Tax payments are a major part of running your business. There's no avoiding giving Uncle Sam his due, and if you want to avoid an audit, it's important to do it right the first time. Unlike W-2 employees, self-employed individuals do not have their taxes automatically deducted from their paychecks. It's up to them to keep track of what they owe and pay it on time.
Because taxes aren't automatically deducted, take-home pay for the self-employed tends to be a bit higher than for wage earners throughout the year. It might be tempting to consider all that money yours, simply pocket it and move on. But unless you want the IRS to come knocking, it's wise to set aside a chunk of those funds to cover your tax obligations.
"Business owners, whether they are self-employed freelancers or corporation owners, are responsible for complying with tax law with respect to their business," said Shoshana Deutschkron, vice president of communications and brand at freelance job platform Upwork. "Financial literacy is a critical skill, [and] that literacy includes an understanding of taxation." [Interested in online tax software? Check out our best picks.]
"You need to hold on to some of your money," added Lisa Greene-Lewis, CPA and tax expert for TurboTax. "You should pretend you don't have that much money, because your income varies so often. You have to think about paying your taxes."
Not only are government forms daunting, but learning the ropes of taxation can be truly complicated. Those embarking on a self-employed career should consider how and why filing taxes correctly can impact your business.
If you're filing as self-employed with the IRS, here are the basics of filing, paying and saving for taxes. [Want to Be a Full-Time Freelancer? What You Need to Know]
Self-employment tax obligations
Freelancers must take their taxes into account when setting their pricing, consider tax burden in planning their finances for the year (e.g., saving money vs. reinvesting it in the business), and track their business expenses to deduct them at the end of the year, Deutschkron said.
According to the IRS, this is how self-employed individuals are classified:
- Carrying on a trade or business as a sole proprietor or an independent contractor
- Being the member of a partnership that carries on a trade or business
- Being otherwise in business for yourself (including a part-time business)
According to Pew Research, roughly 15 million Americans are self-employed. When you're self-employed, you must pay a self-employment tax (SE tax) as well as an income tax. The SE tax is a Social Security and Medicare tax that is primarily for individuals who work for themselves. This is separate from income tax.
Before you can determine your tax obligations, know your tax rate, and consider whether your region requires separate city taxes. To get your rate means you must figure out your net profit or net loss from your business. You can calculate this by subtracting business expenses from your business income. If your expenses are less than your income, the difference is net profit and becomes part of your income. However, if your expenses are more than your income, the difference is a net loss.
You must file a Schedule C (Form 1040) income tax return if your net earnings from self-employment were $400 or more. Even if your net earnings from self-employment were less than $400, you still have to file a return if you meet any other requirements listed in Form 1040. You should also file if you are eligible for any of the following credits:
- Earned income credit
- Additional child tax credit
- American opportunity credit
- Credit for federal tax on fuels
- Premium tax credit
- Health coverage tax credit
According to the IRS, self-employed taxpayers who expect to owe more than $1,000 in SE taxes must make estimated tax payments four times per year. You will need to use IRS Form 1040 to file these quarterly taxes.
You can estimate your expected SE tax using free calculator tools like this one from QuickBooks.
How to file your taxes
If you expect to make quarterly estimated tax payments, use the Form 1040-ES, Estimated Tax for Individuals, which contains a worksheet similar to Form 1040. Be sure to keep track of your return from one year to the next, as you will need your prior year's annual tax return to fill out Form 1040-ES.
The IRS allows you to fill out Form 1040-ES, which contains blank vouchers you can use when you mail your estimated tax payments, or you may make your payments using the Electronic Federal Tax Payment System (EFTPS). If this is your first year of self-employment, you will need to estimate the amount of income you expect to earn for the year. See the IRS's Estimated Taxes page for more information.
To file your annual tax return, you will need to report your income or loss from a business you operated or a profession you practiced as a sole proprietor. To report your Social Security and Medicare taxes, you must file Schedule SE (Form 1040), Self-Employment Tax.
Use the income or loss calculated on Schedule C or Schedule C-EZ to calculate the amount of Social Security and Medicare taxes you should have paid during the year. The instructions for Schedule SE may be helpful in filling out the form.
Ways to save on taxes
If you're transitioning from a full-time position, it's important to pinpoint write-offs. Here are six tax-saving tips that may assist you as a first-time self-employed taxpayer, according to TurboTax:
- Startup costs: Newly formed businesses may be able to deduct startup costs, including legal fees, the cost of experimentation and advertisements.
- Vehicle expenses: In addition to the mileage deduction and other expenses, self-employed taxpayers may be able to deduct up to $25,000 of the cost of their car or SUV.
- Home office deduction: Self-employed workers who have a dedicated space in their home that they use only for business can deduct a percentage of their home expenses, including mortgage payments, utilities and property taxes.
- Supplies and equipment: Office supplies – such as paper, computers and even snacks for customers – may be deductible if they were used exclusively for business.
- Social Security and Medicare taxes: Self-employed workers must pay the entire 15.3 percent Social Security and Medicare tax, but they get a break by writing off half of what they pay.
- Health insurance premiums: Self-employed workers may be able to deduct what they pay for medical insurance for themselves and their family.
"You may be surprised about what is tax-deductible," Greene-Lewis said. "For example, advertising helps people make money, but it's also a big deduction for people."
Tax software can also be used to help you pinpoint write-offs you might otherwise miss, as well as streamline the filing process and more easily identify your tax rate. Tax software can also save your returns year after year so that, if nothing changes, you can simplify the process even further the following year.
Other expenses to consider
The key to being prepared for your tax obligations is to keep track of your expenses year round. Don't wait until the last minute to add up all your expenses, Greene-Lewis said. She advised using an accounting software package to track what you're earning and spending.
Business News Daily recommends QuickBooks as the best accounting software for small businesses overall and Zoho Books as the best accounting software for microbusinesses (sole proprietors, freelancers, consultants, etc.). For more suggestions and software reviews, visit our best picks list.
The information above is intended as a basic guide for self-employed individuals. If you are self-employed and have questions about your taxes, seek the help of an accounting professional.
Additional reporting by Shannon Gausepohl.