internal Revenue System requirements in mind. If you’re in a different country, you might find them helpful in suggesting what tax issues might be important to you.
Disclaimer: I’m not an accountant, just a self-employed web worker with an interest in minimizing my tax liability at the same time I meet IRS requirements.
1. Profit motive. If you are not trying to make a profit, then it’s not a business, it’s a hobby, and you can’t deduct your expenses from any other income you have. You need to show the IRS that you are serious about making a profit and not just trying to have fun. You can deduct expenses into eternity without showing a profit so long as you have good evidence that you’ve been trying to make money the whole time.
How do you show intent to profit? In a number of ways including marketing your services with a website or email newsletters, showing evidence of contacting potential clients via email (print the emails) or phone (keep a phone log), dedicating significant effort to your work (e.g., by blogging regularly about the subject of your work), and best of all, actually showing a profit.
2. Deductible business expense. Once you’ve learned how to establish your profit motive and engage in the ongoing marketing activities and record-keeping that shows your intent, you’re eligible to deduct business expenses from your income on your taxes. That means you pay less tax. But what’s deductible?
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.
3. Estimated taxes. Life was easier when your employer bought your health insurance, paid half your social security obligation, and withheld taxes all year so that you stayed in the good graces of the IRS. Once you’re in business for yourself you have to pay taxes as you go. The IRS is not about to give you a free loan until next April 15th rolls around.
If you expect to owe tax of $1,000 or more when you file your return, you likely need to pay estimated taxes four times a year. There is a loophole though–see “safe harbor” below.
How do you compute your estimated taxes? IRS Publication 505, Tax Withholding and Estimated Tax gives you all the gory details. If you find that too daunting as a starting point, review the IRS summary page on estimated taxes. Or do like I do, and hire an accountant. It’s worth the money if it lets you get back to money-making work.
4. Prior year safe harbor. If you’re self-employed with a working spouse, you must understand this rule. It can get you out of having to pay estimated taxes–but you have to pay close attention.
If your total withholding–including your spouse’s and any W-2 withholding you have (as in the case where you work as an employee in addition to your self employment)–meets or exceeds 100% of your previous year’s total tax liability, you don’t have to pay estimated taxes this year.
However, high-income earners be aware: if your adjusted gross income for the prior year was $150,000 or greater, you will need to have at least 110% paid to the IRS via withholding (or estimated tax payments) in order to guarantee you don’t pay interest or penalties on additional tax due.
Read more about avoiding estimated tax payments at the Motley Fool.
5. Independent contractor or employee. You thought we might be nearly done? Not quite. Even though you think of yourself as self-employed, the IRS and one or more of your clients may not. According to the IRS, if a client controls both what you do and how you do it, then you are actually an employee, no matter what agreement you’ve struck with that client.
Why is this important? Because if you are an employee, you can no longer file Schedule C and deduct business expenses. It also means that the company paying you must withhold taxes and pay a share of your social security taxes, among other things.
In Preserving Your Status as an Independent Contractor, attorney Stephen Fishman writes:
The IRS is always looking to reclassify independent contractors as employees of the businesses it audits. (It gets more money from employees than from contractors, who can deduct business expenses from their incomes. And it gets its money faster from employees, who have to pay taxes every payday through payroll withholding.)
Make sure your clients only decide what you need to do, not how you do it, and you should be able to preserve your independent contractor status.
6. Schedule C. This IRS schedule associated with Form 1040 is where you report your business income and expenses. You will likely also need to file Schedule SE, the Self-Employment Tax schedule, which calculates your Medicare and social security tax liabilities.
You can read about these forms and download PDF versions at the IRS frequently asked questions page. They’re not too tricky–the trickiness comes earlier, with establishing your profit motive, keeping track of deductible business expenses, paying estimated taxes if necessary, and ensuring the IRS thinks your a business owner rather than a de facto employee. If you get a handle on all of that, you’re well on your way to managing your self-employment taxes.
Check in for more tax talk between now and April 15th. We’ll be deep-diving on the topics of deductible business expenses, retirement savings options for the self-employed, and best practices for tax-related record-keeping.