Self-Employed? Understanding Your Taxes Now

Are you among the many Americans who switched to contractor work or started a side hustle last year? Now it's tax time, and you are unsure if you are doing things the right way. Although every situation is unique, it never hurts to review the basics to ensure you're approaching your self-employed taxes correctly.

Another new thing for contractors — self-employment tax! The self-employment tax rate is 15.3% of income, including 12.4% for Social Security and 2.9% for Medicare. As an employee, your employer would have covered a portion of these taxes, but as a self-employed person, you are on your own to cover those contributions and make sure that you're "paid in" when you need to access those programs later in life.

Here’s a guide to what you need to know.

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What’s Your Business Structure?

The first step in determining how to pay your self-employed business taxes correctly is to determine your business structure. If you’re not sure, you’re probably a sole proprietor. Sole proprietors are usually freelancers or solopreneurs who have to worry only about themselves in their business. You don’t have to fill out any paperwork with the IRS to be a sole proprietor.

The next level up is an LLC, or limited liability company. LLCs require you to apply for your LLC with the state where you do business. You'll receive an EIN and can open business bank accounts and file your taxes on behalf of your business. An LLC can choose to be taxed as a sole proprietor or as a corporation.

A corporation (think: Inc. at the end of your business's name) is a full-fledged incorporated business entity. Therefore, you can be the owner of a corporation, even if you have no employees.

So, what’s the difference when it comes to taxes?

A sole proprietor (or an LLC being taxed as a sole proprietor) files a Schedule C each year that records their income and business expenses. Because you're focusing only on your taxes as a sole proprietor, you pay income taxes on whatever profit your business pulls in, and you pay self-employment tax.

A corporation or partnership (or LLC being taxed as a corporation) operates a little differently. The profits your business pulls in likely still flow to you, the business owner, but not 100% of the time. You may have other employees or be investing back into your business. So, corporations pay taxes on payroll and their business profits. In short, you're getting taxed as a salaried employee (even as the business owner), and the business also pays taxes on any profit earned.

Your Tax-Filing Requirements

Typically, employees at a traditional 9-to-5 pay their income taxes with every paycheck.

But your income as a self-employed person may fluctuate significantly by the project or the month, and taxes are not withheld. Therefore, you will generally have to pay quarterly estimated tax payments to the IRS.

To estimate your quarterly payments, you can use the IRS' Form 1040-ES. However, if you don't keep up with your estimated tax payments, you could get stuck with a penalty from the IRS.

Setting up a corporation may reduce your tax by saving you on self-employment tax. But you will need to make quarterly filings, run payroll and issue a W-2, even if it's only for yourself. Talk to your tax adviser to see what makes sense for you.

Your Potential Tax Deductions

Knowing what's deductible and what's not is a game changer for the self-employed. Some things may seem obvious, like a new laptop you purchased for work purposes.

However, some aren't as predictable and can be a significant benefit come tax time! Some of these might be:

• Continuing education.
• Automobile expenses.
• Health insurance premiums.
• Home office expenses.
• Internet and phone.
• Travel for business meetings or conferences.
• Interest on business loans.

Don't forget retirement savings! Self-employed people need to save for retirement, too, and contributions to a retirement plan and deductions as well. Those contributions reduce your taxable income, which reduces your taxes. Talk to your tax adviser or financial planner to determine the best type of retirement plan for your situation.

Helpful Tools

Using the right tools can make all the difference for someone who is self-employed. However, trying to DIY your taxes can be headache-inducing, and you can leverage many types of technology or resources to make your life significantly easier. Here are a few things to look into:

Accounting software. Accounting software isn't just for tracking your receipts. Programs also offer time tracking, invoicing, reporting, budgeting and payroll capabilities. In some cases, they estimate your quarterly tax payments. So although you should receive 1099s for your income from all sources at the year's end, you should keep track throughout the year.

Solid accounting software can help you avoid slip-ups and stay organized when it comes time to file your taxes at the end of the year. Popular programs include QuickBooks, Xero and Wave.

A bookkeeper. Outsourcing your accounting to a bookkeeper can free up a significant amount of time in your business and help ensure you're ready at tax time. (I love having a bookkeeper — my reports are reconciled every month, and they send out 1099s at tax time.)

A financial planner. A financial planner who works with business owners can help you to stay organized and set goals for both the business and the business owner. Whether you need help walking through how to maximize tax benefits as a business owner, if you should hire an employee to support your growing team, or how to start efficiently planning for retirement as a business owner, a financial planner can help.

If you’re new to taxes as a self-employed person, don’t fret! Getting up to date once and staying organized throughout the year will save you time in the long run.

This article is designed to be educational and is not tax advice. Please consult your tax adviser to discuss your situation.