Why Should I Care?
As a self-employed individual, it is important that you understand your tax obligations to avoid penalties or large balances due when you file your tax return.
Of course, you should be making your business as tax efficient as possible, however, if your business is profitable, you will likely owe some amount of tax.
By taking the time to familiarize yourself with the various taxes you may be subject to, you will not only ensure that you’re compliant with the law but also more effectively manage your business's cash flow.
Taking the time to understand how taxes work for the self-employed can help save you a lot of time, money, and frustration in the long run. Hopefully, by the time you've finished this article, you'll have a better grasp of how taxes work for the self-employed.
Understanding Taxes Imposed on the Self-Employed
Who is "Self-Employed?"
The Internal Revenue Service (IRS) considers you to be self-employed if you are operating a business as a sole proprietor, independent contractor, or freelancer.
Also, certain partners and limited liability company (LLC) members also fall under the category of self-employed taxpayers in the eyes of the IRS. Being classified as self-employed means that you are personally responsible for paying your own taxes.
Self-Employment Tax Basics:
Generally speaking, the self-employed are subject to three different types of tax obligations: FICA & Medicare taxes, Federal income taxes, and State & Local taxes.
In addition to filing an annual return, self-employed individuals may also be required to make estimated tax payments throughout the year. This is done using IRS Form 1040-ES and requires you to calculate your expected taxes based on income earned and expenses incurred in a given year.
Generally speaking, these estimated tax payments must be made quarterly. Failure to make estimated payments can result in penalty and interest charges.
Federal Income Tax
You will pay income tax on your taxable income, which will incorporate your net profit from the business. That is, your gross income minus any allowable expenses. Other factors are involved which will influence the ultimate rate, including your other sources of income and allowable non-business deductions.
Predicting the tax burden on your income can be very complicated, and if you have experienced large shifts in income from previous years, you may want to hire a tax professional to perform a "tax projection."
This is a service that involves walking through all the same income tax calculations that would typically be done on a tax return, but with estimated figures. This tax projection will allow for better cash-flow planning and more accurate estimated tax payments.
FICA Taxes for the Self-Employed
The Federal Insurance Contributions Act (FICA) requires that the self-employed pay both an employer and employee portion of their Social Security and Medicare taxes. The combined rate for these two taxes is 15.3%. This means that if you have "net earnings from self-employment" of $100, you will need to pay a total of $15.30 in these taxes.
This is before the income tax, which will be computed on "taxable income" rather than "net earnings from self-employment." Typically, the way this plays out means that you will pay income tax on less income than you will pay self-employment taxes.
When you are an employee in a business, the employer pays half of these taxes for you, and they withhold the other half of the FICA taxes (along with Federal income tax and applicable state income taxes) from your gross pay.
As a self-employed taxpayer, the IRS sees you as both the business and the employee, so you pay both sides. This means that to "take home" the same amount after taxes, you need to be grossing more to account for the increased taxes. While the increase in tax is not massive, it frequently feels like you are paying more tax since you are not having it withheld.
Instead, you are responsible for figuring the correct amount of tax and remitting it to the government quarterly in the form of estimated tax.
State and Local Taxes
Finally, you may also be required to pay state and/or local taxes as a self-employed individual. What types of taxes you are subject to and the rate you pay will vary depending on where you live.
Generally speaking, most states impose some type of income tax on self-employed individuals, as well as sales taxes if applicable.
Conclusion
Understanding the various types of taxes that you may need to pay as a self-employed individual can be confusing. However, taking the time to familiarize yourself with the basic rules can help you feel less stressed and make you more confident as you create a plan to get into compliance. Getting a handle on your business's tax obligations is the first step in building a sustainable business that provides actual cash flow to you, the owner.
Of course, if you'd like me to help, I offer services designed to help you get a handle on your business tax obligations. You can schedule a call here.
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