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Understanding Taxes: What Every Self-Employed Business Owner Should Know
Federal income taxes can be daunting at best and can border on infuriating. This is true for all Americans but especially true for self-employed business owners. Self-employment tax, hidden tax deductions, and quarterly estimated tax payments can add new headaches and regardless of complexities, taxes and tax compliance are an unavoidable part of doing business.
The National Association for the Self-employed (NASE) can help you manage your tax obligations with education, access to resources, and even tax professionals who can help with your questions one-on-one. Whether you are a freelancer, part of the gig economy, a solopreneur, or the owner of a micro-business, the following paragraphs will help you conquer your new tax world.
Self-employment Tax
In addition to regular federal income tax, the small business owner must also pay Self-employment Tax on the net earnings from their business. Self-employment tax is calculated as 15.3% of net earnings from self-employment (subject to limits) and is reported on IRS Schedule SE, Self-Employment Tax. An employee working for a company and receiving wages must pay 7.65% in Social Security Taxes, consisting of FICA tax and Medicare tax. The employer must also pay a separate 7.65% of employee’s wages for a total of 15.3%. Since the self-employed business owner is both the worker AND the employer, the Self-Employment Tax represents both halves of the applicable Social Security Tax, also 15.3%.
IRS Instructions for Schedule SE, Self-Employment Tax
The good news is that there is no separate income tax return for the sole proprietor, instead a few more forms are attached to their personal income tax return. The key point is that setting aside money for Uncle Sam as you plan for your business activity should include not only regular federal income tax but also Self-Employment Tax. Keep in mind that both federal income tax and the Self-Employment Tax can be reduced by making sure you account for all available expenses that you incur in operating your new small business, including those that may be hidden from your business check book.
Hidden Tax Deductions for the Self-Employed
Most valid business deductions for the self-employed business owner are found right in the business checkbook or on the business credit card statement. You pay for something that is ordinary and necessary and has a business purpose and therefore, it is deductible. It is certainly important to keep track of your bank account and your credit card bills so that you have a record of all of those deductible items. But there are some ‘hidden’ deductions that don’t show up in either of those places.
Business Use of Your Vehicle
If you use your personal vehicle in connection with your small business you have a tax deduction related to the cost of maintaining that vehicle. This deduction does not show up in your business checkbook so, it is easy to miss. The IRS allows two methods for determining the allowable deduction, The Standard Mileage Rate method and The Actual Expense method. Most small business owners use the Standard Mileage Rate method simply because it is easier. This method requires that you keep a mileage log detailing all business miles you drive. The IRS provides a standard rate per mile, 67 cents per mile for 2024 and 70 cents per mile for 2025. Multiplying your total business miles by the standard amount per mile determines the deduction for your tax return. That’s it!
The Actual Expense Method is a bit more cumbersome but not overwhelming. This method requires that you keep track of all expenses you incur to maintain the vehicle. That includes gasoline, oil changes, maintenance, repairs, insurance, etc. You still must maintain a mileage log, but now you much determine the ratio of business miles driven divided by total miles driven. This percentage is then multiplied by the total costs to arrive at your allowable deduction. You can choose whichever method works best for you, just make sure to choose one of them and don’t forget to include this deduction on your tax return.
IRS Publication 463, Travel, Gift, and Car Expenses
Business Use of Your Home
If you have a space in your home that you use regularly and exclusively for business then you have a business deduction related to that use. This also does not show up in your business checkbook and therefore can be easily missed. Congress recognizes that the small business owner most likely works, as least part of the time, from their home and recognizes that those costs should be deductible. There are also two ways to determine this deduction. The “Long Form” requires you to keep track of all expenses you incur to maintain your home. Those include mortgage interest, property taxes, utilities, maintenance, rent, etc. etc. The total square footage of that space used for business is then divided by the total square footage of your home. The product of those two numbers provides the allowable deduction, subject to limitation.
The IRS also provides a short-cut by allowing a simple $5 per square foot of office space up to a maximum of $1,500. The standard amount is a great way to reduce some record keeping but maintain a significant deduction for your tax return. Regardless of which method you choose, make sure you don’t forget the Home Office Deduction.
IRS Publication 587, Business Use of Your Home
Retirement Plan Contributions
The last thing you should consider before you hit ‘send’ on your income tax return is the possible tax deduction available for contributing to your own future. Congress recognizes the need for all Americans to save for their own future so they are willing to put their money where their mouth is. If you contribute money to a qualified retirement plan, the IRS will give you a tax deduction for saving for your own future. Its like the IRS is subsidizing your own savings plan. There are many options available including traditional IRA accounts, SIMPLE plans, 401(k) plans, and Simplified Employee Pension plans or SEPs. All of these options are beneficial but perhaps the easiest and most flexible for the self-employed business owner is the SEP.
The small business owner can contribute up to 20% of the net income from their business to an SEP, make that contribution as late as the extended due date of their tax return, and still take a full deduction on last year’s tax return. This not only can save significant amounts in current taxes but also provide for your own future. Some years it may seem difficult from a cash flow standpoint, but always try and maximize the contribution to your future. When you retire, you will be glad you did.
Quarterly Estimated Tax Payments
The IRS tax concept is based on a “pay-as-you” system so that they expect all taxpayers to pay their federal income tax evenly throughout the year as they are earning the related income. Individuals who work for someone else accomplish this through withholding on their payroll checks. The employer withholds the tax and sends it to the IRS on behalf of the worker. For the self-employed business owner, no such withholding process exists. Therefore, those small business owners must make quarterly estimated tax payments in order to meet the pay-as-you go system. No one from the IRS will call you to remind you to make your quarterly estimated tax payments, however, if you don’t make the required payment amounts, you will be subject to penalties and interest that you wouldn’t otherwise have to pay.
There is no great secret on calculating these payments and there are no tax returns or forms necessary to make the payments. The IRS just wants you to make a good guess as to how much you will owe and then send that amount in…a little each quarter. Take a good guess at what your income will be for the whole year. Prepare a ‘what-if’ tax return based on those educated guesses. From the amount of tax on that pretend tax return you can determine a good guess on how much you should send in each quarter. Remember, these are only supposed to be ESTIMATED tax payments. So don’t spend too much time, but just pick a good number and send it in. When April 15th rolls around, you will be very happy that you made the estimated tax payments.
You’re Not Alone
Navigating the Internal Revenue Code can be difficult for everyone, but particularly for the small business owner. If you can remember only one thing from the detail provided in this discussion, it should be this…No matter how much you may feel isolated, you are not alone. There are significant resources available for you right at the click of a mouse. The IRS has a great website at
www.IRS.gov as does the Small Business Administration at
www.SBA.gov. The NASE has a slate of experts available to help you with any question you might have through its member benefit,
Ask the Experts
at
www.NASE.org.
Meet The Author:
Keith was born and raised in Dallas, Texas and graduated from the University of Texas at Austin in 1981. He began his career with the public accounting firm of KPMG and has worked with and on behalf of the NASE since 1991. Of his many duties with the NASE, his passion remains answering tax and financial questions every day directly from NASE members via Ask the Experts.
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