Sole Proprietorship

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The self-employment tax is a tax that gets added to your normal income tax. The tax is calculated by multiplying your earnings from self-employment by approximately 15%.

Why the Self-Employment Tax Exists

At first glance, it seems unfair that entrepreneurs — probably the most important driving force behind our economy — would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.

If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the fact that part of your income was withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the Social Security and Medicare taxes.

The way these taxes are structured, the burden is shared equally between the employee and the employer. The employee’s share is calculated as 6.2% of the employee’s wages for Social Security tax and 1.45% for the Medicare tax. At the same time, the employer also pays both taxes, calculated at the same rate. As a result, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for Social Security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for the Medicare tax.

Given that you are self-employed, there is no employer with whom you can split the burden. You are therefore responsible for paying both halves of the Social Security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the self-employment tax.

How to Calculate Your Self-Employment Tax

As long as your “net earnings from self-employment” are $400 or more, you will be responsible for paying the self-employment tax—calculated as 15.3% of your net earnings from self-employment.

To calculate your net earnings from self-employment, subtract your business expenses from your business revenues, then multiply the difference by 92.35%. (This multiplication figure is the result of the odd reality that you’re allowed to deduct 1/2 of your self-employment tax when calculating the income upon which the tax will be charged.)

It’s important to note that the Social Security portion of the self-employment tax only applies to the first $106,800 of self-employment earnings. (This number is updated annually, so be sure to check what the most recent limit is.) For any self-employment earnings beyond $106,800 the self-employment tax is only 2.9% rather than the usual 15.3%.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The Importance of Business Expenses (Schedule C Deductions)

Now that you’re self-employed, you have an additional, extra-valuable level of deductions: business deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and thus your regular income tax), but also your earnings from self-employment, thus reducing your self-employment tax as well.

From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thus saving you even more money.

In order for an expense to be deductible for your business, it must be both “ordinary” and “necessary.” The IRS considers an ordinary expense to be one that is both common and accepted in your field. A necessary expense is one that is helpful and appropriate for your business. (Note that this means that an expense does not have to be absolutely indispensable for it to be considered necessary.)

Deduction for One-Half of SE Tax

One small piece of good news relating to the self-employment tax is that you get a little bit of it back in the form of an above the line deduction. After using Schedule SE to calculate your self-employment tax, you’ll enter an amount equal to one-half of your self-employment tax on line 27 of your Form 1040 as a deduction to arrive at adjusted gross income.

Simple Summary

• The self-employment tax exists simply to take the place of the social security and Medicare taxes that you and your employer would be paying if you had a job as an employee.
• The tax is calculated as 15.3% of your net earnings from self-employment. (Note: For 2011 this is temporarily reduced to 13.3%.)
• Business deductions (sometimes called Schedule C deductions) are more valuable than either above the line or below the line deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your self-employment tax.
• You will get a little bit of the money you pay for self-employment tax back when you file your taxes for the year. This is because you are allowed an above the line deduction equal to 50% of the amount you pay for self-employment tax.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less See it on Amazon.

• Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
• Self-employment tax: What it is, why it exists, and how to calculate it,
• Business retirement plans: What the different types are, and which one is best for you,
• Click here to see the full list.

• Read other reviews on Amazon

March 7, 2011 0 comments

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more noteworthy options:

1. Simplified Employee Pension (SEP IRA),
2. Savings Incentive Match Plan for Employees (SIMPLE IRA), and
3. Individual 401(k)—sometimes called a solo 401(k) or a self-employed 401(k).

The bad news: Much of the IRS literature comparing these three options is rather complicated.

The good news: Most of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is the contribution limit for each. (Note: These limits are not cumulative, so there’s usually no benefit to opening more than one retirement plan for your business.)

If you do have employees and you want to set up a retirement plan for your business, I strongly recommended that you consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting requirements as well.

I should also note here that there are several other types of retirement plans aside from  the three listed above. But for self-employed taxpayers without employees, it’s unlikely that any of the other plan types will be a better choice.

Retirement Plans in General

The basic idea behind each of your options is very similar to the idea behind a traditional IRA. That is, contributions made to the plan reduce your taxable income, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, contributions do not reduce your net earnings from self-employment. (In other words, they only save you money on income tax, not self-employment tax.)

SEP IRA

SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an above the line deduction for any contributions you make. The only really important difference is the contribution limit. For 2011, if you have a SEP, you are allowed to contribute the lesser of:

1. 25% of your net earnings from self-employment, or
2. $49,000

Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 591/2 without being penalized.

One important thing to know is that, for purposes of calculating your maximum contribution, “net earnings from self-employment” is perhaps not quite what you’d expect. Basically, it’s all your revenues, minus your expenses (makes sense so far), minus two other items:

1. The deduction for one-half of your self-employment tax, and
2. The deduction for contributions to your SEP IRA.

The idea of deducting your contribution amount when attempting to figure out how much you can contribute in the first place might sound a little confusing. It turns out it’s not so tricky: 25% of your net earnings from self-employment is just 20% of your net earnings from self-employment before considering your deduction for SEP contributions.

EXAMPLE: Prior to considering any deduction for SEP contributions, your net earnings from self-employment for this year are $80,000. Assuming you do not contribute to another retirement plan for your business, your annual SEP contribution will be limited to $16,000 (20% of $80,000).

SIMPLE IRA

SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make:

1. An employee contribution equal to 100% of your net earnings from self-employment, up to $11,500 for 2011 ($14,000 if you are 50 or over), plus
2. An employer contribution equal to 3% of your business’s net profit after subtracting an amount equal to one half of your self-employment tax.

EXAMPLE: You’re under 50 years old, and, after subtracting your deduction for one half of your self-employment tax, your business’s net profit is $50,000. Assuming you don’t contribute to any other retirement plans, the most you’ll be able to contribute to a SIMPLE IRA is $13,000 ($11,500, plus 3% of $50,000).

One other potentially important difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).

Individual 401(k) Plans

An individual 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. You are allowed to make:

1. An employee contribution of 100% of your net earnings from self-employment, up to $16,500 for 2011 ($22,000 if you are 50 or over), plus
2. An employer contribution of 25% of your net earnings from self-employment.

Note that this employer contribution is the same as the contribution you can make to a SEP IRA. As with a SEP IRA, 25% of net earnings from self-employment works out to 20% of your net earnings from self-employment before considering your deduction for retirement plan contributions.
Again, as with a SEP, the total contribution is limited to the lesser of the taxpayer’s net earnings from self-employment, or (for 2011) $49,000.

EXAMPLE: You’re under 50 years old, and you have a business with no employees. Prior to considering any contributions you make, your net earnings from self-employment are $100,000 for 2011. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $36,500 calculated as follows:

• Employee contribution of $16,500, plus
• Employer contribution of $20,000 (20% of $100,000).

If you had a SEP IRA instead, your contribution would be limited to $20,000 (20% of $100,000). Alternatively, if you have a SIMPLE IRA instead of the other types of plans, your contribution would be limited to $14,500 ($11,500, plus 3% of $100,000).

The conclusion here? In most circumstances you can contribute more—sometimes much more—to an individual 401(k) than you could contribute to a SEP IRA or SIMPLE IRA.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

Individual 401(k): Roth Option

In addition to usually allowing for greater contributions, individual 401(k) plans have another benefit: If you would prefer to do so, you can make Roth contributions to an individual 401(k) rather than pre-tax (“traditional”) contributions.

Note, however, that many brokerage firms do not allow for this option, so be sure to check with the brokerage firm you’re considering if it’s important to you to be able to make Roth contributions.

If you decide to open an individual 401(k) with a Roth option, it’s important to know that only the employee contributions (those limited to $16,500 per year or $22,000 if 50 or older) can be Roth contributions. The employer contributions (those limited to 25% of your net earnings from self-employment) must be made as traditional, tax-deferred contributions.

Is an Individual 401(k) Always Best?

Given the dual advantages of Roth contribution capability and (usually) higher contribution limits, one might wonder why anybody would choose a SEP or SIMPLE IRA over an individual 401(k).

Previously, a significant disadvantage to individual 401(k) plans was that they came with higher administrative costs. In the last few years though, price competition has brought costs down considerably at some brokerage firms. For example, Fidelity’s individual 401(k) has no set-up or administrative costs at all. Similarly, Vanguard’s individual 401(k) has no set-up fees and only a modest administrative fee: $20 per year for each mutual fund in the plan—and this fee is waived if you have at least $50,000 of assets with Vanguard.

Given the decline in costs, the only real remaining drawback is paperwork. Setting up an individual 401(k) will likely require you to fill out more forms than opening a SEP or SIMPLE IRA (either of which can usually be done online in just a few minutes). In addition, individual 401(k) plans require  you to file Form 5500 (or 5500-EZ) with the IRS every year once the plan reaches $250,000 in assets.

Deadlines for Retirement Plans

A SEP IRA can be set up as late as the due date (including extensions) for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension).

Assuming you’ve never had one before, a SIMPLE IRA can be set up as late as October 1 of the first year for which you wish to make contributions. (If you have had a SIMPLE IRA before and are setting up another one, you must set it up by January 1 of the first year for which you wish to make contributions.)

For a sole proprietor, the deadline for SIMPLE IRA employee contributions is January 30 of the following year. The deadline for the employer contribution is the due date (including extensions) for the business’s tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

The deadline for opening an individual 401(k) is December 31 of the first year for which you wish to make contributions. For a sole proprietor, contributions can be made up until the due date (including extensions) of your tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

What if You Have Other Retirement Accounts?

Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. None of the above-mentioned plans will affect your ability to contribute to a traditional or Roth IRA. They could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have one of the business retirement plans described above, you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.

In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) at that job, contributions you make to your plan at work—to take advantage of an employer matching contribution for instance—will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA. Conversely, employee contributions you make to an individual 401(k) or SIMPLE IRA will count against the contribution limit for your plan at work.

EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Prior to considering any contributions, her net earnings from self-employment are $40,000.

To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $12,500 ($16,500 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment, before considering contributions).

Simple Summary

• As a business owner, you have several options for retirement plans.  In most cases, contributions to these plans reduce your taxable income.
• Generally speaking, you want to choose the plan that has the highest contribution limit for your situation.
• In most cases, an individual 401(k) plan will allow for the largest contribution. In addition, individual 401(k) plans allow for Roth contributions (though this is not available at all brokerage firms).
• SEP IRAs and SIMPLE IRAs, however, can sometimes be good choices because of their simplicity and lower costs.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less See it on Amazon.

• Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
• Self-employment tax: What it is, why it exists, and how to calculate it,
• Business retirement plans: What the different types are, and which one is best for you,
• Click here to see the full list.

• Read other reviews on Amazon

March 7, 2011 0 comments

I recently received the following question from a reader:

I’ve earned a significant amount this year so far in self-employed income. Is there anything special I need to be doing taxwise before actually doing my taxes next April?

I know many of you earn self-employment income, so I thought it’d be worth addressing as a blog post. In brief, yes, there are a few things you should be doing. Specifically:

1. Keeping records,
2. Making estimated tax payments (maybe), and
3. Saving money (maybe).

Keeping Records for Your Sole Proprietorship

It’s important to track your business transactions if you want to be able to claim every possible deduction come tax season. An easy way to do this is to set up a spreadsheet with columns for the date, description, and amount of each transaction. This way, when tax time rolls around, you’ll have all the necessary information in one place.

If you have more than a handful of business-related transactions each year, your best bet is to open a separate checking account for your business. That way, you won’t need to bother with recording every transaction, because the bank statements from your business checking account will have all the necessary information already.

Note: For the purposes of protecting yourself against an audit, you’ll actually need to do a little more recordkeeping — in addition to keeping bank statements (and/or credit card statements), you’ll have to keep receipts for your business expenses.

Making Estimated Tax Payments

Unlike salary or wages from a normal job, payments made to your business will not have anything withheld for taxes. As a result, you may end up needing to make estimated tax payments throughout the year.

In order to avoid interest or penalty, over the course of the year, the sum of your withholding (if any) plus your estimated tax payments must equal the smaller of:

1. 90% of your tax for this year, or
2. 100% of your tax from last year (Line 60 from Form 1040).

For many people who start a business in addition to their normal job, no estimated tax payments will be required in the first year, because the withholdings from their normal job are sufficient to meet requirement #2.

Saving Money to Pay Taxes

Even if you don’t have to make estimated tax payments (because the withholding from your or your spouse’s “real job” will be equal to your total tax from last year), you’ll still probably want to start saving now for next tax season. It’s likely that instead of getting a refund this year, you’ll be writing a check to the US Treasury.

When attempting to estimate how much you need to save, be sure to remember that income from a sole proprietorship is also subject to self-employment tax (calculated as roughly 15% of the net profit from your business) in addition to being subject to income tax at your current tax rate.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less See it on Amazon.

• Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
• Self-employment tax: What it is, why it exists, and how to calculate it,
• Business retirement plans: What the different types are, and which one is best for you,
• Click here to see the full list.

• Read other reviews on Amazon

July 5, 2010 4 comments

Form 8829 is the form used by sole proprietors to calculate and report Expenses for Business Use of Home (aka “The Home Office Deduction“).

Step 1: Download the Form and the Instructions.

Step 2: Fill-in your name and SSN.

Step 3: Fill-in “Part I – Part of Your Home Used for Business”

(Click to enlarge.)

• On Line 1, enter the total square footage that you use regularly and exclusively for your business. [Note: When they say "exslusively" here, they really mean exclusively. If you use the space for anything else, you can't count it for your Home Office Deduction.]
• On Line 2, enter the total square footage of your home.
• Divide the square feet used for business by the total square feet of your home, and enter the resulting percentage on Line 3. Also, as long as your business is not a Daycare facility, skip to Line 7, and enter the same percentage that you entered on Line 3. This percentage is the “Business Percentage” of your home. It will be used later in the calculations for determining how much of certain expenses you’ll be able to deduct.

Step 4: Fill-in “Part II – Figure Your Allowable Deduction”

• On Line 8, enter the total profit from your business. (This can be taken from Line 29 of Schedule C.)
• For lines 8-35, simply follow the instructions printed on the form. It may not intuitively make sense while you’re filling it out, but here’s what’s happening:
  • In column A, you’re entering and totaling all the expenses that relate only to the business-use portion of your home. (For instance, if you repainted your home office, the costs for the paint job would go here.)
  • In column B, you’re entering costs that relate to your entire home (rent, home mortgage interest, homeowners’ insurance, ultilities, etc.). Then you end up multiplying all of these “indirect expenses” by the Business Percentage of your home (from Line 7), thus giving you the portion of these expenses that relates to your home office.

Step 5: Fill-in “Part III – Depreciation of Your Home”

If you own your home, you can include an expense known as depreciation in your Home Office Deduction. Here’s how it’s calculated:

• On Line 36, enter the smaller of the home’s fair market value or it’s adjusted cost basis (the amount you paid for it, minus any amount that you’ve already deducted as depreciation in prior years).
• On Line 37, enter the value of the land that your home is located on.
• Subtract Line 37 from Line 36. The difference (entered on Line 38) is known as the basis for the building.
• Multiply Line 38 by Line 7 (Business Percentage of Home). Enter the product on Line 39. This is known as the Business Basis of Building. This is the amount that you will be allowed to deduct, spread out over a period of several years.
• For Line 40, you’ll enter the percentage of the Business Basis of the Building that you’re allowed to deduct this year. (See the chart on Page 3 of the instructions.)
• Multiply Line 40 by Line 39. This is the amount of depreciation for your home that you can include in your Home Office Deduction this year. (Also enter this amount on Line 29.)

Step 6: Fill-in “Part IV – Carryover of Unallowed Expenses”

Every year, your Home Office Deduction is limited to your profit from your business. If your expenses for the business use of your home exceed the profit from your business, you’ll have to fill out Part IV of Form 8829. (What ends up happening is that the remaining expenses end up being carried forward, and you can add them to your Home Office Deduction in the following year.)

Step 7: Go Outside and Play.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less See it on Amazon.

• Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
• Self-employment tax: What it is, why it exists, and how to calculate it,
• Business retirement plans: What the different types are, and which one is best for you,
• Click here to see the full list.

• Read other reviews on Amazon

June 7, 2009 0 comments

Jessica (realtor) asks:

Michael, this year I started working part-time as a realtor. I have been told that I will be receiving “1099 income.” I think this means I will be an independent contractor. Is this right?

Answer:

Hi Jessica. You’re absolutely right. You are now considered an independent contractor, meaning you are self-employed for Federal income tax purposes. This will impact your tax situation in many ways:

• You will, most likely, have to make estimated tax payments at four (approximately quarterly) intervals throughout the year.
• You will have to fill out at least two additional pieces of paperwork (Schedule C and Schedule SE). Don’t worry though, if you do some homework ahead of time, you’ll be able to tackle these on your own.
• You will be subject to Self-Employment tax. (This is really just a different name for a tax that you and your employer would be paying if you were an employee.)
• You’ll be able to deduct many expenses that would otherwise be nondeductible.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less See it on Amazon.

• Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
• Self-employment tax: What it is, why it exists, and how to calculate it,
• Business retirement plans: What the different types are, and which one is best for you,
• Click here to see the full list.

• Read other reviews on Amazon

June 7, 2009 0 comments