Many people envision self-employment as the ultimate freedom. Being your own boss and making all your decisions is undeniably compelling. But along with the independence of self-employment comes a maze of tax issues.
If you’ve already successfully launched your business, you have what it takes to navigate your tax issues. In this guide, we’ll investigate how to reduce self-employment taxes and provide you with other self-employed tax tips.
In the U.S., “self-employment tax” specifically refers to two tax obligations: Social Security and Medicare. The term does not include income tax, which is paid separately.
As of now, the self-employment tax rate is 15.3%. That figure is charged against net profits. The 15.3% tax rate is the sum of the 12.4% rate that goes to Social Security and the 2.9% that goes to Medicare. Unlike regular employees, the self-employed must cover the entire tax bill since there’s no employer with whom to split the cost.
The two tax obligations also have different minimum earnings for kicking in. In 2023, the Social Security tax applies to the first $160,200 of your annual earnings. The Medicare tax comes into play after your earnings surpass $200,000 for single filers or $250,000 for joint filers.
The rule of thumb for self-employed individuals is that 92.35% of your total profits are applicable to these taxes — your “tax base.”
The first step in calculating your tax exposure is determining your tax base. Take your net earnings and multiply them by the 92.35% figure. Then, multiply that figure by the 15.3% tax rate.
If you make $80,000 in net earnings this year, you would:
Before we discuss ways of lowering self-employment tax obligations, let’s talk about why monitoring it is crucial.
In the final accounting, taxes may be the most significant “expense” a self-employed person pays over their lifetime. Dealing with these taxes is rarely fun. But it’s essential to do so for several reasons.
For self-employed individuals, proper tax planning isn’t just mandatory — it can be beneficial in several ways. Here are some reasons to monitor your tax situation carefully.
The main reason planning is critical is that taxes are legal requirements. You must provide an accurate summary of your tax obligations and pay them on time.
The SE tax goes toward Social Security and Medicare, two government initiatives that help millions of Americans. When you finally retire, these safety nets could be your lifelines to continued health.
If, for some reason, you need to apply for a loan in the future, potential lenders may ask to verify your history of tax compliance. Accurate record-keeping and consistent adherence to tax payments are vital.
Neglecting to maintain precise and comprehensive tax records can have dire consequences. Not only might you face penalties, fines, and escalating interest charges, but you also risk triggering an IRS audit. This oversight could jeopardize your Social Security and Medicare benefits, tarnish your credit reputation, or even land you in legal proceedings.
The personal repercussions of poor planning can be daunting. Overlooking valuable tax deductions due to hasty decisions not only strains your finances but untangling the mess can consume hours of your time, amplifying stress and anxiety.
Taking advantage of deduction opportunities is vital to avoiding self-employment tax bills that could cripple your business. Here are some self-employed tax tips that can limit your exposure to high fiscal debts.
The tax code regularly changes. Every new year brings new deductions — and canceled deductions — that impact small businesses. Here are a few of the standard deductions that can help you avoid paying self-employment taxes that are too high.
Although you can’t eliminate your SE tax, you can deduct half of it from your net income tax. The IRS considers the SE tax to be a legitimate business expense.
Just like any business, self-employment has deductible expenses related to business operations. These can include:
You can deduct up to $66,000 of your 401(k) plan contributions in 2023. If you’ve made additional contributions to catch up with your plan, you can deduct up to $7,500 of those.
On top of those common deductions, a few lesser-known items can be deducted. These legal tax hacks for self-employed individuals include:
The self-employed can take deductions on certain meals. If you’re entertaining a client for dinner, you can deduct half of the cost of the food if you keep your receipts. (The cost of entertainment, like the ticket price of a show, is not deductible.)
If you keep up with your health insurance payments and can’t participate in your spouse’s employer’s medical plan, you can deduct the cost of health, dental, and certain long-term care insurance. You can also deduct their insurance premiums, even your children’s through age 27.
If you’ve taken out business loans, you can deduct the interest payments from your tax return. It’s best to ensure that these loans go strictly toward business operations. If you’ve used the loan for business and personal needs, only the business ones are deductible.
Small businesses can deduct up to $5,000 in their first year of existence for costs associated with starting up. You can deduct an additional $5,000 in the first year if you've incorporated your business.
You can deduct expenses for education as long as the classes are directly related to your business. For example, if you run a small construction business, you can deduct the cost of a course called “Accounting 101 for Construction Businesses.” However, you can’t deduct the cost of a class called “Learn Piano in 10 Easy Lessons.”
Besides business expenses and tax-related deductions, the government offers a few other opportunities for tax credits that can lower bills. Here are some independent contractor tax tips for finding credits.
Two of the most common tax credits are the Earned Income Tax Credit and the Child and Dependent Care Credit.
The Earned Income Tax Credit (EITC) is available to small business owners who meet eligibility requirements. If you do, it can provide substantial tax relief. You may also be able to earn the Child and Dependent Care Credit if your family requires regular medical services.
Other possible tax credits — which go along with business deductions mentioned in the last section — include credits for health coverage, education, and retirement fund contributions.
A self-employed business owner must meet specific standards to qualify for certain tax credits. For example, your business and investment income must be below certain limits to get the EITC. The Child and Dependent Care Credit applies only to children under the age of 13.
To maximize the benefits of tax credits, ensuring eligibility is paramount. The potential savings, particularly from credits like the EITC and Child and Dependent Care Credit, can be significant. While other credits may seem modest in comparison, their cumulative effect can lead to considerable tax savings.
As a self-employed person, you have a few options for structuring your business. Some of these structures can help with self-employed tax avoidance more than others.
In a sole proprietorship, the self-employed business owner is responsible for all taxes. If you run a business with a partner, your business is exempt from paying taxes, but you both must report your profits and losses on your personal income tax returns.
You may decide to turn your business into a Limited Liability Company (LLC). Although you’d still be responsible for paying the self-employed tax bill, you may have some flexibility regarding income splitting. That option is unavailable to sole proprietorships.
If your business becomes successful enough to become a corporation or an S corporation, you’ll have even more agility in paying your tax bills.
When choosing the business structure that’s right for you, some of the most critical steps to take include:
One self-employed tax tip that’s especially helpful is to make estimated tax payments. These are quarterly remittances paid to the IRS against your expected annual tax liability.
When it comes to how to reduce taxes for self-employed individuals, estimated tax payments are highly advantageous. They can improve cash flow, encourage tax planning, deter penalties or interest charges, and remove the time crunch tax preparers often face.
All of these benefits are not just good for improving your tax liability. They’re solid business practices that can impact your operations and success.
The biggest key to making estimated tax payments is ensuring the forecasts are as accurate as possible. This also involves taking advantage of tax credits and deductions as outlined above. Make sure you’re aware of the deadlines for submitting your payments.
Keep on top of every aspect of your financial status. Maintain accurate records, review your incoming revenue often, and be aware of state or local regulations that may impact them. Generally, you can avoid penalties for underpayment if you can pay 90% of your current annual tax liability. That’s a reasonable goal to have.
Hopefully, these self-employed tax tips have opened your mind to new savings possibilities. Porte Brown’s experts, including certified accountants for contractors, know how to avoid self-employment tax legally and effectively. To learn more, contact Porte Brown today.
Get in touch today and find out how we can help you meet your objectives.
