When starting your own business, you can expect some challenges along with the rewards. Working for someone as an employee generally includes benefits, and your employer is responsible for the taxes on your salary. When you're working for yourself, however, you must plan for your own benefits, such as health care and retirement, and take care of paying the applicable taxes. These can be quite a drain on your income. The good news is that there are deductions you can take on your income tax to help offset the expense.
If you are self-employed, there are some tax considerations you'll need to understand. Generally, a person who is self-employed is categorized as one of the following legal entities:
- Sole proprietor
- General partnership
- Limited liability corporation (LLC)
- S Corporation or C Corporation
The simplest and most common form of ownership for people just starting a small business is a sole proprietorship. That means that you are the sole owner of the business. In a sole proprietorship, you are required to file a Schedule C, Profit or Loss From Business, with your tax return. All you need to do is keep track of your income and your expenses, then place the information on the Schedule C.
There are legal and accounting expenses associated with starting up a partnership or corporation and different considerations concerning taxes. Business owners usually set up a LLC or a corporation so that their liability is limited to the assets of the business. This protects personal assets from being lost due to a lawsuit.
Dollars and Cents
A sole proprietorship is easy to start and easy to end. If you're thinking of starting a business, it's probably the best way to begin, unless you have special circumstances. A Schedule C can be filed for a partial year.
Dollars and Cents
If you're self-employed, it's a really, really good idea to establish a bank account into which you pay taxes on all your income. That way, when taxes come due, you aren't left scrambling for cash to pay them.
While paying quarterly taxes can seem cumbersome, it actually is a safer practice than trying to pay just once a year, because it forces you to keep money in reserve and be accountable at regular intervals.
The economic concept that seems to confuse the self-employed the most is double-paying Social Security and Medicare taxes. When you are an employee, you pay 6.2 percent Social Security tax and 1.45 percent Medicare tax. Your employer pays the same amount, meaning that a total of 15.3 percent of every employee's salary (up to a certain amount) goes into the U.S. Treasury.
When you are self-employed, you must pay the entire 15.3 percent yourself. That, along with local, state, and federal income taxes, can take a big bite out of your income. If you make $100, for instance, and are in the 15 percent tax bracket, you'll lose $30.30 off the top to the IRS and Social Security.
Also, when you're self-employed, you are required to pay quarterly estimated tax payments to the IRS. Payment due dates fall on April 15 (this payment is always tough because you owe the balance due from the prior year, plus a payment on the first three months of the current year), June 15, September 15, and January 15. These payments are made on a Form 1040-ES.
Schedule SE (Self-Employment Tax) is the form to use to figure out how much Social Security and Medicare tax you'll owe. It's a good idea to get this form early and calculate how much money you'll owe so you can plan to pay the taxes each quarter and not be hit with a big tax bill (and possible penalties) when April 15 rolls around.
Dollars and Cents
If you're self-employed, be sure to look into Individual Retirement Accounts de-signed especially for you. Called SEP-IRAs, these allow you to contribute up to 25 percent of your income, up to $41,000 a year.
These same taxes are due if your business is a cor-poration or a partnership, but they are reported differently on your tax return. Partners and corporate owners receive a Schedule K-1 on which income is reported for their tax return.
Paying taxes can be daunting for the self-employed, there's no question about it. You might need to consult with an accountant or tax advisor if you have special concerns. Software programs such as Quicken, QuickBooks, Microsoft Money, Turbo Tax, and TaxCut can help you through the tax maze.
If you work from home for an employer, you may be able to deduct nonreimbursed expenses from your federal income tax. You would use Form 2106 to take deductions for parking fees, tolls, travel expenses, car rentals, and so forth. You're even permitted to deduct 50 percent of the costs of meals and entertaining. You can also deduct office expenses that exceed 2 percent of your income, which may be advantageous if you need to buy a lot of equipment when you're first starting to work from home. If your employer reimburses all your expenses, however, you cannot claim them as deductions.
If you use your own car for business and are not reimbursed for mileage, you can also deduct that. You are required, however, to keep track of how many miles you rack up for business. The standard mileage rate, set by the IRS, is set at 37.5 cents per mile in 2004.
If you are an independent contractor with your own business, the vehicle deductions are calculated the same as for an employee. Instead of using Form 2106, however, you'd list your vehicle expenses on Schedule C.
Independent contractors and some employees are able to take the “Expense for the Business Use of their Home” deduction, as listed on Form 8829. The rules regarding that deduction are as follows:
If you're planning on deducting expenses incurred while working at home, especially for business space, be careful. Although it's more common for taxpayers to claim these deductions than it used to be, they still can be a red flag to the IRS.
- Business space must be used exclusively for business. Having a computer on the dining room table doesn't count as business space. A workspace in an area of the family room used only for your work does count as business space.
- Know what percentage of the overall living area of your home or apartment your workspace occupies. That number will be important.
- Total all expenses related to your living area, including the cost of heat, electricity, rent or mortgage, and so forth. If your work space occupies 15 percent of your living space, you may deduct 15 percent of your heating bill (and so forth) as a business expense.
- Know if an expense is direct or indirect. Indirect expenses, such as electricity, are a percentage of your total expenses. Direct expenses are completely attributed to the business, such as the installation of an entrance door for your office space.
- If you own your home and use it for business purposes, you may be able to de-preciate a portion of the cost of the property each year. This means the cost of the building only—not the land. There's a formula for this based on 27.5 year increments, along with the percentage of space used for business.
Starting in 2003, self-employed folks can deduct up to 100 percent of their premiums if they buy their own health insurance. To make it even better, they get to subtract the deduction from their total income, which lowers the amount of taxable income. And even those who don't itemize their deductions or qualify for the itemized medical de-duction can take this insurance deduction. To find out more about it, check out www. turbotax.com/articles/DeductingSelfEmployedHealthInsuranceCosts.
While claiming deductions can be a little tricky, it's still important to know what you are entitled to so you can maximize your deductions. Save receipts for everything—and that means everything—you think you might deduct.
Insurance Is Especially Important
As you read in the last chapter, insurance is crucial. Unfortunately, many self-employed people don't have all the insurance they need, especially in the area of health insurance.
Health-insurance is expensive, and the rates continue to rise. According to a March 16, 2004 piece in USA Today, the average health insurance premium for a family in America is $9,086 a year. That's 21 percent of the average family's income of $42,409. If you have a job where your employer pays all or most of your health insurance, you don't think much about the cost, although many employees are facing increasingly higher co-pays and deductibles. If you're self-employed and need to pay for your own insurance, however, it's a different story. There's no question, however, that you need health insurance.
To learn more about buying your own health insurance and where to find an affordable policy, check out www.healthinsuranceindepth.com. For insurance information relating specifically to those who are self-employed, see the National Association for the Self-Employed at www.nase.org.
In addition to the types of insurance coveres in , self-employed individuals may need to obtain special business coverage. If you have a lot of computers and other equipment, you might want to look at special computer insurance or business property insurance. You might also need to consider malpractice, errors and omissions, or product liability insurance, depending on the type of business you have.
Insurance is always important, but, the more you have to lose, the more important it becomes. As your business expands, so should your insurance.