By Justin Smith
I have many clients who are either fully self-employed or have a side business in addition to their fulltime job. If you fall into this category, you may have special tax considerations that may enhance your tax return’s complexity.
The IRS generally considers taxpayers to be self-employed if they carry on a trade or business as a sole proprietor or independent contractor (as opposed to an employee), are a member of a partnership or conduct a part-time or side business.
Benefits of Self-
Employment
Business deductions available to self-employed taxpayers vastly exceed those available to employees, subject to IRS regulations and business relevance. Business expenses such as telephone, Internet, office supplies and furniture, liability insurance, marketing and advertising, computer equipment, allowable business meals and even medical insurance premiums may qualify for tax deductions under the right circumstances.
Business Structure
Your business structure is another important consideration. The typical options are sole proprietorships, partnerships (for two or more business owners) and corporations. Alabama law permits each of these options. The IRS will typically consider individuals to be sole proprietors unless they specifically elect another type of structure, such as a Corporation (or the more popular S Corporation for smaller businesses). For example, you may register a limited liability company (LLC) or a corporation with the state. In such cases, you may also obtain a Federal Employer ID Number (FEIN) from the IRS to avoid using your personal Social Security Number.
Many people assume forming an LLC automatically provides better tax treatment, but this is not the case. Forming an LLC is primarily designed to help reduce legal liability as opposed to preferential tax treatment.
Self-Employment Tax
Taxpayers who start a side business or transition from employment to entrepreneurship are often at risk of sticker shock when they receive their tax bill. The primary reason taxpayers are unprepared for their tax bill is because of the self-employment (SE) tax in addition to federal and state income tax.
SE tax is similar to Social Security and Medicare taxes withheld from employee paychecks. However, the SE tax is double employee withholdings, because employers are required to match their employee Social Security and Medicare taxes. Self-employed individuals must pay this tax entirely on their own, and it is a whopping 15.3% of your business net profit.
The good news is that Social Security tax is capped at the annual Social Security Wage Base (which is $137,700 for 2020 on your combined employment and self-employed income). However, amounts exceeding this are still taxed at a minimum 2.9% to cover Medicare (which has no cap).
Oftentimes, taxpayers with a small side business can cover this tax through a reduced refund. However, as the business grows, individuals often find themselves owing significant taxes at year-end, even if they increased withholdings at their primary job. In other situations, taxpayers may fail to pay estimated taxes throughout the year, only to encounter the full tax bill at tax time. To make matters worse, taxpayers often face penalties and interest for failing to pay their bill throughout the year. This is why paying estimated taxes throughout the year is important for entrepreneurs.
Many other considerations exist, such as maintaining proper books and records, paying employees and independent contractors (and determining how to classify them), managing payroll returns, identifying taxable and nontaxable income and even retirement account options. Be sure to thoroughly explore and discuss all your options with your accountant to help set your business up for success.
Justin Smith is a licensed certified public accountant in Opelika, specializing in individual and small business tax and accounting. He can be contacted at 334-400-9234 or Justin@JSmithCPA.net. His website is www.jsmithcpa.net.