Filing your taxes as a "solopreneur," or one-person business, can be more complicated than the process for an employee with a single W-2 form. If you don't know what you're doing, a misstep could really cost you in the form of forfeited tax refunds, a painful audit process, late penalties or interest for underpayment.
There are more than 21 million one-person businesses in the U.S., according to the most recent Census Bureau data, and many of them learn how to file their taxes the hard way--by trial and error. Solopreneurs "just don't get [some rules] until they get stung," says Gene Zaino, CEO of MBO Partners, a Herndon, Va., company focused on independent consultant issues. "There are really great things that come with being self-employed, but there is also responsibility."
Here are some tips for solopreneurs heading into tax season for their very first time. Keep in mind that in addition to the federal guidelines, each state and city may have its own regulations.
1. Expect to pay the self-employment tax. If you are self-employed, either full or part time, and have net earnings of $400 or more per year, you will have to pay the self-employment tax. This additional tax, which includes obligations for Social Security and Medicare, tends to surprise many new solopreneurs. If you worked for a company, Social Security and Medicare payments would be automatically withheld, and your employer would pay half. But if you're self-employed, you have to pay those taxes on your own. The self-employment tax is typically equal to 15.3% of your income (12.4% for Social Security and 2.9% for Medicare), and you can deduct half of it when you figure your overall gross income. For the 2011 tax year, the self-employment tax was reduced by 2% to 13.3% (10.4% for Social Security and 2.9% for Medicare), thanks to the 2010 Tax Relief Act.
What's more, if you owe more than $1,000 in self-employment tax, you are required to estimate your self-employment tax for the coming year and begin paying it in quarterly installments, Zaino says. "If you are going to earn anything more than a few thousand dollars a year, you need to check [your estimated self-employment tax]." You can calculate it on federal tax form Schedule SE.
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2. Pick your business structure carefully. A self-employed person must determine how he or she will structure the business legally. The legal structure of your business--whether a sole proprietorship, S corporation, C corporation or limited liability company--determines the degree to which your personal assets are protected from your business assets in the event of a lawsuit. Additionally, the type of legal entity of a company affects the ability of a company to borrow money (corporations can issue stock to raise capital).
Equally as important, the legal structure of your business affects how much you owe in taxes and the amount of paperwork required to file those taxes. Sole proprietors are likely to find it easier to pay taxes, but don't have the same legal protections as those who set up as C or S corporations or LLCs.
"The easiest way is to operate as a sole proprietor," says Sherrill Trovato, president of the National Association of Enrolled Agents, an organization of government-approved tax specialists. A sole proprietor simply files a Schedule C form along with the personal tax return to report business income. If you have to pay the self-employment tax, then you also must file a Schedule SE. The risk of filing as a sole proprietor is that your personal assets aren't protected in a lawsuit against your business.
The alternatives--a C corporation, S corporation and LLC--usually require special state paperwork and fees. In addition, filing taxes as a corporation is more complicated and requires a corporate return, a payroll return and your individual return, according Trovato. The benefit of forming your business as a corporate entity, however, is that your legal liability is limited.
Because the question of legal structure is complex, Trovato recommends that you "see a tax professional who can explain in your set of circumstances what is best."
3. Keep receipts organized. One benefit of starting your own business is the ability to deduct business expenses from your taxable income. Be sure, however, to keep paper or digital receipts in case you get audited.
One expense solopreneurs often take advantage of is the home-office deduction, which can be claimed on IRS form 8829. If they work out of their homes, they can deduct part of their housing expenses. But they need to do so with care. "That home-office deduction is something you want to be very careful with because that can be an audit trigger," says Charley Moore, founder of Rocket Lawyer, a San Francisco-based online legal advice company. Another common, but sometimes overlooked deduction is the cost of using a personal vehicle for business purposes.
4. Understand the worker misclassification rules. Self-employed individuals may enlist others to handle some business projects or other tasks. But be careful not to misclassify them because it can be a costly mistake.
If you hire someone to complete a temporary, specific project, on an independent contractor basis, for example, be sure to draw up an independent contractor agreement to establish the nature of the arrangement, Moore advises. Also, ask the independent contractor to fill out an IRS 1099 form and report your payment to him to the government. That way, he is required to pay taxes on his income from your business, but you do not have to worry about payroll taxes. Even so, should the IRS determine that your contractor has been acting more like an employee, you could be required to pay back taxes on the individual, plus a penalty.