Self-Employment Tax Considerations

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Being your own boss has a lot of appeal. Goodbye 9-to-5 grind, incessant meetings and office politics. Hello independence and, yes, taxes.

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If you operate as a sole proprietorship, taxes are not nearly as complicated as if the business were incorporated or set up as a partnership. Your business doesn't even have to be your primary source of income. If you decide to keep your full-time job but turn your love of photography into a side business, the tax considerations are the same. In either case, you'll be able to use your Social Security number as your business's tax identification number and the bulk of your tax filing can be done on Schedule C or C-EZ as part of your individual income taxes (either C form is an attachment to the long Form 1040).

Which Form?

If your business is still quite small, Schedule C-EZ is the way to go. You may file this one if you ended the year with a profit, had no employees, don't claim home-office deductions, don't have any depreciation to report and had minimal business expenses. This brief form asks for your gross receipts, less your expenses, to arrive at your net profit. If you used your vehicle for business purposes, there's an information section the IRS requires you to complete. You then take your net profit amount and transfer it to your personal income tax Form 1040 and complete the rest of your return, and that's it.

Deductions for The Self-Employed

There are tax advantages; some expenditures that were personal now might be allowable business deductions. And there are tax costs that, as an employee, you didn't think about.
  1. Equipment
  2. Operating expenses
  3. Home office
  4. Health insurance
  5. Social Security taxes
  6. Retirement savings

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If, however, your independent operation is more elaborate, you must use Schedule C. It, of course, asks for your gross income, but this longer form also requires more detail on your business expenses. If one of those expenses is use of a home office, you must also fill out Form 8829. Like the EZ, Schedule C has the business vehicle information section, plus a portion related to your inventory valuation method.

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The key difference between the two forms is that it's possible with the Schedule C to have a loss rather than a profit. Once you get that final number, either plus or minus, then it is transferred to your 1040 and you complete your individual tax return as usual.

Taking the Loss Personally

If you had a great number of expenses and just couldn't turn a profit, it may hurt professionally, but it could be a tax blessing. Since your sole proprietorship income is reported on your personal Form 1040, any loss is subtracted from your total income, helping you reduce the amount of income that will be taxable. This business loss can help reduce your personal income taxes. Technically, all the IRS requires is an indication that you started your business with the intention of earning a profit. This intent is presumed by IRS if you net any income in any three out of five business years.

Since the IRS business profit motive test is subjective, you stand a better chance of surviving any tax questions if you conduct your business professionally. That's what matters, along with your training and background in the field, the amount of time you put into the venture, the operation's profit/loss history, your overall financial status and the "recreational" elements of the project. That doesn't mean you have to hate your own business, but you can't claim your hobby is your work. You may have escaped the restrictions of a traditional job and gone your own direction, but consider your audience.

Equipment Costs and Expenses

One of the major considerations for any business is how to pay for the equipment you need. Tax laws can ultimately make your life a bit easier when it comes to these expenses. Although you have to come up with the initial outlay to buy the computer and office furnishings, you may be able to deduct their entire cost the same year rather than depreciating the costs over several tax years. One thing to keep in mind, though: This deduction, called Section 179 expensing -- after the portion of the tax code where the law appears -- gives you an immediate benefit and greatly simplifies your bookkeeping. There is a limit to the amount of Section 179 expenses you can claim and the amount changes periodically; check IRS Publication 946 for the latest figures. Any amount you spend on business assets over the limit is depreciated normally.

Other operating costs can be deducted as part of your day-to-day expenses when you fill out Schedule C. To qualify as business deductions, your expenses must be connected with your business, necessary for its operation and paid for during the tax year.

As with other businesses, your travel (including mileage) and a percentage of meal and entertainment expenses also are deductible. The key to all these expenses is to keep the receipts and clearly note what the expenditures were for.

Business Use of Your Home

Everyone knows that claiming a part of your home as an office expense is an audit red flag. But an easing of tax rules expanded the definition of "principal place of business." Previously you could only claim a home office deduction if the office was used exclusively and regularly as your principal place of business and was the main place where your business was conducted.

The IRS still considers the exclusivity/regularity test (that is, you can't turn your den into an office a few afternoons a week), but it now accepts an office claim if you have no other fixed location where you conduct your business's administrative or management responsibilities. This change is a boon for professionals who spend most of their time doing business outside their home office, but rely upon the home space to file all that follow-up paperwork.

Now that you're out on your own, you have to bear the full cost of any benefits. This includes health insurance and paying self-employment taxes. However, you can get some of that cost back through your taxes.

Health Insurance

If you pay health insurance premiums for yourself, your spouse and your dependents, you may be able to deduct a portion of the cost of the premiums as an adjustment to income. If you itemize your deductions, include the nondeductible premium amount with all your other medical care expenses. There's one catch: You cannot take this deduction for any months that you were eligible to participate in a health plan maintained by your employer or your spouse's employer.

Social Security Taxes

Social Security benefits are available to the self-employed just as they are to wage earners. To cover these future benefits, you're required to pay Federal Insurance Contributions Act (FICA) taxes if you earned $400 or more. The FICA payments total 15.3 percent, with 12.4 percent going to the Social Security system and the other 2.9 percent to cover Medicare.

The earnings limits are the same for self-employed as for wage earners. The maximum amount of net earnings subject to the Social Security is adjusted annually to reflect inflation, but all of your net earnings are subject to the Medicare part. You will need to file Schedule SE (which will have the latest earnings limit) to figure your self-employment Social Security tax.

You can get a portion of this payment back, however. When you complete your personal 1040 tax form, half of your self-employment Social Security tax can be subtracted from your total income. Because this deduction is made on the Form 1040 and not your business filing Schedule C, it will not have any effect on your net earnings or the amount of Social Security tax you pay.

Self-Managed Retirement Benefits

Your new independent business also will afford you an added retirement planning route, and another tax benefit.

As a sole proprietor, you can open a self-employed retirement plan. You have several options here, including a Keogh or Simplified Employee Pension plan. IRS Publication 560 has details on the various small business retirement plans. Whichever you choose, you can contribute a portion of your self-employment earnings. And, depending upon the plan, you might be able to subtract those contributions from your adjusted gross income when you file your personal 1040. This means you get the tax-deferred earnings of your new retirement plan, plus an immediate break on your tax return.

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