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:
- Keeping records,
- Making estimated tax payments (maybe), and
- 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:
- 90% of your tax for this year, or
- 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.