Self Employment tax filing
Taxes aren’t just for employees and companies to pay; self employed individuals too have to pay business income taxes. And dealing with taxes has always been an overwhelming situation for most, especially for the self-employed. Just to be clear, the people who own their own company and work for themselves are known as self-employed or independent contractors.
In fact, there is a difference between the two. Every independent contractor is a self-employed individual, but not all self-employed individuals are independent contractors. And if you are a self-employed person then you should know that it will affect your tax liabilities. This article will explain all you need to know about self employment tax filing, and what the deductions are that you can enjoy on tax returns.
What is self-employment?
Self-employment means working for yourself as an employee. As per the IRS, a self-employed person is one who is running a business or a sole proprietorship, a member of a partnership, is doing business for himself/herself, or a person who is an independent contractor. In short, a self-employed person can be anyone from a mechanic to a sculptor or a doctor.
Just like every other employee in the world, a self-employed person has the responsibility to pay federal income taxes. But in this case, they do not have anyone to withhold taxes from their paycheck and send it to the IRS. Neither do they have anyone to share the burden of paying medicare and social Security taxes.
So, it is important for self-employed individuals to focus on their own tax return and filing completely. They need to keep track of their own income, determine how much tax they owe the government and in many cases, make estimated payments throughout the year.
So, what is a contractor?
As mentioned above, a contractor is different from a self-employed individual. An independent contractor is a person that uses their skills to perform a task for someone else on a contractual basis and not as an employee. For instance, if you are an electrician and a family hires you to repair some things at their home, you are not their employee. You are there to just help them for that time on a contractual basis, making you an independent contractor.
As the contractor doesn’t report back to anyone and works for themselves, they are known as self-employed individuals. On the other hand, a person who makes products and sells to the public is a self-employed individual, and not an independent contractor.
If you are a person who works in a traditional company, you will get a W2 form from your employer that will let you know how much money you made throughout the year. But when you are self-employed, you have to take care of this on your own. This means that you need to keep track of all the money you earn from your business and how much you spend as well. After all, you are the boss and this recordkeeping is one of your responsibilities.
And when you reach your tax time, you will then have to use the Schedule C to report all your business income and expenses. You need to subtract the expenses from the income so that you can get the total profit earned from self-employment. This is then added to your personal income tax return.
In case you have worked as a contractor for clients, you should expect to get the 1099 forms that will report the amounts paid to you. This will help you file your business income as well. The next part would explain how to file the form and also what you can deduct from your tax return.
Common Business deductions
Being a person who is self-employed means taking on a lot of risks that you would not normally take if you work for someone else. You are the one who is responsible for providing value with your service for your customers. You are also the one who needs to pay all the bills and costs for keeping these customers. In short, there are a lot of things that you need to take care of and pay for.
To reduce the burden of taxes on the self employed, legislators have set in place a tax code that will help you cover many of these costs. You can do this by claiming various business cost deductions on your tax return. Some of the common business deductions that you can claim on your tax return as a self-employed have been explained below:
The very first deduction you can take advantage of is the home office deduction. This is the deduction of the cost that you use on any workplace exclusively and regularly for your business, even if it is an owned office or just a rented space. Just remember that you should be able to defend the deduction in case of an IRS audit.
You have two choices for calculating your home office deduction: the standard method and the simplified option and you don’t have to use the same method every year. The standard method requires you to calculate your actual home office expenses. The simplified option lets you multiply an IRS-determined rate by your home office square footage. To use the simplified option, your home office must not be larger than 300 square feet and you cannot deduct depreciation or home-related itemized deductions.
Additionally, you can also have the expenses like the business percentage of property taxes, utilities, home maintenance, homeowners insurance, mortgage interest and home depreciation that you pay in a year deducted. An accountant will be able to help you better in this case.
Internet & Phone
You can also deduct the business internet, fax and phone expenses. Just remember that you need to deduct the costs related only to your business and not personal ones.
Things you use in your office like the envelopes, paper, toner, etc., can be deducted in Part II of Schedule C. On a separate section, you can also deduct the things like calculators, printers, cameras, computers, etc. Just ensure that they are things you use in the office and not personally.
Permits & Licenses
You can also deduct the amount you pay for permits and licenses that you get for your business.
Entertainment & Meals
Another thing that you can deduct is 50% of the costs for business entertainment and meals. You can deduct the amount you spend to entertain a client or the meals you have while on a business trip. Also, remember that your meal cannot be lavish and you can only deduct 50% of the actual cost. The lunch you eat alone at your desk in your office is not deductible.
In case you are a self-employed individual, and you have your own insurance premiums along with the insurance of your spouse and your children or dependents who are lower than 27, then you can deduct all the dental, health and qualified long-term care insurance in your tax returns.
Auto & Travel
For you to be able to qualify for this, the business travel has to be longer than a normal workday. In short, the travel deduction is for when you have lived outside the city or state in which your business or home is located. Moreover, you will need to mention the reason for the trip, which cannot be for say a bachelor party or a place where you simply went to hand out your business card and network.
You can also deduct the costs of transportation and automobile expenses under Line 9 on Schedule C. This is if you live far from your home and have to use a transport to get to your business. Parking fees and toll costs are also added to this.
To get the best out of the deductions, you can easily take the help of a tax accountant for your self employment tax filing.
If you are still wondering what self-employment tax is, then here you go – it is the employer portion of the Social Security and Medicare taxes that self-employed people have to pay. To explain better, self-employed individuals have to pay the federal government with (self-employment taxes) taxes to fund Medicare and Social Security programs.
So, when a person is earning more than $400 in a year being self-employed, they have to pay self-employment taxes for their income in that tax year. The percentage for the self-employment taxes is 15.30% and here is how it breaks down:
- 6.2% of the Social Security tax for each employer and employee on the first $128,700 in the salary.
- 1.45% Medicare tax each for employer and employee with no wage limit.
Other than this, you will also owe an additional amount of Medicare tax for 0.9% in case any of the following conditions are true:
- Married filing separately – $125,000
- Married filing jointly – $250,000
- Single – $200,000
The income threshold for this additional tax of Medicare is not just for self-employment income, but to combine self-employment income, compensation, and wages that you and/or your spouse gets.
For instance, if you are earning self-employment income of $100,000 and your spouse has a salary of $160,000, you will have to pay the additional 0.9% Medicare tax on the $10,000, the total amount over the income threshold of $250,000.
How do you pay self-employment taxes for yourself?
Well, since you are self-employed, it is your duty to take care of the self employment tax filing. And in this case, you need to withhold the Social Security from your taxes for contributing both the employers and the individual portions of Social Security. But many self-employed people do not withhold Social Security taxes from their paycheck as they don’t get regular paychecks. Instead, they pay all the taxes when they file their annual federal income tax return. You too can do this.
The Schedule SE is used to report the profit or loss of your business as calculated on Schedule C for self-employment tax. The government then uses this to calculate the Social Security benefits you will get later on. Just to clarify, the self-employment tax consists of both the employer and employee position of the Social Security:
- Medicare (1.45% + 1.45% = 2.9%)
- Social Security (6.2% + 6.2% = 12.4%)
The total self-employment tax rate is 15.3% from the above. The form will be explained better in the next sections.
Self-Employed Tax Deductions
As mentioned above, you need to use Schedule SE to get the net profit or loss you earned as calculated on Schedule C by 92.35% before you can find out the amount of self-employment taxes you owe to the government. This means that if the profit on your Schedule C is $100,000, then you will only have to pay 12.4% of the Social Security tax on $92,350, which is $11,451.40 instead of $12,400. In short, you save about $948.60 on your taxes.
In fact, half of $11,451.40 is the employer’s portion of the Social Security tax, and this can be deducted as a business expense in your tax return. Other than this, there are many other deductions (as mentioned above) you can make when working on the self employment tax filing and your tax returns.
But you need to keep in mind that the lower your income is on the Schedule C, the lower you tax will be. And with this, you will get a lower amount of Social Security in your retirement plan. So, do remember to take the help of a lawyer so that you do not lose out on just trying to lower your taxes now.
New Pass-through deduction (20%)
There was a tax overhaul in the previous years, after which a new 20% deduction for small businesses was introduced. This has made things better for self-employed individuals. Just to be clear, if you are under a certain limit, you are good. But if you are above the limit, there are many complicated rules too if you qualify for a full or partial deduction.
To begin with:
- You need to have a ‘pass-through’ business (such as a partnership, sole proprietorship, an s corporation or a limited liability corporation);
- It is a deduction only for those who have a “pass-through income.” In short, it is for those who pay business taxes on their personal income tax return.
This deduction is only applied to the QBI, which is qualified business income. It is the total amount of your business profit. But not all businesses qualify for this. In fact, QBI includes:
- Income earned outside the U.S.
- Interest income
- Capital gains or losses
- Certain wage and guaranteed payments made to shareholders and partners
So, in case you have a total taxable income which is below:
- $157,500 – for single filers
- $315,000 – for joint filers
That is when you can benefit from the 20% deduction on your taxable business income. And if you are wondering why, then if your income is above the limit, the pass-through deduction claim would depend entirely on the nature of your business. And after you find out that your business qualifies for this, there is a chance you might not be able to enjoy the complete tax break of 20% deduction. This is because it is phased out for a few companies.
Tests for pass-through businesses over the income limit
One such test to determine if you qualify for this deduction is to see if your business is a specified service business or trade. These are financial planners, actors, consultants, lawyers, doctors or any professional as such that gives high earnings. In this case, if your income is between:
- $315,000 to $415,000 (joint filers); or
- $157,500 to $207,500 (single filers)
Then there is a chance you can get this deduction. Just to be clear, it is the same for any non-specified business or trade as well where the taxable income is above:
- $315,000 (joint filers); or
- $157,500 (single filers)
In these cases, the deduction will be based on the amount of salary you paid to your employees, which also includes yourself. It is also based on the value of property that you own. The higher these figures, the more chance you have to qualify for the deduction.
How does the deduction work?
This deduction is not that easy. There are a few things that need to be kept in mind, including:
- There are two figures of the 20% where the deduction is worth up to 20% of the business taxable income. But while you claim the pass-through deduction, it can’t add up to more than 20% of the business income that is taxable.
Here is how you do it: You determine the income and expenses on Schedule C and get the adjusted gross income on form 1040. After this, you will be able to calculate this pass-through deduction. And this means that you have already had deductions, and there is no hard saying that you will be able to get the complete 20% deduction after that as well.
- You are allowed to claim this even if you do not claim your itemized deductions. So, if you use the standardized deduction, you can still qualify for this 20% pass-through deduction.
To be clear on this, it is again advised to take the help of a professional lawyer or accountant for this.
Now that the basics are clear about the self employment tax filing and business tax returns, let us talk about the forms you will come across to file your tax returns as a self-employed individual.
As also mentioned above, the form 1040SE (also called Schedule SE) is the form used by self-employed individuals to determine the amount they owe for the self-employment tax. So, if you earn more than $400, you need to file this form with the IRS. Here are some things you will need for filling in the form:
- Total profit and loss that can be taken from the Schedule F, line 36. For partnerships, it is obtained from Schedule K-1 (Form 1065) box 14, code A.
- Amount obtained in any Conservation Reserve Program from Schedule F, line 6b.
- Net profit or loss from Schedule C, line 31; or Schedule C-EZ, line 3; or Schedule K-1, line 14, if the income is from one business contract; and Schedule K-1, line 9, code J1.
By taking all the information on these forms, you will have to file your Schedule SE to get the total amount you earned to pay the self-employment tax on. Again, do not forget to take the help of an accountant when working on the self employment tax filing as you might miss out on something or make a mistake.
It is understood that being a self-employed individual requires you to file Schedule C. This is to report the amount that you made in the business. It has to be completed and included with your income tax returns and the Schedule SE. To explain better, the Schedule C has 5 parts:
- Part 1: For the income your business made and to calculate the total profit/loss.
- Part 2: Subtract all the business expenses from the amount in part 1 and get the net profit/loss. This will be reported on your income tax return.
- Part 3 to 5: These sections have to be completed only if your business need to buy inventory. In these parts, you will need to claim the expenses that you could not in part 2.
Regardless if you are a self-employed individual or an employee, you need to pay taxes throughout the year to the IRS. You can do this by withholding from your earnings and paying the estimated taxes every quarter of the year, which is the 15th April, 15th June, 15th September and 15th January. In fact, you need to pay estimated taxes if both of the following apply:
- You expect at least $1,000 in taxes after subtracting your withholdings and credits; and
- You expect your credits and withholdings to be less than the smaller of:
- 100% of the tax shown on your prior year tax return (which is the last 12 months); or
- 90% of the tax to be shown on your current tax return.
In case you are late to pay your estimated taxes, you will need to file the form 2210 for the federal penalties. This is the reason why it is important for you to always pay the estimated taxes properly and on time.
State tax returns
Other than paying federal taxes every year to the Internal Revenue Service (IRS), you also need to pay the state tax based on the state you live in. However, if you live in the states, Alaska, South Dakota, Wyoming, Washington, Nevada, Florida, and Texas, you do not have to worry about the state taxes.
If you live in any other state, you might need to pay additional state taxes. You will be able to learn more about the state taxes that you need to pay by checking with your lawyer or a government branch. You can also find out the details on the official website for your state’s Secretary of State. But do make sure you are following the rules well and paying the taxes in case you need to. The same is for your local government as well.
Unfortunately taxes are inevitable, and you will have to pay self-employment taxes if you are doing business on your own. But as shared above, you can overcome this by claiming all the deductions possible and making sure to properly fill in all the tax forms each year. Ensure your company is registered as the right business entity and can qualify for each relevant tax break. Also, do not forget to get the help of an account. In case you have not yet registered your business with the government, then IncParadise can help you out. Contact us to know more!