Maybe you’re newly self-employed and trying to get a handle on all things self-employment…or maybe you’ve been on your own for awhile and want to understand your taxes better. One thing is certain, being self-employed can complicate your tax situation. Here are some frequently asked questions about taxes when you are self-employed.
Question: Do I get to claim more tax deductions now that I’m self-employed?
Answer: Probably. The federal tax code allows you to deduct business expenses that are “ordinary” and “necessary” for the production of your income. The specific expenses you can claim as tax deductions will vary based on your individual self-employment situation and industry. Allowable deductions typically will reduce your self-employment income. You will then be taxed on your “net” (income after deductions) self-employment income.
Question: I’m self-employed for the first time. I should set up an LLC so I can take deductions, right?
Answer: You don’t need a separate business entity to claim business deductions against your business income. Whether or not you should set up a business entity to run your self-employment activity through is as much a legal question as a tax question.
Question: Do I need to file a separate self-employment tax return?
Answer: It depends.
-If you do not have a separate entity and are in business by yourself (no partners), you are considered a “sole proprietor” and your business revenue and expenses will be reported directly on your personal income tax return.
-If you have set up a LLC and:
–are in business by yourself, the default tax filing is for the business revenue and expense to be reported on your personal tax return.
–have partners in your business, or make a separate tax election to have your entity taxed as a corporation, you will need to file a separate business tax return.
-If you have set up a corporation or partnership with your state, you will also have a separate business tax return filing requirement.
Question: I report my self-employment income and expenses on my personal tax return. How is self-employment tax calculated?
Answer: Your net self-employment income will be taxed in several ways.
-You will be subject to federal income tax on your net self-employment income. Self-employment income is subject to ordinary income tax rates.
-If you live somewhere that has state and local income taxes, you typically will be subject to state and local income tax on your net self-employment income.
-You will also be subject to self-employment tax. This is made up of two components: Social Security tax and Medicare tax.
-Social Security tax is 12.4%. (Social Security tax is imposed on wages/self-employment income up to $147,000 in 2022)
-Medicare tax is 2.9%.
-Total self-employment tax is 15.3%
This is on top of your regular income tax. This is a shock to many people when they first become self-employed.
Question: How do I pay these taxes? When I worked as an employee, my company withheld tax from my pay. Now that I’m self-employed, I don’t have any tax withheld from my payments. I’m not sure what to do.
Answer: Now that you are self-employed, you may need to send in quarterly estimated tax payments to the IRS. Typically the IRS wants you to pay in the tax you owe evenly throughout the year. If you wait until you file your tax return to pay all of your tax for the year, you may be subject to an underpayment penalty. Making quarterly estimated tax payments can prevent you from paying this penalty.
To avoid the underpayment penalty, you need to pay in 100% of your prior year tax amount (110% if your prior year adjusted gross income was $150,000 or higher), or 90% of your current year tax amount.
So for example, let’s say you worked a W-2 job in 2021 and your total tax for the year was $6,200. You became self-employed in January 2022. To avoid the underpayment penalty for 2022, you could pay in $6,200 via quarterly estimated tax payments, or $1,550 per quarter. Even if your tax liability for 2022 was much higher than $6,200, you would not owe an underpayment penalty if you paid in $6,200 evenly throughout 2022.
Federal quarterly estimated tax payments are due as follows:
1st Quarter – April 15th
2nd Quarter – June 15th
3rd Quarter – September 15th
4th Quarter – January 15th
Question: I had a spike in income last year; I don’t think it makes sense to make estimated tax payments based on last year’s tax. How do I estimate my current year tax so I know how much I should pay in quarterly estimated tax payments?
Answer: In this situation, it may be a good time for you to work with a tax professional to help you estimate your tax for the year to determine how much you should pay in estimated tax payments.
Question: Okay I think I need to make quarterly estimated tax payments. How do I actually make the payments?
Answer: There are a few different ways you could make payments to the IRS.
-You could send in quarterly payment vouchers with a check. The instructions and payment vouchers for most individual taxpayers can be found here https://www.irs.gov/pub/irs-pdf/f1040es.pdf
Anytime you send something to the IRS ,it is a good idea to send it via certified mail with return receipt. You want to be able to prove when you sent it if any issues come up.
-You can make a payment via the IRS website. Here is a link https://www.irs.gov/payments
Question: I didn’t make any quarterly estimated tax payments all year, even though I should have. Am I going to tax jail?
Answer: Probably not. The purpose of quarterly estimated tax payments is to reduce or eliminate any underpayment of estimated tax penalty when you file your taxes. The underpayment penalty rate is currently 3%. If your total tax for the year is $10,000 and you made no estimated tax payments, the worst that will happen is when you file your taxes you will have a maximum $300 underpayment penalty ($10,000 x 3%). (The actual penalty calculation is slightly more complicated and your maximum underpayment penalty would actually be a little less than $300).
Question: It’s October and I accidentally missed the first three quarterly payments. What should I do?
Answer: If you are able to, you may want to make one payment now equal to what your first three quarterly payments should have been. So if you were supposed to make quarterly payments of $1,000 per quarter, you could make a payment now of $3,000. You may still end up with some underpayment penalty when you file your return but paying now rather than waiting until you file your tax return will reduce the penalty.
Question: The current underpayment of estimated tax penalty is only 3%. I think I can earn 10% putting my money in fill in the blank investment (stock market, iBonds, crypto, my cousin’s food truck, etc etc). Can’t I just wait until April of next year to pay all of my tax due plus the underpayment penalty since I’m earning a higher return than the penalty rate?
Answer: Sure, that’s your choice. However, if you have a hard time saving money it may work better for you to go ahead and make payments quarterly so you don’t end up with a large tax bill and no cash to pay it.
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