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Self-Employment Q & A
I have recently become self-employed. What tax issues do I have?
Congratulations! Being your own boss can be very exciting and rewarding. For taxes, a self-employed person has some unique income tax and payroll tax considerations.
Deductions
please see the following question
Self-employment (SE) tax
Net Income from self-employment is assessed for Social Security and Medicare taxes. Generally, an employee pays this tax at 7.65% of his/her wages. Employers withhold this from an employee's paycheck. The employer then "matches" the withheld amount so that both the employee's and employer's share of tax, which is 15.3%, is paid to the government. However, as a self-employed person, you will need to pay the entire 15.3%. THIS IS IN ADDITION TO REGULAR INCOME TAX!!
Retirement
A self-employed person has the unique opportunity to establish a retirement plan to save pre-tax dollars. Many types of plans exist such as a 401(k), SIMPLE or SEP plan. Generally, a taxpayer can contribute a maximum of 20% of their business net income and perhaps as much as $46,000 for 2008.
Quarterly estimates
You may be required to estimate your taxes and pay money in 4 times a year. Please see second question below.
Record Keeping
It is important to find a system which allows you to track your business income and expenses. The type depends on what you are personally comfortable with using. You may keep a simple ledger on sheets of paper or a computer spreadsheet. Many accounting software programs are specifically designed to help you, including QuickBooks or Peachtree. Whichever method you choose, expenses need to be tracked by category. Please see the list in the following question on deductions.
Also, some additional categories are special and need to be tracked separately. These are:
- Equipment – cost, date purchased and description
- Vehicles – costs using either the actual or standard rate method (please see below)
- Meals and Entertainment – subject to 50% limitation for tax deduction
- Home Office – please see below
Separate Bank Account
It is very useful and a good business practice to establish a separate bank account for your business activity. Doing so keeps all your transactions in one place. Technically a separate account is not required if your business is not incorporated but we strongly recommend it.
I am self-employed. What can I deduct?
The general rule for deductions is that they must be ordinary and necessary costs of doing business. This encompasses, but is not limited to expenses such as:
- accounting
- interest
- rent
- advertising
- internet
- repairs
- answering service
- janitorial
- security
- bad debts
- laundry and cleaning
- supplies
- bank charges
- legal and professional
- taxes
- cell phone
- maintenance
- telephone
- commissions
- meals
- tools
- delivery and freight
- office
- travel
- dues and subscriptions
- parking and tolls
- uniforms
- employee benefits
- pension and profit sharing plans
- utilities
- entertainment
- postage
- vehicle
- insurance
- printing
- wages
The following expenses require special treatment:
Equipment
Equipment purchased can be deducted over the period of time it is used. This is called depreciation. The IRS has specific guidelines for this calculation, but generally the time period is 5-7 years. One especially useful election a taxpayer can make in this area is called "Section 179" election. For 2008, taxpayers can elect to expense up to $250,000 in equipment purchases during the first year. This election is subject to several limitations. This amount is scheduled to decrease to $133,000 in 2009 unless the law is extended by Congress.
Vehicle Use
Vehicle use is an important deduction. Taxpayers have the choice of two methods of deducting vehicle expenses. For 2010, the IRS allows 50 cents per mile as a standard rate (plus interest expense on the vehicle loan, if applicable). For 2011 the rate will be 51 cents per mile. The alternative method is to track the business percentage of actual expenses relating to the vehicle including gas, maintenance, oil, repairs, tires, insurance, registration fees, and depreciation. With both methods good record keeping is needed. Keeping a mileage log throughout the year is critical in supporting this deduction. A mileage logs needs to include the date, beginning miles, ending miles, number of miles driven each trip, destination and reason for the trip.
Start Up Expenses
Expenses incurred prior to starting a business are required to be deducted (amortized) over no less then 180 months. However, there is an exception. You can deduct up to $5,000 of start up expenses incurred in the first year. The remaining amount of start up expenses will be deducted over 180 months.
Vehicle Use
Vehicle use is an important deduction. Taxpayers have the choice of two methods of deducting vehicle expenses. For 2009, the IRS allows 55 cents per mile as a standard rate (plus interest expense on the vehicle loan, if applicable). The alternative method is to track the business percentage of actual expenses relating to the vehicle including gas, maintenance, oil, repairs, tires, insurance, registration fees, and depreciation. With both methods good record keeping is needed. Keeping a mileage log throughout the year is critical in supporting this deduction. A mileage logs needs to include the date, beginning miles, ending miles, number of miles driven each trip, destination and reason for the trip.
Business Use of Home
Deductions for the business use of a home or "home office expense" are another unique deduction for the self-employed person. This has been a particularly controversial area of tax law and some courts cases have argued the application of this deduction. The IRS requires that to deduct home office expense, the taxpayer must use the space exclusively and regularly as a principal place of business, either as a place to meet with customers or in connection with the business (such as a barn or garage that is separate from the residence). If a taxpayer takes this deduction and depreciates the business portion of their residence, the future sale of the residence will create "depreciation recapture".IN MOST CASES THIS RESULTS IN TAXABLE INCOME.
Self-employed Health Insurance
For 2009 a taxpayer who is self-employed is allowed a deduction equal to 100% of the total paid during the year for medical, dental and long-term care insurance for himself and his family members (note: the deduction for long-term care insurance premiums is based on the taxpayer's age. A full deduction for the entire premium amounts may not be allowed). This deduction is a special "above-the-line" deduction on page one of the tax return.
If I am self-employed do I have to make quarterly estimated tax payments?
Yes, but there may be some exceptions. As a self-employed taxpayer, the IRS requires that you pay income taxes "as you go" through the year. This is because you are earning income without any withholdings.
To make quarterly estimate payments, the taxpayer needs to send in their payment with a form 1040-ES by April 15th, June 15th, September 15th and January 15th. Keep in mind these dates do not correspond to actual 3-month intervals. Also, the first payment is due at the same as the personal tax return is due (therefore, you may have 2 payments due at the same time.)
Before making these payments we need to know how much money to send. The IRS allows taxpayers to avoid an underpayment penalty if they pay estimates using the "safe-harbor " rule. This requires that the taxpayer pay at least 100% of the prior year's tax liability. (Taxpayers with adjusted gross income over $150,000 must pay 110%). If a taxpayer knows that their income will be significantly more or less that the prior year the estimate payments can be adjusted accordingly.
However, if you or your spouse is already having income taxes withheld by your employer, these withholdings may be sufficient to meet the 100% test and thus quarterly estimates are not required. Another option may be to increase your withholdings with your employer.
A simple approach to calculating the quarterly amount is to look at your prior year return and find your total tax (line 60 on your 2009 and 2010 tax returns). Divide this amount by 4. This number is the minimum amount that should be paid for each quarterly payment to avoid any underpayment penalties and interest. Please keep in mind that you still may owe by April 15th, but using this approach allows you to keep your money longer during the year.