I’ve had a few requests to write on this subject, but I can’t stress enough – I am in no way, shape or form a tax professional and am in no way, shape or form qualified to give you financial advice. What I’m going to share with you here is based on my own situation and experiences, which may not be relevant to your finances. Read at your own risk 🙂
Okay – disclaimers out of the way, now let’s talk taxes!
Let’s start with the bad news. All earned income is taxed to fund the Social Security and Medicare programs. In 2010, income earned was taxed at 12.4% and 2.9% respectively for these programs, although the 2010 Tax Relief Act gives self-employed workers a break for tax year 2011 by reducing the Social Security tax to 10.4%. This leaves us with a tax rate of 13.3%-15.3% on pre-income tax earnings.
When you earn income as an employee of another company, your Social Security and Medicare contributions are taken directly from your paycheck before your earnings are taxed. In addition, your liability for these charges is limited to around 7.65% of your pre-tax earnings, as your employer typically pays for half of your tax bill.
As a self-employed worker, there’s no benevolent employer covering part of your contribution – you’re on the hook for the entire 13.3%-15.3%, in addition to whatever you’ll pay as regular income tax (as long as you make more than $400 from self-employment throughout the calendar year).
In addition, if you anticipate owing more than $500 (corporations) or $1,000 (sole proprietors, partnerships and S-corporations) at the end of the tax year, the government expects that you’ll pay estimated taxes throughout the year, instead of settling up on April 15th. For more information on estimated taxes or for a worksheet that will help you calculate what you owe, check out IRS Publication 505 – Tax Withholding and Estimated Tax.
To put together a quick estimate of what you’ll owe in taxes, take the following steps:
*Estimate your net business income for the year (remember to subtract your expenses from your income to get your net income).
*Multiply your net business income by 92.35% to find your net self-employment earnings (this deduction helps to make up for the fact that you’re paying all of your own FICA taxes as a self-employed worker).
*Multiply your self-employment earnings by 13.3% (for tax year 2011 only) or 15.3% for all other years (unless similar legislation to reduce self-employment taxes is passed).
The number that results is your estimated self-employment tax – which is only the first half of the battle. In addition to calculating this number, you’ll also want to calculate your estimated income tax, based on your self-employment income and any credits or deductions you’re eligible for. There are a few things to keep in mind here:
*As a self-employed worker, you’re eligible to deduct half of your self-employment tax from your adjusted gross income (AGI).
*You may also be able to deduct any self-employment health insurance premiums paid as part of the 2010 Small Business Act.
The best way to calculate your income taxes is simply to fill out the IRS 1040-ES worksheet, as this will give you the best possible estimate of what you’ll owe each year (and, consequently, what you need to set aside throughout the year from your internet income). But let me give you a quick illustration of how all these elements work together so that you get a “big picture” idea of the process.
Sarah is a self-employed worker who earned $36,000 (after expenses) in 2010 as an affiliate marketer. She assumes that her 2011 income will be about the same, which means her taxable self-employment earnings will be around $33,246 and her 2011 tax year self-employment tax will be an estimated $4,422.
To estimate her 2011 income taxes, she deducts half of her self-employment tax from her income, leaving an AGI of $33,789 (assuming she qualifies for no other deductions or credits). After taking the standard deduction and claiming one personal exemption, her taxable income is $24,339, putting her in the 15% tax bracket and leaving her with a regular tax bill of $3,226.
So, for her total 2011 taxes, Sarah will owe an estimated $7,648 to the US government, which she’s required to pay in four quarterly installments of $1,912.
And since the government can penalize you for not paying enough in estimated taxes (even if you settle up and pay in full at the end of the year), it’s important to put together a good estimate of what you’ll owe in taxes from the beginning and make payments throughout the year as needed.
(Keep in mind – this advice applies to sole proprietors, partnerships and LLCs only. Business owners who have chosen to file for corporate status will need to follow a totally different set of tax filing requirements. Additionally, these only apply to US taxpayers at the federal level – more taxes may be due at the state or county level.)
So now the good news (which I’m sure you’re looking forward to, because that first part was really pretty horrible…). Although there aren’t any legal ways to get around paying your self-employment and personal income taxes, there are ways you can lessen the amount you pay. Consider any of the following:
*Defer income to stay in a lower tax bracket. Say the end of the year is approaching, and you determine that your total self-employment income will put you in a higher tax bracket than you initially estimated. Instead of paying extra on your last earnings, see if it would be possible to structure invoices and payments so that they arrive in January of the next year, enabling you to remain in a lower tax bracket.
*Reduce your taxable income by investing in a self-employed retirement plan. Traditional tax-deferred IRAs, SEP-IRAs, SIMPLE IRAs and solo 401(k) plans are all available to self-employed workers, and making contributions to these funds isn’t just a good idea from a retirement-planning standpoint, it’s also a good way to reduce the amount of income tax you’ll pay at the end of the year.
*Take every possible deduction. Business owners are eligible to take deductions for business expenses that are “ordinary and necessary” to the running of their businesses, but plenty of business owners leave money on the table by missing some potential deductions.
Really, the best way to ensure you pay the smallest amount possible in taxes is to work with a small business accountant who can advise you on the best way to structure self-employment retirement plans or maximize the business expense deductions you’re eligible for. If you’re thinking about becoming self-employed in the future, or even if you simply expect to have significant earnings from your side business at the end of the year, I can’t recommend getting a qualified accountant on your team fast enough.
And finally, one word on ethics when it comes to self-employment taxes… When you make money online, there’s a huge temptation to under-report your income or fail to report certain types of income altogether. Truthfully, there are plenty of people who do this or who jump through unethical loopholes to avoid paying taxes on their internet earnings.
I’m not comfortable with this, and I’d advise that – if you’re considering manipulating your earnings in this way – you get good and familiar with the penalties associated with being audited and filing fraudulent tax returns (which can include huge fines and possibly even jail time). Personally, I say – why risk it? Instead, work with a good accountant who can minimize your final tax bill as much as possible, and then stay in the clear by paying what you owe.
Have you thought about the tax burden of your business before? Or, are there any things you’re doing to decrease your end-of-the-year tax bill? Share your thoughts below in the comments!