Tax Tips for the Self-Employed

f you know what you're doing, you can avoid the pitfalls and leverage as many credits and deductions as possible.
By: Roni Deutch | 05/28/2009


This is the first of a three-part excerpt from The Tax Lady's Guide to Beating the IRS and Saving Big Bucks on Your Taxes, by Roni Deutch, available from BenBella Books.

"Take care of your pennies and the pounds will take care of themselves."
- Andrew Carnegie
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There is a humorous story about the above quote. Apparently as a 10-year old attending Sunday school back in Scotland, Andrew Carnegie, the powerful head of U.S. Steel in the early 1900s and the son of a hardscrabble Scottish weaver, was singled out by the teacher and asked to quote a passage from the Bible.

After he replied with the above, the incredulous teacher admonished the young lad. "Surely," the teacher answered, "such an answer is not in the Bible."

"It ought to be," shot back Carnegie.
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Now there was an entrepreneur who knew the secret to running a business: Take care of the little things, and the big things will take care of themselves.

That is a good lesson for today's self-employed business owners. In the tax world, the pennies can really add up in the form of the many deductions and credits available under U.S. tax laws. The trick is to know where to find them--and how to use them.

That is the aim of this chapter--to help you understand the self-employed tax picture and leverage as many of its tax favors as possible. The best place to get started doing that is to learn more about taxes and the self-employed.

What is the Self-Employment Tax?
The good news is that the income tax form for self-employed individuals is the same as just about everyone else: IRS Form 1040. In addition, the self-employment tax is the same amount for wage earners as it is for self-employed individuals. A portion is even earmarked for Social Security and Medicare.

There are some differences. First, unlike the wage earner, the self-employed individual must voluntarily make self-employment tax payments throughout the year, instead of having them passively deducted from his or her wages as they are paid. Second, unlike a wage earner, a self-employed person can deduct Social Security and Medicare taxes from his or her Form 1040 tax bill.

Fast Fact
What is Taxable

At the end of 2008, Social Security and Medicare tax rate for self-employed individuals was 15.3 percent. The IRS slices that rate into two categories--12.4 percent of it goes to Social Security (yes, as a self-employed taxpayer you pay both the employee and employer portions of that tax, or an extra 7.65 percent) and 2.9 percent of it goes to Medicare. Note that the employer half of the Social Security payment--otherwise known as the "self-employed tax"--is tax deductible. And remember, only the first $102,000 of your annual income is subject to the Social Security tax.

Estimating Your Tax Payments
As a group, self-employed taxpayers already know that tax planning is a year-round event. That is because they often pay taxes on a quarterly basis, four times a year. The self-employed pay these taxes on an estimated basis. That means "estimating" your tax bill if you anticipate owing Uncle Sam when you file your return. In general, the self-employed do so on Form 1040-ES, Estimated Tax for Individuals, which helps figure out and estimate taxes. For example, if you estimate your tax liability to be $10,000 for the year, you can ship the IRS four quarterly checks of $2,500 apiece. Alternatively, you can wait until the following April 15 and fork over the entire $10,000 at one time--however this method may expose you to a penalty, so it is best to stick with the quarterly check approach.

Tax Tip:
$0 in Estimated Taxes

A self-employed individual need not make any estimated tax payments if the amount due after subtracting exemptions, deductions, and credits is less than $1,000.

The IRS offers several different scenarios where you can pay estimated taxes. It has a "voluntary" payment mechanism where you can pay estimated taxes based on your previous year's tax bill, even though this year's tax bill may be higher. By paying under the voluntary method, the IRS allows you to pay just the minimum amount required now and pay the rest on April 15. Voluntary payment is a good move if you have a steady flow of income and have the time and financial wherewithal to spread your tax payments out through the year.

Self-employed individuals can also make estimated tax payments even when they do not have to. Granted, this occurs only when a self-employed individual is running at a loss or an extremely low profit. But with a struggling economy, this may actually be the case for more taxpayers than it has in the past. Perhaps continuing to make your estimated tax payments allows those folks to sleep better at night knowing that April 15 will not bring a big tax burden. Alternatively, maybe these individuals are expecting a big cash crunch when the tax bill comes due. Either way, it is an option worth considering.

When deciding what method to use to pay your taxes, take your personal characteristics into consideration. If you are the sort who cannot resist temptation, pay on a quarterly basis. That way you will not be tempted to grab some of that $10,000 and buy that new big screen TV you noticed down at Best Buy. But if you can manage to leave your mitts off the money, you can gain some valuable interest on it by waiting to pay.

Also, if you have a new business, different tax rates apply. I advise my clients to put about 20 percent of their income aside to handle their tax burden.

Tax Tip
Pay or Hold?

It may be a load off your mind when you pay your taxes on an estimated basis well ahead of April 15. But Uncle Sam is not going to be paying you interest on that money in that saved time like an investment account could.

If you are confident in the stock market, you may be better served holding off on paying your taxes and making a few extra bucks for yourself in the interim. If you are not so sure about exposing your tax dollars exposed to the financial markets, just open an interest-bearing checking account at your bank. That way, you can draw your money out to pay your taxes, but keep that interest you have accrued.

Are You a Business?
How do you know if you are self-employed? The IRS has a few criteria.

In general, any commercial endeavor that attempts to make a profit is a business. That is not to say that your daughter's lemonade stand is something the IRS is interested in. But if a business exceeds certain profit levels on an annual basis, then it does become a taxable entity.

Fast Fact
Tax Dates

If you pay your taxes on a quarterly basis, the IRS is going to make you meet certain deadline requirements. Usually that means you will have to pay up on the 15 of April, June, September, and January of the following calendar year.

Once you establish a profit motive--that is, if your venture has earned any net income during three of the past five years, per the IRS' definition--you can describe yourself as a business and begin taking the appropriate deductions for what, in many cases, you used to call personal expenses.

Fast Fact:
The IRS Rules

In most cases, establishing a "profit motive" is enough to determine if you are self-employed. But what specifically is the IRS looking for to confirm that you are in fact running your own business? Here is a list:

IRS Checklist to Determine if You are Self-Employed

* Manner in which you carry on the activity
* Expertise of individual and his or her advisors
* Time and effort expended in carrying out the activity
* Expectations that the assets used may appreciate in value
* Success in carrying on similar or dissimilar activities
* History of income and losses with respect to the activity
* Amount of occasional profits earned
* Financial status of individual

Source: Internal Revenue Service

Next: Set Up a Tax-Friendly Business

Roni Deutch is the founder and owner of the nation's largest tax resolution law firm, Roni Lynn Deutch, A Professional Tax Corp. She is also founder and owner of Roni Deutch Tax Center, one of the fastest-growing tax preparation franchises in the U.S.