Tax Planning Primer for the Self-Employed
Avoid overlooking your tax obligations before it's too late with this guide that gets down to the nitty-gritty aspects of tax planning.
The IRS's Definition of Self-Employment
According to the IRS, you're self-employed if you carry on a trade or business as a sole proprietor, an independent contractor, a member of a partnership or if you're otherwise in business for yourself. You can be a full-time employee and still have self-employment income from a side job. To determine whether a particular income is self-employment income (rather than employee wages, for example), look at the source of your income and the extent of your involvement in the activity. If you're self-employed, understand the self-employment tax and be aware of the tax planning opportunities.
Tax Consequences of Self-Employment
You must pay self-employment tax if you have self-employment income. If you file a Schedule C as a sole proprietor, independent contractor or statutory non-employee, the income listed on your Schedule C is self-employment income and must be included on Schedule SE, which is filed with your Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed. Self-employment tax is used by the federal government to fund Social Security and Medicare benefits.
The self-employment tax rate on net earnings is 15.3 percent (with 12.4 percent of this rate going to Social Security and 2.9 percent allotted to Medicare). All net earnings from self-employment in excess of $400 are subject to the Medicare portion of the self-employment tax. However, the Social Security portion of the self-employment tax applies only to net earnings from self-employment in excess of $400, up to and including $102,000 in 2008 ($97,500 in 2007). (The maximum is reduced if you have income from sources other than self-employment that has been subject to Social Security tax.)
Employees generally have income tax, Social Security tax and Medicare tax withheld from their paychecks. If you're self-employed, it's likely that no one is withholding federal and state taxes from your paychecks, so make estimated tax payments to cover your federal income and self-employment tax liability. This will help you avoid liability for penalties, interest and substantial tax bills at the end of the year.
As a self-employed individual, you have a number of income tax planning opportunities. Here are some you may wish to consider:
1. Shifting and Timing Income
Shifting income to family members can be an important tax planning technique. If you run your own business, your ability to shift income to a family member who is in a lower marginal tax bracket can be a significant advantage. Your relative may benefit from the increased income and you may benefit by the decreased tax liability. It's also possible that the overall amount of federal income taxes paid by the two of you would be lower. But be aware that the IRS could question an unreasonable amount of compensation paid to a family member, considering the services actually provided by the family member.
As a self-employed taxpayer, you also have greater control and flexibility on timing the receipt of your income. This means that you have more control when you pay tax on the income.
2. Planning Retirement
Establishing a retirement plan is another tax planning advantage for the self-employed. If you're self-employed and have no employees, a qualified retirement plan (such as a Keogh) may allow you to place pre-tax dollars into a retirement account to grow tax deferred until withdrawal. If you have employees, your business may have to provide coverage for them as well. The type of retirement plan that your business should establish depends on your specific circumstances.
3. Reviewing Employee Benefit Plans
Aside from retirement plans, there are other employee benefit plans--such as cafeteria plans and medical benefit plans. You may wish to have your business establish one or more such plans. Employee benefit plans play an important role in attracting and retaining employees. Sole proprietors may also derive certain limited benefits under these plans.
4. Considering Business Expenses and Other Deductions
Make sure your business is taking advantage of all of the deductions it's entitled to, including deductions for certain startup costs. For instance, you may be able to deduct a portion of the expenses for a business trip even when the trip is combined with vacation. Other key deductions that you should consider include the use of a home office, automobiles and business assets.
One major area of concern for many self-employed individuals is the high cost of health insurance. Fortunately, some of your health-care related expenses may be tax deductible. For instance, you may be eligible for the self-employed health insurance deduction, which would enable you to deduct the cost of health insurance that you provide for yourself, your spouse and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., "above-the-line") when computing your adjusted gross income, so it's available whether you itemize or not.
Contributions you make to a health savings account (HSA) are also deductible "above-the-line." An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside tax-free funds for health-care expenses.
Sometimes it's unclear whether you're engaged in a trade, business or merely deriving occasional income from a hobby. Although income generated from a trade or business activity is taxable, losses from such an activity are generally fully deductible. For this reason, taxpayers sometimes try to classify a hobby as a trade or business. Consequently, the IRS closely scrutinizes purported trade or business activities that regularly show losses. If your business consistently shows a loss, be aware of the IRS's rules for classifying activities as hobbies.
This article is to provide general education only and is not intended to be a substitute for tax, investment, legal or financial planning advice. Consult your own advisors for information that's specific to your situation.
Debra Neiman, CFP, is and principal of Neiman & Associates Financial Services, a financial planning firm and registered investment advisor in Watertown, Massachusetts. She's also the co-author of the recently released book, Money Without Matrimony: The Unmarried Couple's Guide to Financial Security.