Simplified Taxes for Self-Employed Business Owners
If you are self-employed, your tax situation may seem a bit overwhelming when you first start out. However, it is actually much more straightforward than it may seem. Nonetheless, many business owners do not want to take the time to learn how their new venture affects their tax situation until it is time to file their tax return in April. By then, however, you may have put yourself in a position that makes tax time a much bigger headache than it needs to be.
Understanding the basics of your new role as a self-employed business owner when it comes to taxes can help you stay organized, keep the right information, and decrease the amount that you owe in taxes, fees, interest, and penalties.
Treat Your Business Like a Business
Most self-employed individuals do not have a separate legal entity for their company. Many business owners simply do not take this extra step for a variety of reasons, from a cost-savings standpoint or because they do not realize that they should.
Regardless of how your company is set up, you should treat your company as a separate entity. That means you should have:
- A separate bank account
- Information regarding expenses exclusively for your company
- Income that your business generates noted separately
- Profit and loss statements
Keeping your business separate from your personal affairs will be very helpful at tax time because your self-employed venture is taxed differently compared to working as an employee for someone else.
The Basics of Self-Employment Taxes
If you are employed by someone else, income taxes are supposed to be taken out of your check each time a payment is issued. Then, your employer pays a portion of your income tax obligation on your behalf on a regular basis. If you work for yourself, you do not have anyone else doing this for you—so you must do it yourself.
The U.S. income tax system is “pay as you go.” That means that you are required to make quarterly tax payments on your income. When you are self-employed, those payments are referred to as “estimated tax payments.” They are estimates because you cannot truly determine your tax rate until you know how much money you made for the year and considered all of your tax deductions and credits.
Social Security and Medicare obligations must also be met on a regular basis. At tax time, your self-employment tax obligation will include amounts to address these obligations.
The amount of tax that you will pay will depend on your gross income, which is your income, less expenses, deductions, and credits. Increasing your deductions and credits will decrease your taxable income—and reduce your income tax obligations for your business.
How Much Is Self-Employment Tax?
The self-employment tax rate is completely separate from your other tax obligations. If, for example, you operate a “side business,” and pay income tax for your regular job, your self-employment tax obligation for your side business will be in addition to your regular income tax obligation.
The 2020 self-employment tax rate is roughly 12.4% for FICA (Federal Insurance Contributions Act) and 2.9% for Medicare, for a total of approximately 15.3%. FICA funds Social Security, so your self-employment tax obligation addresses both of these obligations.
However, half of your self-employment taxes owed can be deducted on your Form 1040, significantly decreasing your tax obligation.
What Schedules Will I Need for my Income Tax Return?
In general, you will need to create Schedule SE to determine what your self-employment tax obligation will be. You also use Schedule C if you are a sole proprietorship. Partnerships, multiple-member LLCs, and other pass-through entities will provide you with a Schedule K-1 so you can enter the appropriate information on your tax return.
Your tax professional will be able to help you walk through the schedules you need and prepare the right information to present to the IRS at tax time.