The first year of freelancing went well for you. You managed to build a client base, get in plenty of work, and make some money. However, April is around the corner, and now it’s time to pay the piper – or the taxman in your case.
Every self-employed person has to pay the IRS a percentage of their annual gross income. You need to ensure that you have some money in your bank account when tax season rolls around. Spending all of your earnings without keeping some aside for the taxman can come back to haunt you during the filing season.
As a self-employed individual, you’re responsible for filing your return and paying your tax. Employees have the benefit of employers deducting taxes for their salaries, but you have to manage this process when you’re working for yourself.
We put together this brief guide to give you everything you need to know when filing your tax return this year.
What Entity Are You Using?
- 1 What Entity Are You Using?
- 2 Self-Employment Tax Explained
- 3 The Tax Rate for Self-Employed People
- 4 How You Can Pay Self-Employment Tax
- 5 What Happens with Late Tax Returns?
- 6 Tips for Reducing Your Self-Employment Tax
- 7 Making Use of Tax Deductions for Gas and Mileage
- 8 Wrapping Up – Hire an Accountant
Self-employed taxpayers require a legal structure to define how they operate in the economy. Individuals can choose to register their business formally through incorporating a company, or they can file as a sole proprietor.
Whether you structure your company as a sole proprietorship, a partnership, an LLC, or an S or C-corporation will affect your tax return. Let’s unpack the tax requirements for each of these entities.
- Sole Prop – As a sole proprietor, you’ll need to report your income and expenses on a Schedule C form. In this case, you are responsible for paying the costs of Social Security and Medicare, as well.
- Corporations and Partnerships – If you run your business with a partner, you’ll be filing as a partnership or as a corporation. Partnerships have to file an information return, but they typically don’t have to pay any federal income taxes.
Information returns are documents, such as Form W-2, requiring taxpayers and businesses to file and report and business transactions with the IRS. You’ll use Form K-1 for reporting an individual’s shares in the partnership, and an S-corps’ income to federal government authorities.
Unlike a partnership or sole proprietorship, a C-corp has recognition as a separate tax in the Federal tax code. As a result, the corporation can claim special deductions on taxable income. This legislation also means that the IRS taxes the entity at the corporate tax level as well. However, the income is taxed again on a recipient’s tax returns if distributed as dividends to company shareholders.
S-corp taxes are similar to a partnership, in that income flows through to personal tax returns as well. However, they are also like C-corps because they set salaries and withhold payroll tax at the corporate level for the owners.
One of the key advantages of owning an S-corp is that you get to set your salary, subject to following reasonable guidelines by the Federal government. If the IRS determines that you are drastically underpaying yourself to avoid paying taxes, there could be severe repercussions.
While an LLC has recognition as a legal business entity, it’s a state-level designation, and not recognized in federal tax purposes. Therefore, an LLC must file as a corporation, sole proprietorship, or partnership.
Self-Employment Tax Explained
Employers withhold FICA taxes from salaries on payday. These Social Security and Medicare taxes are mandatory, and employers must take care of paying the government on behalf of the employee.
Self-employment taxes cover the costs of Social Security and Medicare for self-employed individuals. With no employer around to do this for you, you’ll have to take care of these taxes by yourself. If you have an income that’s greater than $400 per year, then the law requires you to calculate your self-employment taxes. You’ll need to file Schedule SE, which you attach to your individual tax form 1040.
The Tax Rate for Self-Employed People
As of Q3, 2019 – the current self-employment tax rate sits at 15.3-percent. The rate has two components consisting of 12.4-percent for Social Security, and 2.9-percent for Medicare. The Medicare component of the self-employment tax rate has no limit to the amount due from your net self-employment income.
However, there is a cap on the Social Security component of the tax, knows as the “Social Security wage base,” and this rate changes every year, depending on economic and employment conditions.
For the tax year of 2019, the Social Security wage base is $132,000, up a total of $4,500 from a base of $128,400 in 2018. Employees get the benefit of the employer withholding half of these costs from your salary. These costs account for 1.45-percent of your annual salary for Medicare, and a further 6.2-percent for Social Security.
As a self-employed taxpayer, you are going to be liable to pay the full amount to the government for your Social Security and Medicare benefits. However, all hope is not lost, as you can deduct half of the self-employment tax as an income adjustment on Line 27 of Schedule C.
In addition to a 2.9-percent tax on Medicare, those high-earners also pay additional Medicare taxes of 0.9-percent, on any income earned above the thresholds below.
- Married and filing jointly – $250,000
- Married and filing separate – $125,000
- Singles – $200,000
- Household Heads – $200,000
- Qualifying widow – $200,000
How You Can Pay Self-Employment Tax
By now, you have an understanding of the basics involved with self-employment tax. However, it’s time to learn how you pay those taxes over to the IRS and the government. Self-employment and federal income taxes are similar in the fact that they operate as a “pay-as-you-go” system for settlements.
It’s for this reason that employers withhold your tax portion from your paycheck. Can you imagine if you had to write the IRS a big, fat, juicy check at the end of the year with your Christmas bonus and a tax return?
Self-employed individuals are also more likely to have to make estimated quarterly payments if they start to owe taxes above $1,000. The IRS Form 1040-ES, lets you calculate your estimated self-employment taxes on page-6 of the document. There’s also a section for including deductions for half of your self-employment taxes.
Use Form 1040-ES for calculating estimated income tax and your self-employment tax obligations for the year. After you get this figure, divide it into four equal payments made quarterly on the specified dates of April 15th, June 15th, September 15th, and January 15th.
These dates will move to the next business day, should the 15th fall on the weekend or a public holiday. Make your estimated quarterly payments using an online system like IRS Direct Pay, or through mailing a personal check with vouchers included in the Form 1040-ES.
When filing your return at year-end, you’ll need to reconcile totals. Use the estimated payment amounts you made against the amount of self-employment and income taxes that you owe. If you overpay, you can choose to wither have the amount roll-over against next year’s tax obligations or receive a direct-deposit refund into your bank account.
On the flip side, if you underpay, there will be penalty charges on top of the outstanding amount due.
What Happens with Late Tax Returns?
If the taxpayer owes at least $1,000 in self-employment and income for the year and doesn’t make estimated quarterly payments, then the Internal Revenue Service assesses them for a penalty for underpaying estimated tax when filing a tax return.
The IRS will calculate underpayment penalties by initially calculating the correct quarterly-installments responsible for payment by the taxpayer. They then multiply the difference outstanding by the interest rate set at that quarter.
The IRS then calculates the penalty is for each quarterly installment, and charges you penalties for one quarter, but not all the others.
Tips for Reducing Your Self-Employment Tax
If you’re a self-employed individual, then you can take the opportunity to reduce your total tax bill by utilizing deductions. The IRS realizes that business expenses cost you money and that you are already paying tax on most of these expenses when you pay for them with the supplier. Therefore, the IRS lets you make specific deductions related to business expenses.
You can off-set these costs from your annual gross income, and pay a lower tax bill at filing season. When filing for tax deductions, you have the opportunity to choose the standard deduction option, or the itemized deduction option.
The standard deduction is a rate set by the IRS that they feel is fair, ordinary, and necessary for the daily operations and marketing of your business. The itemized option allows you to dive deeper into your expenses and make claims for costs that would not otherwise qualify using the standard deduction system.
With the itemized deduction system, you can claim back for a variety of business expenses, such as the following;
- Home office – You get a percentage of your rent or mortgage costs as a deduction if you work from home.
- Marketing – Costs associated with advertising, website maintenance, and marketing budgets.
- Auto expenses – You can write off gas and mileage as long as you can prove the travel was for business purposes.
- Subscriptions and memberships – Any costs related to industry subscriptions are a valid deduction.
- Operations costs – Any costs relating to doing business on-site of your operations.
- Travel – Plane and train tickets, hotel accommodation, are all valid expenses.
- Food and entertainment – Write off 50-percent of your business-related meals and entertainment-related expenses.
- Communications – Write off your internet and cellphone costs.
It’s also important to check your tax bracket before racking up your deductions. If you have enough deductions, it could place you in a lower tax bracket, saving you more money.
Making Use of Tax Deductions for Gas and Mileage
As a self-employed person, you can claim back your travel costs relating to the gas and oil you put in your car, along with the servicing costs, tire replacements, and wear-and-tear on your vehicle. However, to qualify for a deduction on your gas and mileage, you’ll need to keep accurate records of how you use your vehicle.
The IRS requires you to keep a logbook of your mileage, along with an explanation for every trip you take. You’ll have to differentiate from personal and business use of your vehicle, and you can only claim back for business-related miles.
When claiming back for gas and mileage, you have two options. The standard option gives you a blanket number that you can add as a deduction to your return. The actual option lets you claim back for itemized expenses throughout the year. However, with the itemized option, you’ll still need to account for all the costs.
If your expenses are on the high side, you can expect an audit from the IRS. You better have all of your receipts if they do decide to audit you. Still, with itemized deductions, you can deduct the costs of depreciation on your vehicle, as well as any lease costs for company vehicles.
Wrapping Up – Hire an Accountant
As a new taxpayer or self-employed person, it’s challenging to put your tax return together, and make sure of all of the deductions available. However, with time, persistence, and plenty of learning, you’ll figure out how to successfully submit your return.
However, we recommend you avoid using the do-it-yourself approach when filing your return. The time you waste trying to figure out how to compile your return is costing you money. You could be making productive use of your time, instead of working out what the IRS wants from your business this year.
Also, there’s a good chance you won’t know the thresholds for audits on itemized deductions. Should you accidentally overstep the boundaries, you can expect an audit that could land you in trouble if your reporting is inaccurate.
We recommend you work with a qualified and experienced accountant when filing your return. These professionals know what they are doing. All they need from you is your expense receipts. Leave the pros to do the job right, and they’ll end up getting you more back on your tax return than if you had to do it yourself.