How to Pay Taxes as an Internet Business Owner

How to Pay Taxes as an Internet Business Owner

internet business taxesI’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!

11 Responses to How to Pay Taxes as an Internet Business Owner

  1. Tim Webster says:

    Whew. Daunting topic, for certain! As a few little nuggets of information come to mind.

    Now, I am not an accountant. This is not legally binding advice, these are merely helpful observations.

    1) Create a second banking account to keep money in for paying taxes. Future Wife is an independent contractor and keeps 40% of earnings separate. 40% sounds like a lot, but it’s better to have some extra funds than to realize you must scramble for money.

    2) REALLY withhold (and deposit into your separate account) more than you need to withhold for taxes. Figure out a rough number, and add 10%. If you don’t need to use it all for paying taxes, weeee! Free money!

    3) Pay someone to calculate your taxes and advise you on what you can write off as an expense. Seriously. You might save a few hundred bucks by not hiring a professional, but it’s likely the pro will save you WAY more.

    Other than that, I learned a few tricks on this article. Thanks for that. =)

    • Sarah says:

      Tim – Couldn’t agree more with what you shared here. Yes, separate accounts for business expenses are crucial and yes, it’s a good idea to set aside more than you think you’ll need to. There’s always a chance your income will be higher than expected (what a good problem to have!) and setting aside more than you need means no last minute scrambling!

      And yes, definitely pay someone who’s qualified to make helpful recommendations, instead of getting all your financial advice off blogs like mine 🙂

      Thanks for sharing!!!

  2. Scott Mackes says:

    Sarah, you are brave for tackling such a complicated subject. Very helpful info, I especially like the example that you provided.

    I think the first two people that any new business owner should hire are an attorney and accountant. I’m a big believer in spending time doing what you are good at, and “contracting out” the rest. That way you invest your time where you get the highest return.

    Great article, thanks for sharing.

    • Sarah says:

      Scott – Definitely agree! I’m not an accountant or an attorney, so I’ll hire people to handle those aspects of my business while I focus on writing and building websites.

      I’m actually in the process of finding these two professionals right now, so I’ll keep you posted on the results.

      Thanks for stopping by 🙂

  3. plin says:

    Great article! It addresses a lot of the questions as I just paid the estimated tax for September 15th.

    Did you by any chance have an analysis of different brokerage that offers SEP-IRAs, SIMPLE IRAs and solo 401(k)? I would also note that these accounts don’t have to be funded until tax deadline. So effectively you can lower your tax by contributing to these accounts up to April 15th. 🙂

    • Sarah says:

      Hey Plin – Good for you for paying estimated taxes on time!

      As far as retirement accounts go, I’m probably going to stick with a traditional IRA initially. My goal for my first year of self-employment (next year) is to set aside the full $5,000 contribution limit. If, after that, I find that it makes sense for me to contribute more (either because I’m able to or for tax purposes), then I’ll investigate those structures.

      The reason I’m staying away for now is that they all have different setups, reporting requirements and fee structures that are more complicated than it makes sense for me to deal with right now. But I’ll definitely do some investigation into that, and I’ll plan on sharing the results here.

  4. Kalen says:

    Thank you for all the info Sarah. i thought we had to pay taxes quarterly for the current year, not the following (ie. quarterly taxes for 2011 throughout 2011 rather than quarterly payments for 2011 throughout 2012). Thanks for setting things straight for me.

    • Sarah says:

      Hey Kalen! You’re right – you estimate your taxes for the end year and pay them throughout the year (at least, according to what I get from the IRS Estimated Taxes page – again, not an expert in this!!!).

      I’ve adjusted the example above to be a little more clear 🙂

      Thanks for stopping by!

  5. Sarah- Awesome article! Ive had to pay my own taxes since 2007 and its been a struggle to keep up. Last year I had to pay $23k more than what I had already been paying throughout the year. I have two S. corps and one of them wasn’t set up to payout taxes. The best thing for us is that we have a great CPA who now takes out taxes and pays it all to the right agencies (social, medicare) and anything else the government requires. I even have them take out extra money every month that goes straight into taxes since Ive been behind for so long. Hiring a CPA is a great way to go

    When you make money online most companies don’t take out taxes, so its your responsibility at the end of the year.

    • Sarah says:

      Ben – Wow, that’s a pretty big chunk! I bet that must have sucked at tax time, but I hope the people reading this article can learn from your example and see how important it is to plan for taxes ahead of time.

      That, and to find a good CPA. Definitely some good advice there!

  6. Enrique says:

    Hi, I just have one question, I join ZeekRewards and JustBeenPiad I started make good money about $1000 or more a day, my question is how do I report that money to the IRS? There is not 1099 form, I would like to do it the right way, Sarah Can you please give me some tips on it.
    What should I tell the accountant? Should I tell the accountant that I made that money as Internet Marketer?
    Thanks

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