Taxes for Self-Employed Individuals
Taxes for Self-Employed Individuals – Who Qualifies?
People who work as an employee don’t have to be very concerned with having their various taxes paid to the IRS. The employer withholds FICA, Medicare, federal income tax, and also state income tax, and sends in this money to the IRS and the state. Taxes for self-employed individuals are different.
Not so for someone who works as a freelancer. This individual must keep accurate records as to income and expenses, so that he can calculate his tax liability. The taxing agencies aren’t much help either, with their confusing payment dates for estimated taxes.
Most individuals find it easier and more convenient to use calendar quarter dates. The payment dates of June 15 and September 15 are arbitrary and not well thought out. Why not July 15 and October 15 so all dates fall 15 days after the end of each calendar quarter?
Working as a freelancer means some independence, but it also creates more of a tax burden. You have the responsibility of paying your own taxes to the IRS and also the state agency. In order to perform the various required tax calculations, the freelancer must understand the various taxes for self-employed individuals and when they’re due.
Employee or an independent contractor?
The IRS used to use 10-point criteria to determine if an individual was an employee or an independent contractor a few years ago. They now cover this topic quite well in Publication 15, Employer’s Tax Guide. It pretty much boils down to the fact as to who controls what is to be done and how it will be done.
If you’re going to an employer’s place of business and performing services that the employer wants you to do, and you’re told how and when they are to be done, you’re an employee. Now, with the effects of the pandemic, and many workers are working from their homes, this issue is going to be tested more and more.
It’s to the employer’s benefit if they pay you as an independent contractor. With that classification, the employer doesn’t have to pay benefits like medical insurance, retirement, and federal and state unemployment insurance. Plus, they don’t have to pay the employer’s share of FICA & Medicare taxes, which is 7.65% of your wages.
Calculating taxes for self-employed individuals
Working as a freelancer (independent contractor), you are taxed on the amount of your net self-employment income. That is calculated by subtracting your allowable expenses used to earn the income from the gross amount you received.
Three calculations are made based on the net self-employment income. First is the federal income tax due, second is your state income tax, and the third is the FICA and Medicare tax. Since you are working as a freelancer, you have to pay your portion and also the employer portion too.
You do get a little break though. Instead of paying the full amount of 15.3% for FICA and Medicare, you only pay about 14.2% because of a reduction on Schedule SE. Plus, you can also deduct 50% of the total self-employment tax paid on the front of your return, reducing your total income.
The tax rate for Social Security is 12.4%, and all self-employed individuals pay the same rate. However, there is a maximum amount of earnings, the wage base threshold, that the tax is calculated on. The wage base increases slightly each year, and for the 2020 tax year, it is $137,700.
The tax rate for Medicare is 2.9%, and again, is the same rate for all self-employed individuals. There is one big difference, though…Medicare has no wage base threshold. You pay that tax rate no matter how high your net self-employment income.
Complete Schedule C, Profit or Loss from Business
As a freelancer, you are required to report your gross income received and you can deduct your allowable expenses that are incidental to the self-employment income. Another expense that is fairly common for freelancers is business use of their personal auto.
Most use the mileage deduction of .575 per mile, which is the 2020 amount. Be advised, however, that you must keep an accurate log of all business miles driven for the business. You can get an inexpensive log book at most office supply stores.
Do not enter any other type of income on this schedule. That would include a W-2, interest, dividends, royalties, capital gains, etc. These types of income are taxed separately.
Keep in mind too, that as a freelancer, paying taxes for self-employed individuals and filing a Schedule C, isn’t your only option. You have the option to incorporate your business, and file a Form 1120 or an 1120-S if you elect to file as a pass-through entity. You can also form a partnership and file a Form 1065. I advise my clients to use the Schedule C for at least one year, and then decide if a different form of filing is in their best interest.
Complete and File Schedule SE
When you have self-employment taxes to pay, you need to complete IRS Schedule SE. This form must accompany the other forms that are required on the Form 1040. As we mentioned earlier, there is some good news with this form.
The result on the Schedule SE is carried to the Form 1040 in two places. Firstly, 50% of the total self-employment taxes due is carried to the front of the Form 1040 as a deduction from total income. It’s also carried to page 2 of the Form 1040 in the category of taxes due, and is added to the amount of federal income tax due.
Calculate and file estimated taxes
If you were working for someone as an employee, the employer would be withholding and filing all of your taxes. But, since you are a freelancer, and considered a self-employed individual, you will have to do this yourself.
The IRS and state agencies require you to pay estimated taxes throughout the year instead of all at once when you file your tax return. They check this on every return filed, if applicable. If you don’t estimate properly, and have a balance due of $1,000 or more on the federal return, they will assess a penalty.
You should also get in the habit of paying your state estimated tax payments when you file the federal. Some states have a lower threshold than the federal, such as mine, which is $500. Remember, estimated taxes are due April 15, June 15, September 15, and January 15 of the following year.
Keep accurate records
By keeping accurate records and saving all business receipts, you may be able to reduce the net profit of your business. This will not only reduce the income taxes due, but will also reduce the self-employment taxes that have to be paid.
It’s also a good idea to sort through your receipts maybe on a weekly or semi-monthly basis, and mark those which are business and the ones that are personal. Using one credit card only for business will help to identify those expenses easier. When you’re calculating the taxes for self-employed individuals, that credit card statement will make your life a lot less stressful.
Don’t be tempted to deduct personal expenses on your business schedule either. You may fly under the radar for a while, but if you get selected for an audit and the IRS sees this, the penalties are severe, and someone will be watching as you move forward.
Completing the Schedule C is fairly straightforward. There are a number of lines for certain expenses, such as office, advertising, etc. where you only have to enter the amount you spent for each of those items. You may have other expenses for items that are not listed on the schedule.
As long as they were ordinary and necessary, which means that other businesses who are in the same type of business as you, also had these expenses to deduct. Plus, the expenses must be necessary to produce your income, or to increase income.
Good tax planning means that a freelancer should maintain accurate records, knowing what the business has earned as the year goes by. It’s important to have good accounting and financial advice so that you can fine-tune your plan. Setting up a retirement plan might be an excellent idea also.
As you get near the end of the year, and you have consulted with your account and and/or financial adviser, calculate again to get a handle on what your tax bill will be at the end of the year. Send the IRS and your state agency additional estimated taxes if necessary.
Even though the IRS and states have set up four instalments to pay in your estimated taxes, some have found it easier to make those payments more frequently. They find it much easier to budget the estimated tax payments on a monthly basis.
As far as the IRS and the various states go, this is fine with them. If you know what your quarterly payment is, just divide by three, and send that amount. Paying those taxes online is much easier and you won’t have to be printing out additional estimated tax forms.
Others simply take a certain percentage from the payment received as tax liability, and put it in a separate account, and send it in when it’s due. Whatever method works for you, do it, and be consistent. Paying all taxes for self-employed individuals on time is a good habit to develop.
An accountant and tax preparer by profession, Gust’s true passion lies in his company blog titled “HBS Financial Group, Ltd.”. Through this venue, he not only tries to teach individuals about budgeting, money management, and taxation but he writes the majority of the articles as well.