Beginner's Tax Guide for the Self-Employed
Many people harbor grandiose dreams of being self-employed, but you’re different: You actually have a shot at it. You have the start-up capital and a solid business plan that will help make your dream a reality.
But before you take your first step into the world of entrepreneurship, there’s a checklist of things you’ll need to do if you don’t want to get nailed by tax problems while your venture is still in its infancy.
It’s always a good idea for self-employed people to get a separate tax ID number for their business so they can give it to customers that require a W-9 form from them.
-Wray Rives, Coppell, Texas-based certified public accountant
One of the most important decisions you must make as you start your journey toward self-employment is determining what your business structure will be.
Whether your company will be a sole proprietorship, an LLC, a partnership, an S-corporation, or C-corporation will affect how your taxable income flows through to your personal tax return, said Phoenix-based certified financial planner Dana Anspach.
If you are a sole proprietor, your business income and expenses should be reported on Schedule C, Anspach said. You’ll be responsible for paying self-employment taxes -- such as Social Security and Medicare.
“If you have a business partner, you will file as either a partnership or as a corporation,” she explained. “A partnership must file an information return, but it does not pay income tax.”
Information returns are tax documents (the most common being Form W-2) that businesses and taxpayers must file to report certain business transactions to the Internal Revenue Service. You use Form K-1 to report partnership income to the federal government.
Choosing to file as a C-corporation would be highly unusual for a start-up. Anspach says she can only see a new business owner choosing this organizational structure if a personal accountant or CPA recommended it for advanced tax benefits.
“Unlike a sole proprietorship or a partnership, a C-corporation is recognized as a separate tax-paying entity for federal tax purposes,” she said. That means the corporation may take special deductions, she explained. It also means the profit it earns is taxed at the corporate level, then taxed again when it is distributed as a dividend to shareholders.
S-corporations are similar to partnerships in that your income flows through to your personal tax return, Anspach noted. But they are like C-corporations in that you may set a salary and withhold payroll taxes at the corporate level. Some or all of your income may be reported to you on a Form W-2 at the end of the year.
One of the advantages of being an S-corporation is the taxpayer’s ability to choose a salary, subject to reasonable guidelines, she said. But Anspach cautioned entrepreneurs to consult an experienced CPA or accountant: There can be serious tax ramifications should a person severely underpay himself when the business is making money, because wages are the only taxable income the IRS can subject to payroll taxes.
Although an LLC is a legal business structure, it is a state-level designation that is not recognized for federal tax purposes, Anspach said. It must file as a corporation, partnership or sole proprietorship.
Now that you know what you are, you can take the steps that can lead to tax deductions down the road.
That involves securing a tax ID number, said Coppell, Texas-based certified public accountant Wray Rives.
“You can get a tax ID number for free; all it takes is about five minutes' time on the IRS website,” he said. “It’s always a good idea for self-employed people to get a separate tax ID number for their business so they can give it to customers that require a W-9 form from them.”
If you can carve out a little nook in your home that you can dedicate solely to your business affairs, Rives said, you’re setting yourself up for a great tax deduction.
“It does not have to be a separate room, as a desk in the corner of the kitchen will qualify,” he explained. “But it does have to be used exclusively for business tasks, so the kitchen table probably does not qualify.”
If you’ve never been a stickler about keeping track of the money you earn and spend, now is the time to make it part of your daily routine.
Personal finance tools like Mint.com and Quicken (brought to you by Intuit, the same company that makes TurboTax) can help self-employed individuals categorize and keep track of their business and personal income and expenses separately. QuickBooks, also from Intuit, offers a range of financial products for businesses to manage their finances, whether you’re just starting out or established and expanding.
One of the most common deductions self-employed taxpayers can claim is automobile expenses. So don’t fret over the steadily depreciating value of that new van you purchased to make deliveries for your catering business.
Several tax options can help you recoup some of the money you spend maintaining and using your car for business-related purposes.
To get the maximum deductions for your business vehicle, you must maintain a written log of business miles, said Martinsville, New Jersey-based CPA Gail Rosen. You must also jot down your odometer reading at the beginning and end of each year so you’ll know your total miles.
You may choose to use the standard mileage rates set by the federal government or deduct the actual expenses. Using the standard mileage rates involves keeping track of your business miles and multiplying these miles by the mileage rate. Deducting actual expenses allows you to deduct specific expenses including depreciation or lease costs (subject to “luxury limits” that disallow deductions for expensive cars) gas, insurance, repairs and car washes, she added.
“If your car is over 6,000 pounds gross weight, you are not subject to the luxury rules and therefore get a higher deduction for depreciation or your lease payments,” Rosen explained. “All expenses must be ‘ordinary and necessary’ to deduct. You shouldn’t miss any legitimate deduction because every deduction is very valuable.”
It's not all about the cars, though. A bevy of other deductions are available to the self-employed, such as office supplies, reference material and out-of-town travel expenses, to name a few. But keep in mind they require meticulous bookkeeping and receipt filing to satisfy IRS rules.
With the freedom of being a self-employed individual comes the sole responsibility for paying taxes.
In addition to income taxes, you may be required to collect and pay sales tax, a state-mandated surcharge that varies from state to state. Business owners should check with their state government to see if they must charge customers sales tax for their products or services, said Martinsville, New Jersey-based certified public accountant Gail Rosen.
“If they should have collected taxes and don’t, then the individual can be personally liable on the sales tax they should have collected but didn’t,” she said.
Individuals may also be held responsible for a use tax, Rosen noted, which is applied to all the items a person buys for the business and should have paid sales tax on but didn’t.
Whether you file as a sole proprietor, partnership or a corporation, she said, an individual has to pay estimated taxes to the federal and state on profits from the business.
And finally, if you have employees on your payroll, including yourself, they and you are still required to pay Uncle Sam the standard payroll taxes on salaries.