Small Business Tax Issues for Self-Employed Individuals

The United States is a nation of entrepreneurs. There are literally tens of millions of self-employed individuals that enjoy pursuing their dream business. Of course, few of you enjoy the paperwork and confusing tax issues that arise from owning your own business.

Many self-employed individuals are considered “sole proprietors” or “independent contractors” for legal and tax purposes. This is true regardless of whether you are turning a hobby into a business, selling an indispensable widget or providing services to others. As a self-employed person, you report business revenue results on your personal income tax return. Following are a few guidelines and issues you should keep in mind if you are pursuing your entrepreneurial spirit.

Schedule C – Form 1040.

As a self-employed person, you are required to report your business profits or losses on Schedule C of Form 1040. The income earned through your business is taxable to you as an individual. This is true even if you do not withdraw any money from the business. While you are required to report your gross revenues, you are also allowed to deduct business expenses incurred in generating that revenue. If your business efforts result in a loss, the loss will generally be deductible against your total income from all sources, subject to special rules relating to whether your business is considered a hobby and whether you have anything “at risk.”

Home-Based Business

Many self-employed individuals work out of their home and are entitled to deduct a percentage of certain home costs that are applicable to the portion of the home that is used as your office. This can include payments for utilities, telephone services, etc. You may also be eligible to claim these deductions if you perform administrative tasks from your home or store inventory there. If you work out of your home and have an additional office at another location, you also may be able to convert your commuting expenses between the two locations into deductible transportation expenses. Since most self-employed individuals find themselves working more than the traditional 40-hour week, there are a significant number of advantageous deductions that can be claimed. Unfortunately, we find that most self-employed individuals miss these deductions because they are unaware of them.

Self-Employment Taxes – The Bad News

A negative aspect to being self-employed is the self-employment tax. All salaried individuals are subject to automatic deductions from their paycheck including FICA, etc. In that many self-employed individuals often do not run a formal payroll for themselves, the government must recapture these taxes through the self-employment tax. Simply put, you are required to pay self-employment taxes at a rate of 15.3% on your net earnings up to $87,900 for 2004. For net income in excess of $87,900, you will pay further taxes at a rate of 2.9% on the excess.

In an interesting twist that reveals the confusing nature of the tax code, you are allowed a partial deduction for the self-employment tax. Simply put, you are allowed to deduct one-half of your self-employment taxes from your gross income. For example, if you pay $10,000 in self-employment taxes, you are allowed a deduction on your 1040 return of $5,000. Many self-employed individuals miss this deduction and pay more money to taxes than needed.

Health Insurance Deduction

This used to be a very messy area for self-employed individuals, to wit, you received little tax relief when it came to your health insurance bill. This was a particular burden for small business owners when considering the astronomical cost of health insurance. All of this has changed and you now may deduct 100% of your health insurance costs as a business expense.

No Withholding Tax

Unlike a salaried employee sitting in a cubicle, you are not subject to withholding tax on your paycheck. While this sounds great, you are required to make quarterly estimated tax payments. If you fail to make the payments, you are subject to a penalty, but the penalty is not the biggest concern.

A potential and dangerous pitfall of being self-employed is failing to pay quarterly estimated taxes and then getting caught at the end of the year without sufficient funds to pay your taxes. The IRS is not going to be happy if you fail to pay your taxes and you will suffer the consequences in the form of penalties and interest. Making sure you pay quarterly estimated taxes helps avoid this situation and it is highly recommended that you follow this course of action.

Record Keeping

You must maintain complete records of all business income and expenses. Simply put, document everything. Create a filing system for each month and file every receipt, etc. All business travel expenses must be documented, including auto mileage you incur when performing business tasks. Office supply stores sell business mileage books that you can keep in your car and use whenever you travel. If you have any doubt about documenting something, just do it!

In Closing

As a self-employed individual, your focus and time is spent on making your business successful. Your focus is not on the complexities of the tax code and how to limit the amount of taxes you owe. If any of the information in this article is new to you, then it is highly likely you have paid far more in taxes than required.