Taxes for the Self-Employed

NEW YORK (MainStreet) — Taxes are due on Tuesday just in case anyone had somehow forgotten. For most people filing taxes is a relatively straightforward, if unpleasant, chore. Since the government withholds income on a biweekly basis, and the standard deduction comes to more than most people could itemize, the average 1040 is a straightforward affair.

In fact, about 75% of Americans will actually get a refund this year.

Not so for the self employed. We live in an entirely different world and need to play by different rules. For everyone out there working to pay his own way, April 15 is considerably more complicated and, frankly a lot more expensive. If you're an entrepreneur, here are a few things you should know.

The Self-Employment Tax

Everyone who works for himself has to pay the self employment tax. This refers to the portion of Social Security and Medicare that your employer would otherwise pay, but which you now have to cover instead.

Anyone who works has to pay Social Security and Medicare tax, which in 2013 is 15.3%. For employees, their employer picks up the first half of that, but anyone self-employed has to cover the entire tax. For those playing along at home, that's an effective increase of 7.65% for having the audacity not to work for someone else.

There are a few breaks here (although you'll still end up paying more). First, the IRS considers this a business expense and allows you to deduct the employer half of your total Social Security and Medicare taxes as far as income tax is concerned. Basically, you get to treat yourself as your own employee.

Second, this only applies to net income, so apply the self-employment tax after you've calculated the rest of your business deductions. Finally, the tax only applies to 92.35% of your net business income (your income after deductions). Reducing the base taxable income, plus the deduction, helps to level the playing field between the entrepreneurs and employees.

Quarterly Taxes

Unfortunately, April 15 isn't just tax day for 2013 year end taxes. For the self-employed, it's also the first of four payments over the course of 2014. The self-employed need to make estimated tax payments quarterly to both state and federal governments, due on April, June, September and January 15 respectively.

"Because you're self employed no one is taking taxes out for you," explained Patrick Sheehan, an Illinois tax attorney. "When you work at a W-2 job, when you work for someone else, your employer takes money out of your pay for you and sends that money to the government... When you're self- employed, there's no one to take taxes out for you so its incumbent on you to do it yourself."

If you've been self employed for more than a year you should already know this, but the newbies out there might not have run into it yet. Everyone else pays taxes in small portions so the government gets to use that money over the course of the year. For the self-employed, the government wants to use your money too.

If you last filed taxes off a standard W-2, there's some leeway for ignorance, but anyone else who skips quarterly taxes owes fees and interest. On the bright side, paying out a quarter at a time makes year end taxes less painful instead of cutting one lump sum check.

Small Income Sources

Most likely your income will come mostly from a handful of large clients that send over 1099s to document your income. But what about those couple of places where you did just light work, the ones who didn't send over any year end forms?

The answer for them is a little more informal. Clients who only paid you a small amount might not consider a 1099 worth the paperwork, but that doesn't get you off the hook for the taxes. Do an informal schedule of your own with any sources of "other" income and include it in the total. List how much and who it came from to make sure you capture all the earnings from a year.

It might suck, but not nearly as much as getting audited. When in doubt remember the golden rule for paying taxes: be honest and deal in good faith.

Deductions

The one piece of good news is that the self-employed get a list of deductions a mile long. In addition to any personal deductions, you also operate as a business and can withhold any reasonable expenses. We've already covered the self-employment tax, but there is so much more.

For example the home office deduction allows you to carve out any section of your home specifically set aside for business purposes. So if you have an office, or even just a dedicated desk, that percent of floor space counts. The home office deduction includes all expenses associated with the house: rent, mortgage, utilities, Internet, etc.

That's the actual accounting approach: multiply the percent of your house that you use, according to dedicated floor space, by your actual expenses and deduct the result. Alternatively there is the new "no-doc" deduction in which you multiply the actual square footage that you use for work space at home by $5 and deduct the results, up to $1,500 maximum.

The proportionality rule also applies across all deductions since you've thoroughly comingled your personal and professional life. Take a mixed business and pleasure trip, how much of each was it? Deduct your phone bill, sure, but only up to the extent that you used it for business, etc. One nice bonus is that you get to deduct any health insurance premiums, which only the self-employed get to do.

 

All this said, don't get greedy. Self-employment deductions rest on so many reasonable estimates that if the IRS does come calling, your entire filing could get really messy really fast.

--Written for MainStreet by Eric Reed, a freelance journalist who writes frequently on the subjects of career and travel. You can read more of his work at his website www.wanderinglawyer.com.

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