Are you thinking about going out on your own and freelancing, or are you newly self-employed? Fantastic! I think just about everyone should give self-employment a try. Most of the prosperous women and men you know wouldn’t be where they are today if they hadn’t chosen self-employment at some point.
Self-employment can be awesome, but one aspect that’s going to suck a little bit is that you will have to become educated on a few tax topics. (Or spend money to hire someone who is. In that case, you needn’t read further!) But don’t let the extra tax burden scare you off from self-employment. Once you get through a bit of an upfront learning curve and get organized, staying on top of your taxes and in the IRS’ good graces is easy.
Self-Employed People Wear Lots of Hats, Including Payroll
The IRS is not okay with people earning money all year, then paying 100% of the their income tax bill only when they file their return on April 15 the year after. Employers withhold taxes from each employee paycheck and send these mini-installments to the IRS on the employee’s behalf. In this case, the employee doesn’t have to worry about anything except properly completing the W-4 form the employer will provide and keep on file.
As a self-employed individual, you have to do the same function that a company’s payroll department does for employees: periodically send to the IRS income tax installments over the course of the year.
To get started, have a look at these IRS webpages:
While you’re on the IRS’ website, go ahead and and download Publication 334, Tax Guide for Small Business.
To extract some of the key info from these resources:
- The equivalent of a W-4 for self-employed individuals is IRS form 1040-ES. You will need to work through it (found at the Estimated Taxes link above). As you will see, you’ll need to guess your income and other numbers for an upcoming tax year.
- The bottom line of form 1040-ES is the estimated income tax you’ll owe the IRS for the subject tax year, based on the assumptions you make while completing 1040-ES.
- You will send to the IRS quarterly installment payments, with at least the first payment equal to 25% of your total estimated income tax for the year from form 1040-ES. These payments have specific due dates. For 2016 the due dates are: April 18, June 15, September 15, and January 17, 2017.
- Naturally your guess of your annual income will be off by some increment. If and when it becomes apparent as the year progresses that your guess is going to be way off, you can recalculate, and make adjustments as you go along through the year, boosting or reducing your remaining installment payments. But by the time the fourth and final installment is due (January 2017 for the 2016 tax year), you will know your income for the prior year. So at that point you should really fine tune your final payment so that the total of all your estimated payments comes pretty close to your actual tax liability for the year (which you won’t know exactly until you prepare your tax return for the year).
- Avoiding penalties is important. From the IRS’ introduction to form 1040-ES: “In some cases, you may owe a penalty when you file your return. The penalty is imposed on each underpayment for the number of days it remains unpaid. A penalty may be applied if you did not pay enough estimated tax for the year or you did not make the payments on time or in the required amount. A penalty may apply even if you have an overpayment on your tax return.” So you have to be pretty diligent about staying on top of re-calculating as needed your quarterly payments and meeting the deadlines.
Self-Employed Individuals and Business Expenses
You may be wondering about deducting business expenses, as you will owe tax not on your income, but on your net income: what the people you’re working for pay you minus your business expenses. Potential business expenses for you might include travel; a portion of your rent or mortgage interest, home insurance, and utilities if you’re working at home; office supplies; health insurance; intangible drilling costs (really!); and more. (I believe my Dad deducted even tea expense when he worked from home as a freelance architect!)
Here you have to make a choice. Depending on your natural tendencies, tracking your business expenses can be pain in the posterior, and including them will complicate your record keeping and tax return. (Have a look at the IRS’ 53-page Publication 535, Business Expenses, to get a sense.) However, deducting business expenses will reduce the tax you owe. So you have to weigh the two. In my opinion, deducting a couple hundred dollars in business expense is not worth the extra effort—a quick calculation may show that the savings work out to about 12 cents an hour for the extra time required. I also have read that deducting home office expenses boosts the likelihood of an audit. But some people are driven to pay the IRS as little as possible, regardless of anything. (They’re called “Republicans.”)
For Self-Employed Tax Preparation, Organization Is Key!
Regardless of your natural tendencies, you must keep—for at least seven years—organized documentation of every piece of income (the detachable stub if you’re paid by paper check, and electronic record if not), your invoices, and every business expense. Just keep in mind that, if you are audited, you will need to prove, by providing documentary back-up, every single number on your tax return. If you can’t do that, the IRS makes assumptions, which you can be sure will not work in your favor.
Now get out there and kick some self-employed butt!