Consulting Tips: Tax Implications for the Self-Employed

By Frances Chaves

The self-employed, according to the IRS, are people whose earnings come from work done on their own, rather than as an employee of a company. In most cases, the clients of the self-employed do not withhold taxes the way employers do. So, the self-employed are responsible for filing and paying their own taxes which generally include:

  • Self-employment tax (SE tax): a Social Security and Medicare tax which is similar to the Social Security and Medicare taxes withheld wage earners’ compensation.
  • Income tax

How to determine if you are subject to self-employment tax and income tax:

The self-employed are required to pay taxes on their income after expenses.

IRS form 1040-ES helps determine how much you need to pay. By subtracting your business expenses from your business income you arrive at your net profit or net loss from your business. If your expenses are less than your income, the difference is net profit and becomes part of your income on page 1 of Form 1040. If your expenses are more than your income, the difference is a net loss. You usually can deduct your loss from gross income on page 1 of Form 1040. But in some situations your loss is limited. See Pub. 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ) for more information.

You have to file an income tax return if your net earnings from self-employment were $400 or more. If your net earnings from self-employment were less than $400, you still have to file an income tax return if you meet any other filing requirement listed in the Form 1040 instructions.

In addition to paying a tax on your income, you will probably need to pay an additional tax that covers both employer and employee contributions for Medicare and Social Security. For 2012, this rate is 15.3% (13.3% until February 29, 2012).

Please note that the 2012 self-employment tax is 10.4% for the FICA portion and 2.9% Medicare. The FICA rate was reduced from 12.4% as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The FICA portion of the self-employment tax is scheduled to revert to 12.4% in 2013.

The self-employed generally pay estimated taxes quarterly. The Freelancers Union recommends putting aside about 30% of your income into a separate account that you can draw on when you need to pay your taxes.

Every client who pays you more than $600 must file a 1099 and send you a copy. Keep these together so you have all your forms in one place.

Estimated tax is the method used to pay Social Security and Medicare taxes and income tax, because you do not have an employer withholding these taxes for you. Form 1040-ES, Estimated Tax for Individuals (PDF), is used to figure these taxes. Form 1040-ES contains a worksheet that is similar to Form 1040. You will need your prior year’s annual tax return in order to fill out Form 1040-ES. Use the worksheet found in Form 1040-ES, Estimated Tax for Individuals to find out if you are required to file quarterly estimated tax.

Form 1040-ES also contains blank vouchers you can use when you mail your estimated tax payments or you may make your payments using the Electronic Federal Tax Payment System (EFTPS). If this is your first year being self-employed, you will need to estimate the amount of income you expect to earn for the year. If you estimated your earnings too high, simply complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter. If you estimated your earnings too low, again complete another Form 1040-ES worksheet to recalculate your estimated taxes for the next quarter.

Estimated quarterly tax due dates tend to be April 15, June 15, September 15, and January 15.

In order to report your Social Security and Medicare taxes, you must file Schedule SE (Form 1040), Self-Employment Tax (PDF). Use the income or loss calculated on Schedule C or Schedule C-EZ to calculate the amount of Social Security and Medicare taxes you should have paid during the year. The Instructions (PDF) for Schedule SE may be helpful in filing out the form.

Expense Deductions

Deductions are expenses that you can subtract from your income when calculating a tax rate. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

Be sure to keep receipts—both the proof of payment and the invoice from the vendor. You may wish to consult a tax professional for advice.

Here are some of the big things that can reduce your tax bill:

  • Unpaid wages.
  • Meals and entertainment. The IRS will let you deduct 50% of the cost of meeting a client over meals or entertainment.
  • Professional services. The cost of tax preparation (or the cost of a lawyer or other professional) is fully deductible.
  • Professional organizations. Professional dues are deductible.
  • Your computer. Not only can you deduct the cost of your computer, you can also deduct depreciation, the cost of normal wear and tear.
  • Professional development.
  • Home use for business: If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Refer to Home Office Deduction and Publication 587, Business Use of Your Home
  • Car: If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses. For a list of current and prior year mileage rates see the Standard Mileage Rates.
  • Health Insurance: Reduce your net self-employment income by the amount of your self-employed health insurance deduction on Form 1040. See the Instructions for Schedule SE (PDF).
  • Other expenses are deductible depending on the nature of your business. A tax professional can be helpful here.

Self-employment Tax Calculator

To estimate your self-employment taxes for 2012, use the Freelancers Union Tax Calculator at  http://www.cpasitesolutions.com/content/calcs/TaxSelfEmployment.html. This calculator uses 2012 tax tables and should not be used for estimating 2011 self-employment taxes.

Independent Contractors

The IRS considers Independent Contractors to be self-employed. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.

Resources:

Self-Employed Individuals Tax Center http://www.irs.gov/businesses/small/selfemployed/index.html

 

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4 Responses to Consulting Tips: Tax Implications for the Self-Employed

  1. John Green says:

    Unless it has been changed back for 2012 filing, this part is out of date:

    Health Insurance: Reduce your net self-employment income by the amount of your self-employed health insurance deduction on Form 1040. See the Instructions for Schedule SE (PDF).

    For 2011 you could no longer do this. You still got a deduction for self-employed insurance, but it was an individual, not a direct deduction of the amount you paid from your net income.

  2. John Green says:

    should be “as an individual” above. I could dig up my taxes, but as a result of the change I got taxed on about $10,000 more (my insurance for the year) for 2011 than I did in 2010, even though I made less money than in 2010.

    • PSGCNJ Newsletter Editor says:

      Thanks for your feedback, John. We have queried the IRS for clarification on this point and will post their response as soon as it comes in.

    • PSGCNJ Newsletter Editor says:

      The Answer To Your Question Is:
      Thank you for using our service. As the law stands today, you are correct. For tax years beginning before January 1, 2010 and after December 31, 2010, you can not reduce net earnings from self employment by the amount of the self employed health insurance deduction taken on line 29 of the 2011 Form 1040. This means that the deduction reduces adjusted gross income which then reduces the income tax liability. It does not reduce self employment income and thus does not reduce self employment tax. I hope that this information is helpful.

      IRS forms and publications may be accessed on our web site at the following address: http://www.irs.gov or ordered through our toll-free forms line at: 800-829-3676
      Expect delivery within 10 business days.

      Other useful toll-free numbers include:
      800-829-1040 IRS Tax Help Line for Individuals
      800-829-4933 Business and Specialty Tax Help Line
      800-829-1954 Refund Hotline
      866-562-5227 Disaster Relief Toll-Free Number, Monday
      through Friday, 7 am to 7:00 pm local time

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