Friday, February 6, 2009

Tax Hacks, Part 3: Self-Employment Taxes

If you are self-employed, whether you have another job or not, you have to pay Self-Employment (SE) taxes by filing Schedule SE with your 1040. SE taxes include social security and Medicare tax, just like those paid by everyone else, but you're responsible for "withholding" them yourself. (For tax purposes, you are only self-employed if your net earnings (profit) from your self-employment are $400 or more per year.)

For the purposes of this post, we're going to focus on sole proprietorships, businesses owned and run by only one person. As a sole proprietor, you can choose to figure and set aside taxes for every "paycheck" or payment you receive for your services. These are your estimated taxes, and they must be paid quarterly. Yes, that's right. If you wait until the end of the year without making quarterly IRS payments, you could get slapped with a sizable tax penalty. If withholding tax from each "paycheck" isn't practical (e.g. you receive many small payments rather than lump sums), you can simply calculate your taxes on your quarterly earnings.

Sole proprietors also need to file Schedule C, Profit or Loss from Business, which is part of Form 1040. Alternatively, you can file Schedule C-EZ if all the following are true:
  • your expenses are not greater than $5,000
  • you have no employees
  • you have no inventory
  • you are not using depreciation or deducting the cost of your home

In order to be able to file taxes properly (and get the most $ back), a sole proprietor needs to keep immaculate records and hold onto them for at least four years. (The IRS has this thing called burden of proof. . . .)

New Ventures
If you're newly self-sufficient, i.e. have been self-employed for less than a whole tax year, you'll be operating on a short tax year the first time you file. You can find more info on short period tax returns and other topics relevant to new business owners on the IRS's page on Starting a Business.

More Resources:
Publications and Forms for the Self-Employed
Self-Employed Individuals Tax Center
Business or Hobby? Answer Has Implications for Deductions

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Wren Caulfield said...

I'm always confused by this--I have a full time job and two income-producing hobbies. But I have to pay self-employment tax, according to TurboTax. I understand needing to pay federal and state taxes for the income I bring in, but neither of these hobbies remotely supports me (I still feel lucky to be making more than I spend on them!) so I really don't get how I have to pay a self-employment tax on them.

Wren Caulfield said...
This comment has been removed by the author.
Wren Caulfield said...

@ Little Miss Moneybags: The government taxes your *total* income, including any profit over $400 (combined) from hobbies. I know it's no fun to pay taxes on it, but that money *is* part of your income, even if it's not a very high percentage of your total income. Luckily for you, there are things you can do to reduce the amount of tax you pay on your self-employment income.

First, keep the receipts from any materials or services you purchase for those hobbies. On Schedule C, you can deduct a bunch of these expenses including advertising, office supplies, and even books you use in your hobbies. You might even be able to deduct certain expenses from your home office. (See Form 8829 and Pub. 587).

Second, assuming neither of your hobbies is a farm, if your total profits from self-employment were less than $4,548 and also less than 72.189% of your total gross income, you may be able to use Schedule SE's "Optional Nonfarm Method" to claim 2/3 of your gross income (rather than your entire net income). This works best if you deducted a lot of expenses in Part II of Schedule C. This method might also qualify you for the EIC.

Even if you can't use the optional method above, there's good news. The income from your hobbies is taxed at 15%, equal to the lowest wage-earner tax bracket, and you get to deduct half of your SE tax on your 1040, thereby lowering your AGI.

Hope this was helpful.

Wren Caulfield said...

For some reason, when I switched the comment hosting for the site from JS-Kit back to blogger, all comments made through JS-Kit appear under my name. The first comment on this post is by Little Miss Moneybags.

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