SCORE: The basics for self-employment tax
My last column dealt with a growing small business that is needing to decide if they should hire employees or contract for the needed work. That generated a lot of questions about the small business that has no employees.
A CEO asked that I address some basics about the self-employment tax, which is confusing to many small-business owners. Here are some basics on the topic.
Going from employee to being your own boss brings some significant changes professionally and personally. One of the most significant to become accustomed to is no longer having certain taxes neatly taken from your paycheck by your employer.
As a self-employed individual, not only are you responsible for directly submitting the income tax you owe to the federal, state and local governments, you’re also responsible for paying self-employment tax. It is important that a small-business owner understands this situation.
First, who is self-employed? The IRS states generally, you are self-employed if any of the following apply to you:
• You carry on a trade or business as a sole proprietor or an independent contractor.
• You are a member of a partnership that carries on a trade or business.
• You are otherwise in business for yourself, including a part-time business.
What are the tax obligations of a person who is self-employed? The IRS explains a self-employed individual generally is required to file an annual return and pay estimated tax quarterly.
Self-employed individuals generally must pay self-employment tax as well as income tax. SE tax is a Social Security and Medicare tax primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. In general, anytime the wording "self-employment tax" is used, it only refers to Social Security and Medicare taxes and not any other tax (such as income tax).
Most self-employed individuals, because their tax isn’t withheld from paychecks, must estimate their self-employment and income tax amounts due and pay them on a quarterly basis. Not paying the taxes on time or not paying enough could result in financial penalties.
How do I make the quarterly payments? Estimated tax is the method used to pay Social Security and Medicare taxes and income tax, because you do not have an employer withholding these taxes for you. Form 1040-ES, Estimated Tax for Individuals, is used to figure these taxes. Form 1040-ES contains a worksheet that is similar to Form 1040. You will need your prior year’s annual tax return in order to fill out Form 1040-ES. Use the worksheet found in this form to find out if you are required to file quarterly estimated tax.
"It is important to keep your accounting records current so you know the amount of income (or loss) at any point in time," said SCORE certified mentor Irv Plitzuweit. "The actual self-employment results should be compared to your budget to identify shortfalls in revenue and/or overspending. Monitoring actual results compared to your budget aids in identifying overspending and/or revenue shortfalls where corrective action and/or adjustments may be necessary."
Adjusting to planning for and paying self-employment tax doesn’t come easily for all small-business owners. It takes discipline and the ability to forecast revenue and expenses with some degree of accuracy.
"Having accurate and up-to-date accounting records is essential to project your self-employment quarterly income tax liability," Plitzuweit said. "A local accountant and/or CPA can assist you with income tax projections and the correct amount of quarterly income tax payments."