Paying taxes as a self-employed business owner has several advantages, including the ability to more thoroughly wed your personal and business lives.
How Do I File Taxes If I Am Self-Employed?
If you've been caught in the old eight-hours-a-day grind for the last couple of decades, self-employment may sound like paradise. But of course there are responsibilities that go along with being out on your own. When you start your own business, you alone will be responsible for the paperwork that a big business pays a whole staff of accountants and bookkeepers to do. And, at least for the time being, you probably won't be able to afford full-time professional assistance. When you're at the helm, taxes are no longer an annual bother; they pop up at least every three months.
Are You Self-Employed?
Most trade, business or sideline income, other than wages, is considered to be self-employment by the IRS. Exceptions to this include dividends and interest, capital gains and rent from real estate for which you aren't a dealer and don't provide services to occupants (hotels, apartment buildings, etc., do produce self-employment income). If your self-employment income exceeds $400 per year, you're responsible for reporting it to the IRS as a self-employed person.
Is It a Business or Hobby?
Demonstrating that you're in business to make a profit is crucial to your tax treatment by the IRS. If the IRS decides you're simply practicing a hobby, you'll not be allowed to deduct expenses that exceed income, you won't be allowed to deduct portions of bad debts owed to you, and you won't be able to apply for refund of prior taxes. (See the section "What if You Have Negative Income?") But how do you prove profit motive?
If you make money in two out of the first five years of business activity (seven years for raising horses for racing, breeding or showing), the IRS will accept that you are in business to make a profit. If, however, at that point you fail to have had two profitable years, the IRS will disallow losses retroactively — you'll have to pay back any loss deductions you claimed in previous years, unless you can prove profit motive in a different way.
For example, you may still be able to deduct net losses — even without making a profit in two of five years — if you can demonstrate that you carried on in a businesslike manner (capable bookkeeping and management); had expertise in the activity; spent time and effort attempting to make a profit; had assets that were expected to appreciate in value; had been successful in similar ventures; had an expectation that such a business would be profitable; weren't openly attempting to shield other income; and/or weren't engaged in an activity from which you derived primarily recreational or pleasure benefit.
You — Not You, Inc.
A thorough explanation of farming, partnership or corporate taxes is simply beyond the ken of a humble article such as this. Therefore, the following information is geared toward the simpler form of doing business: sole proprietorship. A proprietor is personally responsible for his or her business's finances.
The Tax Responsibilities of Self-Employment
Though filing taxes for a sole proprietorship is simple compared to the bookkeeping expected of a partnership or corporation, you still may have to file the following returns or information forms with the IRS:
- Schedule C is where you report your profit or loss from a business or profession as a sole proprietor. Earned income, for which you may receive Form 1099 from the organization that paid you, must be listed here, along with the expenses incurred in generating that income. Schedule C allows you to deduct many miscellaneous expenses that a W-2 employee would be able to take only if he or she itemized deductions. For example, if you hold equipment or tools for performing your job, you may depreciate them on Schedule C (along with Form 4562). If you divide the use of equipment between self-employment and a W-2 job, first year expensing and depreciation must be appropriately allocated. If you don't itemize, you lose the deduction for the portion of the use that is for your W-2 employment.
- Schedule SE (self-employment) must be filed by all taxpayers who earn more than $400 through self-employment and have an earned income of less than $37,800. It requires you to pay social security tax.
- 1040-ES (estimated tax): This is the self-employed person's version of withholding, and it must be filed quarterly — along with the appropriate funds. The penalty for underpayment of estimated tax in 1984 is calculated on Form 2210 (which also contains exceptions to these and other rules). If you fail to file Form 2210, the IRS will calculate the penalty, which will almost always be greater than the amount figured on 2210. Form 1040-ES must also be filed by any taxpayer who will owe the government more than $400 on Form 1040 ("Amount You Owe," line 68). See Publication 505 for more information on estimated tax.
- 940 and 941: If you have any employees, you must pay FUTA (unemployment compensation) and FICA (social security) taxes and report quarterly. However, if the liability for FUTA amounts to less than $100 per year, you can file 940 just once per year by January 31.
- W-2 forms reporting income of all employees must be given to employees by January 31 and filed with the IRS by February 28.
- Information returns: If you pay more than $600 in interest to an individual, you must file Form 1099-INT. If, in the course of business, you pay more than $600 to an individual for rent (other than to a real estate agent), royalties, fees, or commissions, or to an individual or corporation for medical or health care, you must file Form 1099-MISC. In addition, you must file Form 1096, summary and transmittal of information returns, along with the 1099's. These forms must be filed on or before February 28 in the year after which the payments were made.
- Excise taxes: If you engage in certain activities — such as manufacturing or selling bows and arrows, or dispensing gasoline — you may have to collect excise taxes from customers and pay them to the IRS. See Publication 334 for details, including a list of activities that require collection of excise taxes.
The Tax Advantages of Self-Employment
From a tax standpoint, the main advantage of self-employment is that it allows you to more thoroughly wed your personal and business lives. More of your everyday activities become deductible because so much of your time is spent in business-related activity. (Some writers have dreamed that their entire cost of living might be deductible, since their experience is their work. The IRS has not approved such an approach.)
For example, you may decide to conduct business from your home. You'll need an office to work in, so you can set aside a portion of your household and deduct the expenses for that area as a business activity. You'll probably also be using your personal vehicle for business, so a portion of that expense will be deductible. The tools, materials and supplies of a trade or profession are examples of more deductions taken by the self-employed.
You may be able to take advantage of renewable energy tax credits for energy equipment you install at your business. The percentages are considerably lower than those for residential provisions, but depreciation may also be taken. Furthermore, hydropower retrofitted to existing dams is included in the business energy tax credit code. To take renewable energy or renewable energy and investment tax credits, use Form 3468.
Owners of businesses may also offer themselves, as employees, health and life insurance policies as fringe benefits — just as employees of big businesses are provided with such perks. A major restriction, however, is that there are complicated rules concerning discrimination against employees by owners — you generally can't give yourself substantially better benefits than you provide for all full-time employees.
One potentially major advantage for self-employed people is that they may set up highly beneficial retirement plans (again, as long as all full-time employees are included). The contributions to and earnings of such plans are tax-deferred; that is, the money isn't taxable as income until the benefits are distributed at retirement. As a self-employed person, you may defer taxes on substantially more income than is allowed by employee Individual Retirement Accounts (IRA's) — in some cases, more than $100,000 per year. Additionally, your investment opportunities are much greater with a self-employment retirement account. See Publication 560 for more information.
What if You Have Negative Income?
If your adjusted gross income is negative, you stand an excellent chance of getting money back from tax paid in previous years — plus interest! To get your money back, file an amended return, using Form 1045 (quick refund claim). Double-check the 1045 before mailing it in, because if it contains any mistakes, it will be returned immediately without any further action.
Since your net operating loss will reduce your previous year's income, you may be able to get additional money back by filing Form 1040X with an attached Schedule G (income averaging).
A Final Note
We're not encouraging you to set up a small self-employment business merely to dodge taxes, but it will behoove you to pay heed to the tax effects of being your own boss. Pay careful attention to the type of business you're setting up and the location from which you'll work. (If your self-employment is a second income, see the discussion of tax home in "Off to Two Mines" for an inkling of the importance of your principal place of business.) The tax code has, at least in theory, a number of provisions that were designed to encourage small businesses, and they may help you make a go of your new venture — if, that is, you don't get buried in the paperwork first.