Britain has HM Revenue & Customs and National Insurance. The U.S. has the Internal Revenue Service (IRS) and Social Security and Medicare. Also, some states collect income tax, but that is a topic for another time. The IRS has two broad taxation categories – businesses and individuals. But what if you are an individual who runs your own business? This is where it can get (even more) complicated. If you fall into this category, you may be taxed as being self-employed or as an individual, depending on how your business is classified.
The Self-Employment (SE) Tax
For income tax purposes, the main difference between being an employee and being self-employed is the SE tax. Everyone has to pay into the Social Security and Medicare system. The SE tax is the way the federal government collects these taxes from people who are self-employed.
These payments are commonly called FICA, for the Federal Insurance Contribution Act, which mandates these payments. FICA payments come to about 13.3 percent of your income.
If you are employed, your company pays half of your FICA payment, and the other half is deducted from your paychecks.
If you are self-employed you must pay the entire amount yourself, along with your income tax. You can make estimated payments toward your SE and income tax each quarter. If your income is high enough, making estimated quarterly tax payments is required. If you don’t put money back each month for FICA and income taxes or pay quarterly estimated taxes, you may have a hefty bill due when tax time comes.
Many people don’t realize how much of their paychecks go to taxes, or that their employer is paying half of their FICA tax. This is an important consideration if you are thinking about starting your own business. It means you will need to earn about seven percent more than you were as an employee to net the same amount of money.
If you own or co-own a business, you are probably considered to be self-employed, but there are exceptions. It depends on how your business is set up. There are six business types that the IRS lists on its website, irs.gov.
Types of Businesses
A corporation is a business that is owned by shareholders. It pays taxes on its profits, and the owners and employees then pay taxes on their income from the corporation. In a corporation, the owners have only a limited amount of personal liability for the company’s debts and obligations.
This form of business offers the limited liability of a corporation while avoiding the double taxation. The company does not pay corporate income tax. Instead, the owners of pay taxes on their share of the company’s income as individuals.
Limited Liability Company (LLC)
The LLC is a form of business that is created and regulated at the state level. This is not a corporation, but it offers the same limited liability as one. People will often choose to start a business as an LLC because of this fact and because it is usually easier to form an LLC than a corporation. An LLC can be owned by a single person, a group of people, or even by another business.
A partnership is an official business relationship between two or more people. A partnership doesn’t pay taxes as a separate entity as does a corporation. Each member of the partnership pays income tax as an individual.
This is the classification of a person who is the sole owner a business which does not fall into any of the categories listed above.
The IRS website defines independent contractors as people who “are in an independent trade, business, or profession in which they offer their services to the general public.”
Am I Self-Employed?
The IRS considers you to be self-employed if you own a business as a sole proprietor, are an independent contractor or are a member of a partnership. In all of these cases, you have to pay income tax and SE tax.
If you are an employee of a company, but you work outside the company on your own, your work outside the company counts as self-employment. You have to pay income tax on this income, and if you make more than $400 you have to pay SE tax on it.
The limited liability company a little less simple. The IRS does not recognize the LLC as a business type for tax purposes. You must declare your LLC to be a corporation, a partnership or a sole proprietorship with the IRS. This in turn determines your employment status.
There are literally thousands of pages of laws, rules and regulations concerning U.S. federal and state income taxes. This article provides a brief overview of some of these rules. It is intended to help you decide if you are considered self-employed for tax purposes, and give you an idea of what taxes may be required. You should consult a qualified tax expert like a Certified Public Accountant or a tax attorney for more detailed advice. The information for this post was taken from the official website of the Internal Revenue Service, irs.gov.
An Example Tax Calculation
Here is an example of how much tax you might pay on income as a freelance writer.
Your Gross Income
The first step is to fill out the IRS form Schedule C to calculate your net income. This form sums up all of your earnings from writing, and subtracts your business expenses from that total.
Business expenses can be things like:
- Mileage on your vehicle – You can deduct the cost of using your vehicle for work purposes. This could include driving to interviews or editorial meetings. The IRS website gives various ways of determining your allowable deduction.
- Office expenses – Whether you write from home or rent office space, you can deduct a percentage of your expenses for maintaining your office.
- Materials – Various work-related materials may be deductable. This could include office equipment, books or subscriptions to professional journals and organizations.
We will assume your net income from Schedule C was $50,000.
Your SE Tax
The next step is to fill out Schedule SE, the Self-Employment Tax form.
Schedule SE gives two tax rates, based on whether your net income is more or less than $106,800. Your net writing income was $50,000, so your SE tax will be 13.3 percent of this amount, or $6,650.
There is one more number you will need from this form. You are allowed to deduct, from your income tax, the amount of SE tax that an employer would have paid had you been employed. For this example, that amount is 57.51 percent of your SE tax, or $3,824.
Now you are ready to fill out form 1040 to calculate your total income tax.
Adjusted Gross Income
Your Adjusted Gross Income (AGI) includes your income from writing and other types of income, like rental properties, a pension or gains from stock sales. For this example, we will assume you had no income apart from your writing.
You are allowed to subtract some expenses at this point. This includes the SE tax deduction from the last step. It could also include things like college expenses, alimony and medical insurance. We will assume for our example that the SE tax deduction is your only expense for this section.
Therefore, we subtract $3,824 from $50,000 to get an Adjusted Gross Income of $46,176.
You now get to subtract deductions from your income. You have two options at this point.
Each person is entitled to a Standard Deduction of $5,800. You can also submit an itemized list of expenses, things like medical expenses, charitable donations and interest on a home mortgage. These are called Itemized Deductions. You must choose between taking your Standard Deduction and submitting Itemized Deductions. For our example, we will use the Standard Deduction.
Now you have one last thing to subtract from your income. Each person gets an Exemption of at least $3,700. It may be more under some circumstances, but we will use the minimum figure for our example.
Now we are ready to figure out your taxable income. This is your AGI minus your Standard Deduction and your Exemption. $46,176 – $5,800 – $3,700 = $36,676.
Your Income Tax
The last step is to look up your income tax in the tax table. The income tax on $36,676 is $4,656. Add this to your SE tax of $6,650, and you get a total tax of $11,306.
This comes out to a tax rate of about 22.6 percent.