Figuring out the complex world of taxes isn’t an easy task for anyone. But for freelancers, it sometimes feels like it’s even harder. When you file taxes as an indy, you may find yourself scratching your head about how your tax situation differs from someone who’s self-employed but runs a business with employees. In this primer, I’ll get into the nitty gritty on how to handle self-employed taxes when you’re running a business of one.
How Does the IRS Define Self-Employed?
According to the IRS, you’re considered self-employed if any of the following criteria apply to you:
- You run a business as a sole proprietor. This means that you own and run an unincorporated business entirely on your own. But beware: If you set up your business as an LLC, you’ll no longer be considered a sole proprietor.
- You run a business as an independent contractor. A major legal difference between an employee and an independent contractor is that if you’re employed by a company, the company will withhold your Medicare and Social Security tax (FICA), which is also known as self-employed taxes. Conversely, if you’re an independent contractor, you won’t be responsible for paying self-employed taxes — which I’ll get into a little later.
- You run a business in a partnership. This means you’re a co-owner or co-partner in a business.
- You run a part-time business for yourself. You don’t need to be self-employed full-time to consider yourself self-employed. “Time doesn’t play a factor into taxes,” says Eric J. Nisall, a self-employment tax expert. “As long as you only work for yourself, then you’re self-employed, regardless of if you only put in 20 hours a week or 100 into your business.” In fact, if your business earns over $400 in a year, you’ll need to pay self-employment taxes.
Taxes for the Self-Employed
When you’re an employee of a company, your employer is responsible for half of your self-employed taxes (6.2 percent for Social Security and 1.45 percent for Medicare), while you pay for the other half. But whether you’re a sole proprietor or run a small business with employees, you’re responsible for paying all of your self-employed taxes. In 2017, the Social Security tax rate is currently 12.4 percent, while the Medicare tax rate is 2.9 percent.
While there’s an income cap for Social Security tax, which is assessed for only the first $127,200 of earned income, there’s no income cap for Medicare tax. So no matter how much you’re earning, you’ll still need to pay the 2.9 percent tax.
Solopreneurs vs. Small Business Owners With Employees
How does paying taxes when you’re an army of one differ from when you’re running a business with employees? Well, one major difference is when the taxes are actually required to be paid, explains Nisall. If your business has employees, it needs to make deposits based on the total tax liabilities. This can mean that taxes have to be deposited within two days, once a month or quarterly.
If you’re a self-employed individual, you’re only required to pay quarterly, and the deadlines can vary. Don’t forget: If you don’t pay quarterly, you will be subject to an underpayment penalty.
How Do I Pay Taxes As an S-Corp?
If you’ve set up your business as an LLC and elected an S-Corp, you’re supposed to take a salary, explains Nisall. This means you’ll receive a W-2 form from your business. On top of that, an S-Corp is required to file its own income tax return. The net income passes through to you in the form of a Schedule K-1 tax form — and that’s why S-Corps are known as “pass through” business entities.
“So instead of filing a Schedule C, you’ll be filing a Schedule E, which is just a rehash of the info from the K-1,” says Nisall. “Basically, it’s just the lump-sum bottom line that gets reported on your personal return. Otherwise, it would be redundant to have an S-Corp tax return (1120-S) and a 1040 Schedule C showing the same information.”
When you’re an indy and running your own business, legal and financial matters like self-employed taxes need to stay top of mind. By understanding the nuances involved — and the differences that come into play depending on whether you’re a solopreneur or a small business owner with employees — you’ll be better prepared to handle your taxes. In turn, you’ll be able to run a smoother operation.