Taxes 101 for the Self-Employed
Starting a business can be fun and exciting, but the dreaded “T” word comes rolling around, and often small business owners become confused and stressed. The “T” word I'm referring to is taxes. I understand the frustration of taxes for your business as a tax professional that's been in the business for over 25 years. Business owners struggle with this task more than anything else! I've witnessed the stress and agony some of my clients face surrounding their tax situations.
In this training, I'm going to explain how taxes are different when you're self-employed versus an employee, when your side hustle has to be reported on your tax return to Uncle Sam, and how to estimate your taxes as self-employed along with some deadlines that you really don't want to miss. So let's dive in. First of all, when are you required to file taxes for your business or your side hustle? The IRS breaks this down pretty simply for us.
So for example, if you received income of $600 or more from a contractor or someone that you're working for, they are required to send you a form 1099 NEC reporting the total income that they paid. Now, even if you don't receive one of these forms from the contractor, you are still required to file your income on your tax return if you made a profit of $400 or more. Also, if you have multiple businesses or side hustles, each business’s income and expenses are considered separately, so don't lock them all together. So again, if you made $400 or more in profit you're required to file and if you receive a form 1099 NEC, you're also required to file whether your profit is $400 or more or not.
My rule of thumb is going to be if you've made $600 or more whether you've received that 1099 or not, I always recommend that you filed this on your income tax return because a lot of times it can actually help you with your tax situation.
The next thing I want to go over is the type of taxes that a self-employed individual have, and it's gonna be a little different than if you're working for someone as an employee. So I want to break it down for you. When you earn income as an employee, your employer is going to deduct Social Security and Medicare taxes from your paycheck. These taxes total 7.65% of your taxable income. Now, if you're not working for someone, you don't have anyone to deduct these taxes from, so as a self-employed individual, you are going to be responsible for the full share of Social Security and Medicare. When I say full share, I'm talking about not only what's normally deducted from your paycheck as an employee, but also the part that your employer would match. So for your pay, 15.3% of your taxable income goes into the Social Security and Medicare fund. The employee pays half 7.65%, the employer pays 7.65% and as a self-employed individual, you are responsible for that whole 15.3%. When you're self-employed, you must pay the 15.3% of self-employment tax on the profit of your business. Again, there's that profit word again that we talked about earlier. So you only pay self-employment tax on the profits of your company.
Now you're also able to deduct one-half of the tax as an adjustment to your income so you don't pay income tax on that portion. Okay. Now also as a self-employed individual, you are responsible for income tax. Your income tax is going to be based on the total income, including all sources of income for you and your spouse.
If you’re filing jointly for income tax, there are three different types of taxes depending on where you live. So we're all responsible for federal income tax. You also have a state income tax for those states who have to pay the tax and also some local tax as well. So your federal income tax, which is ranging from 10% to 37% in 2022. The states that do not pay income tax are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Furthermore, there are two states where you only pay income tax on interest and dividends and that would be New Hampshire and Tennessee. So all of those states that I just listed, you do not pay tax on the profit of your company, you would only pay federal income tax.
Now a simple computation for your income tax is going to be:
profit x tax rate + self-employment tax
This will usually give you an estimate, so I tell clients to save up roughly 30%, set that aside for estimated taxes for their company. Speaking of estimated taxes, this has been something that I'm asked a lot.
When do I have to pay estimated taxes?
Am I going to be penalized if I don't pay estimated taxes?
The rule of thumb from the IRS is that if you expect to owe more than $1,000 in federal taxes for the tax year, you may need to make estimated tax payments or face a penalty for underpayment. The thing is Uncle Sam wants to get their money all year long. They don't really like to get a big chunk in April when you file your taxes. So, just like with an employee, your employer is responsible for paying those taxes to the federal government either weekly, bi-weekly, monthly, or quarterly. The IRS is getting those payments throughout the year. When you're self-employed, the same rule applies. You have to pay those taxes throughout the year or when it is earned. That lets you know when or if you have to pay estimated taxes.
The next question is always - how much? Well, the thing is if you owe taxes a prior year, you can pay 1/4 of the taxes each quarter, or what I like to recommend is that you estimate your tax liability every quarter based on your profits and you pay those accordingly in the year that you earn these profits. For example, in 2021, say you owed $4,000 in taxes based on your profit for 2021. You would pay $1,000 per quarter if you were using the first example. If you were using my recommendation which is your estimated tax liability and your profits were much lower, then you would pay lower amounts each quarter. You would also pay those taxes when you're earning the money so that your cash flow is there to pay those estimated taxes. If you happen to be earning more in the current tax year, you're able to estimate those taxes now and go ahead and pay those so that you're not hit with an underpayment penalty when you file your taxes.
Now the deadlines for estimated taxes are a little different. They're not based on normal quarters. There are four estimated taxes. The first one is due on April 15th and this will cover the periods of January through March, your typical three-month period. Your second deadline is June 15th which covers the period of April and May and then the next is September 15th which covers the month of June through August. And the last is actually due the next tax year so it'll be due January 15th. And that covers the periods of September through December. So that is a four-month period that you're paying taxes on.
So we've talked about how to pay your estimated taxes. We've talked about how to compute those estimated taxes. We've talked about how to compute your self-employment tax, and all of these things are based on the profit of your business. So one thing I want you to keep in mind is how you should be computing your profits. It is a simple formula:
revenue - expenses = profit
It's super important for a self-employed individual to keep track of your income and expenses throughout the year, not only to know what's happening in your business but also to keep track of your taxes. There are multiple factors in computing the profit and loss for your business.
Make sure you're familiar with how to record the following transactions. Vehicle expenses for your vehicles not listed in your business name - there are certain ways that you need to do that based on your business entity. You need to know how to record payments on business loans or assets that you have and that you're making payments on. If you took advantage of any of the pandemic relief programs, such as the PPP or the EIDL, those things need to be recorded differently in your set of books. Also if you're working from home, then you should make sure that you are recording your home office deductions as well. Now there are many different types of deductions that you can claim, being self-employed. Make sure that you're claiming all the deductions that you're allowed for your industry! I actually have a cheat sheet that will list all the top deductions for all different industries so make sure that you have that downloaded.
Keeping up with your business finances is super important for you to be able to track how much you should be paying estimated taxes, to figure out if you're even required to file these on your taxes at all, and to make sure that you are claiming all the deductions so that you are lowering your tax liability. A few ways that I recommend for you to keep track of your business finances is my all-time favorite accounting software QuickBooks Online. If you’re not quite ready for QuickBooks Online, then you can download our Calculated Tax Planner which will help you keep up with all of your income and expenses. It will also help you estimate your tax liability for each quarter so that you can make the appropriate estimated tax payments. If taxes and all of this is just so overwhelming and confusing for you, then I highly recommend that you outsource your bookkeeping and your taxes to a professional. If you're ready to take this off your hands please send me a message and we can have a consult to see how we can help you better understand your bookkeeping and what's going on with the finances of your business, and how to save on your taxes so that you're not paying Uncle Sam a dime more than you should of all the hard-earned money that you've had throughout the year.
