11 MIN READ
At the risk of preaching to the choir, we’re here to tell you there are countless benefits to being your own boss. As a self-employed individual, freedom and autonomy are as consistent in your life as are Monday and Tuesday. Yep, you were wearing pajamas to work even before it was the new normal. What else comes along with self-employment? Alongside all the perks comes a variety of nuanced tax implications that can be difficult to navigate. But don’t worry—today, we’re here to offer a guiding light. Whether it be for tax planning or tax preparation, there are four fundamental elements to filing a self-employed tax return that should be understood and checked off your list one by one. Let’s walk through each.
Entity Type & Income Structure
When trying to get a handle on self-employment tax implications, first, you need to consider what type of entity and income structure is best for your business. A Sole Proprietorship, Partnership, and Limited Liability Company (LLC) are all applicable entities or statuses that you may be interested in choosing. Here’s the scoop on each option:
A sole proprietorship is incredibly easy to establish, and it is certainly the most common business structure. As a sole proprietor, you are not required to file with the state or register a federal EIN as long as you do not have any employees or file any excise or pension plan tax returns. Find more information here. The IRS recognizes the sole proprietor and their business as being one and the same for tax purposes.
This means you must report all business income or losses on your personal income tax return. This type of business structure is unincorporated and does not offer the legal protections associated with LLCs. The significant downside here is that as a business owner, you’re solely responsible for any debts and tax obligations that the business accumulates, as well as potential legal liabilities.
A partnership, similar to a sole proprietorship, does not directly pay its income tax. The relevant income and expenses pass through to its partners; these partners must report their share of income or loss on their personal tax return. The partnership must prepare a Schedule K-1 to clearly define the distribution of the taxable income or losses for the year. A partnership must file with the state and is required to register a federal EIN.
Limited Liability Company (LLC)
An LLC is a legal entity that features pass-through taxation, with the option to file as a corporation or a partnership. The formation of an LLC is an arrangement of protection between your personal assets from the liabilities associated with an LLC-related business. This protection shields your personal assets from potential lawsuits. This same protection applies to the owner of any debts of the LLC. These businesses must file with the state and register a federal EIN. Beyond the legal element of LLCs, you must determine which tax status is best suited for your respective business:Disregarded entity status: A disregarded entity is the default tax status for single-member LLCs. When considered a disregarded entity, the business is taxed on an individual basis. The business’s profits and losses are reported on the individual member’s Schedule C as if it were a sole proprietorship.
Partnership: Partnership taxation is the default tax status for multiple-member LLCs. It allows for a high degree of control over profit and loss allocations to its partners. Again, the LLC does not pay tax as an entity; instead, its taxable profits and deductible losses pass through to its members.
S-Corporation: An S-Corporation is an elected tax status that serves as a pass-through entity. As an LLC taxed as an S-Corp, you avoid the corporate income tax, and profits and losses flow through to the respective owners and their individual income tax. Essentially, by electing to be taxed as an S-Corp, your business will be taxed as a partnership, and you prevent corporate-level double taxation.
Owners are considered shareholders, and you are considered an employee of the business; therefore, you must be receiving a reasonable salary. If an entity is taxed as an S-Corp, the only earned income that is subjected to FICA tax are wages paid to its owners and employees. An S-Corp is required to file a 1020-S, but the entity does not pay taxes on the net income. The remaining net earnings pass through to the owners and are taxed at the individual level on the owner’s 1040. Because the owner is required to pay themselves a reasonable salary to avoid double taxation, the net income distributed from the S-Corp to its shareholders is not subject to self-employment taxes (granted that the owner materially participates in the business) and is not considered passive income.
A sole proprietorship business will see self-employment tax due on the entire income amount, while S-Corp business owners with income exceeding their reasonable salary are not subject to self-employment taxes on the amount that remains beyond their salary. The S-Corp tax election is a strong fit for businesses looking to operate under the liability protections of a corporation while avoiding the regulations and the heavy tax burden standard for large corporations. S-Corps must be a United States-based operation, file as an American corporation, and have no more than 100 shareholders.C-Corporation (Corporate Tax): The corporate tax is the only non-pass-through form of taxation that an LLC can elect. The company’s revenues and expenses do not pass through to its members; instead, they are retained within the company and taxed at the applicable corporate income tax rate. If you desire to keep a substantial amount of retained earnings in your LLC, you may benefit from electing corporate taxation. The major caveat of this status is that dividends distributed to its members cause a double-taxation scenario.
Track Your Expenses
It is essential for self-employed individuals to take advantage of every possible deduction because, due to self-employment taxes, self-employed income is taxed relatively heavily. You should be mindful of what qualifies as an expense and, subsequently, track those expenses through a record-keeping system of your choosing. The IRS interprets business costs as being “ordinary” and “necessary” to operate your business.
When you work for yourself, you’ll need to hone in on your receipt collecting to take advantage of some hugely beneficial tax breaks. There are many equally sound means of recording these transactions through spreadsheets or organizing receipts and invoices. It is paramount that you do not skip steps, as having full knowledge of your expenses will simplify the tax reporting process. If your records are in order, it will be much easier to take advantage of the appropriate tax deductions. When you’re a small business, every dollar counts!
Here is a list of some of the most common qualified self-employment expenses to consider:
• Mileage or vehicle expenses
- Actual cost method: This method allows you to deduct the business-use percentage of the actual cost of the vehicle. This method will require some great record-keeping skills regarding gas, oil, repairs, insurance, tires, and licenses, but it also allows for depreciation on the total value of the vehicle.
- Standard mileage method: If you don’t want to deal with tedious record-keeping for your vehicle, you may opt for the standard mileage method. It eliminates the need to keep track of all those receipts and will give you a standard rate of $0.575 per mile instead. This method incorporates the expense of operating and maintaining your vehicle. It doesn’t include the allocated business percentage of auto loan interest, personal property taxes (vehicle registration), and business-specific parking and tolls. Each of these additional expenses may be deducted in addition to the standard mileage rate.
• Insurance premiums
• Office supplies
- When that old printer finally goes kaput, you can deduct the cost of a new one. Paper, printer ink, computers, and work-related software are all common examples of frequently replaced office supplies. If you pay shipping and postage for your business, those are also tax-deductible. Simply file your receipts, enjoy your new supplies, and be rewarded with a deduction.
• Credit card interest
- You can’t deduct credit card interest for personal expenses, but you can for small business-related expenses. It’s important to keep your personal and business expenses separate, so having a card specifically for your business is important. See this as a way to keep track of your receipts without having to do much at all. It will save a headache when tax season arrives.
• Home office expenses
- When working from home, it’s important to understand whether or not your workspace qualifies as a home office. Home-based businesses and freelancers have two options based on IRS guidelines for home office deductions.
- Under the simplified option, you’ll get to deduct $5 per square foot. In order to qualify, your space must be exclusively and consistently used as your office, and it cannot exceed 300 square feet. This is a rather quick and easy way to secure the deduction.
- Under the regular method, the same exclusive/consistent rule still applies, but the size of the space is based on the percentage of the home used for business purposes.
• Phone and internet costs
- Yes, it’s true! These days phones and lightning-fast internet are used for almost everything, including generating income from your businesses. As a self-employed person, you can write off these costs as an expense. If you have a home-based business, only the percentage of time that these things are being used for business qualify as being deductible.
• Business meals
- Generally, the deduction for business meals is limited to 50% of the actual cost, and the TCJA stipulates that you (or an employee) must be present at the meal. The meal expense is not to be lavish or circumstantially extravagant. You’ll need to keep track of some critical details such as location, date, cost, and whom you dined with.
• Startup costs
- The IRS has determined three sources of startup costs that qualify as deductible expenses:
Creating a trade or business: Activities related to creating or investigating a business
Preparing the business to open: Preparation activities made before the business begins operations
Organizational costs: Activities related to setting up partnership agreements, legal fees, temporary administrative salaries, etc.
- You are permitted to deduct up to $5,000 of startup costs in your first year of business. The rest of the costs (if applicable) must be depreciated over time.
• Business travel
- There are nine qualified sources of travel expenses as defined by the IRS:
- Airplane, train, bus, and car travel between your home and your business destination.
- Taxi (and other forms of transport, like Lyft) fares between airports, train stations, hotels, client locations, and business meeting locations.
- The shipping of baggage and sample or display materials between your regular and temporary work locations.
- Car-related expenses (through actual expenses or standard mileage rate), business-related tolls, and parking fees. Rental car expenses are limited to the business use portion of their usage.
- Lodging and non-entertainment-related meals.
- Dry cleaning and laundry.
- Business calls, along with fax and other machine communications while on your business trip.
- Tips that you pay for services related to any of the previous expenses.
- Other similar and necessary expenses related to your business travel (including but not limited to: transportation to and from a business meal, public stenographer's fees, computer rental fees, and operating and maintaining a house trailer).
• Continuing education
- Education expenses must meet certain criteria to be considered deductible. The educational experience must:
Maintain or improve the skills that are required in your present work
Be required by law or regulations for maintaining a license to practice, status, or job. Professionals can deduct costs for continuing education
- There are a variety of subscriptions and memberships that apply to your business:
• Journals or magazines specifically related to your business
• Dues and fees to a professional subscription or organization
• Professional materials subscriptions, such as those for software, ink, and paper
• Business phone plan
• Website hosting fees
- There are numerous advertising and promotional mediums that can be deducted as a qualified expense:
• Media such as television, internet, newspapers, and magazines
• Promotional items like cups, hats, t-shirts, etc.
• Online activities such as email newsletters and SEO services
• Advertising materials such as business cards, brochures, flyers, etc.
• Costs of a public campaign or promotional event
Make Quarterly Estimated Tax Payments
One of the most important yet mystifying aspects of self-employment taxpaying is making your quarterly estimated tax payments. If you expect to owe more than $1,000 in self-employment taxes, you will be required to make quarterly estimated tax payments. The estimated quarterly tax computation is simple in theory; your self-employment tax, income tax, and any other taxes are summed and then divided by four.
Perhaps the greatest obstacle to making informed decisions on quarterly tax payments is projecting your yearly tax liability. Form 1040-ES can prove incredibly insightful. The 1040-ES structure allows the taxpayer to account for potential income, deductions, and credits for the upcoming year. While by no means is this an exact science, this form is a necessary step towards fulfilling your quarterly estimated tax obligations.
Once you ascertain a reasonably accurate estimate of your quarterly tax liability, you have multiple ways of paying. You may choose to send estimated tax payments by mail (include Form 1040-ES), or you can pay online directly through an IRS platform. It is also worth noting that you may need to account for significant changes in income and expenses during the year. For example, if your business loses a significant source of revenue or incurs an unexpected expense, it is worth adjusting your quarterly payments accordingly. Similarly, if you secure a large revenue source or have fewer expenses than anticipated, it also would be prudent to return to the worksheet and ensure that you’re paying the appropriate amount.
Now that these particular nuances and best practices have been established, it is equally important that you understand how these manifest on an actual tax return! Let's talk forms.
Know All The Relevant Forms
Form 1040 Schedule C will be used to document your revenues and expenses and calculate your net profit from self-employment. You will first describe the nature of the business, provide a 6-digit business code from the Schedule C instructions appendix, and include your business name (if applicable). You will not need an EIN unless you are a sole proprietor that has employees or if you maintain a Keogh or other pension plan. You can simply provide your SSN as an identifier in place of an EIN.
Form 1040 Schedule SE uses the income/loss calculated on Schedule C to calculate the amount of Social Security and Medicare taxes that should have been made throughout the year. If 92.35% of your Schedule C profit is less than $400, then you do not have to pay self-employment taxes. The self-employment tax figure then is reported on Schedule 2 of Form 1040 (line 4).
A benefit of self-employed tax filers is that they can deduct a portion of self-employment tax payments as an adjustment to their income. You can deduct 50% of your SE tax on Form 1040, regardless of whether you itemize deductions. Having this deduction be available for both standard or itemized deductions is hugely advantageous and will minimize your income tax liability. 50% of your self-employed tax value should be reported on Schedule 1 of Form 1040 (line 14). This field on Schedule 1 represents the income tax deduction.
Form 8995 is used to calculate the qualified business income (QBI) deduction. A trade or business (excluding income from a C corporation), including income from a pass-through entity (those that pay taxes through individual taxpayer(s) rather than through a corporation), can be entitled to a deduction of up to 20% of their net QBI. They can also deduct 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. The total QBI deduction is limited to 20% of your taxable income.
Need a breather? That’s totally fine. Take a break—you’re the boss, right? Right. In our humble opinion, the benefits of self-employment far outweigh the effort required to understand your tax responsibilities and make sure you have all your bases covered as a small business owner. Making the proper entity election, keeping track of expenses and deductions, making quarterly payments, and getting a handle on all of the necessary forms are all just a part of the job when you’re the boss. Expect to navigate all of these requirements, but don’t let them stop you from moving forward with your firm. When you stay on top of your tax responsibilities and check off these four steps, the IRS loses its bite.