Self-Employment Tax Filing
As a small business owner, you may be required to file an annual business tax return to report your income, expenses, and profits (or losses). The IRS is particularly excited when you make a profit because they will assess the following types of taxes: income and payroll taxes or self-employment taxes (namely Social Security and Medicare taxes). Many small business owners get into trouble with their taxes because they often don’t have any tax withholdings from a paycheck. On April 15th, many are shocked to find they may owe thousands of dollars in tax (or more). Knowing the rules will not only keep you out of trouble but can help you reduce your tax liability significantly.
Selecting a Legal Entity
Selecting the appropriate legal entity is an important first step. Some entities are more taxing than others, so it pays to get this right. The most common small business entities are sole-proprietorship or single-member LLC, partnership or multi-member LLC, S corporation, and C corporation.
If you fail to select any type of entity, you are a sole-proprietorship by default.
Common Small Business Entity Types
|Entity Type||Commonly Selected||File a Separate Return||Return Type||Owner Pays Taxes||Comments|
|Sole-Proprietorship or Single-Member LLC||Yes||No||1040 (Sch C)||Yes||Simple but highly taxed|
|Partnership or Multi-Member LLC||No, except for real estate||Yes||1065||Yes||Legal Protections but highly taxed|
|S Corporation||Yes||Yes||1120S||Yes||Legal protections and can be less highly taxed|
|C Corporation||No||Yes||1120||No||Legal protections but high double taxation|
The tax due dates for partnerships, multi-member LLCs and S corporations are generally March 15th but can be extended until September 15th.
The tax due dates for sole proprietorships, single-member LLCs, and C corporations are generally April 15th but can be extended until October 15th.
In the case of a partnership or S corporation, you will file a business return which includes a K-1 showing your share of the income and expenses. You must then report these income and expense items on your own personal tax return.
With a C corporation, you will file a corporate return in which any income taxes are paid directly by the corporation.
Keeping Good Records
You’ll need to keep track of your income and expenses on an annual basis to accurately file personal and business tax returns. Income is generally the amounts received from your customers during the year.
Expenses are generally amounts paid to your vendors during the year, commonly including:
- Office supplies
- Payroll and many others
Expenses are subtracted from income to obtain your profit (or loss). You pay income tax on your profits and payroll taxes on your S corporation salary or self-employment taxes on your pass-through income.
You should open a separate business checking account for all business income and expenses, to make you don’t comingle your personal expenses with your business.
TIP: The IRS doesn’t like it when you comingle your personal and business expenses.
You Can Deduct More Than You Think
The Internal Revenue Service gives some guidance on allowable business deductions in IRC section 162(a). In order to claim a deduction, it must be an ordinary and necessary expense that was paid during the taxable year in carrying on a trade or business activity.
What is an ordinary and necessary expense?
Some things are obvious such as product costs, hiring employees or independent contractors and office supplies. Many other deductible expenses are often missed. You will want to deduct all allowable expenses in order to keep your income and self-employment taxes as low as possible.
Here are a few expenses that you may not have considered:
- Automobile Expenses – the standard mileage rate or a percentage of actual costs
- Cell Phone – you may be able to deduct some or virtually all your cell phone costs
- Books & Magazines – anything related to your business is deductible
- Education Expenses – seminars or classes related to your business
- Advertising & Promotion – sponsoring a youth soccer team may be deductible
- Meal Expenses – 50% of a business lunch is deductible
- Home Office – If you don’t have an outside office this can be a substantial deduction
- Self-Employed Health Insurance – deductible against small business profits
- Computers & Furniture – you may write off in the year of purchase (Sec. 179)
- Travel – allowable if your trip is primarily for business
- Retirement Plans – SEP IRA, SIMPLE IRA, Individual 401(k), Safe-harbor 401(k)
As a small business owner, unless you have an S or C corporation, you will not be paying yourself a salary, and accordingly, will likely have no taxes withheld from your wages. Not surprisingly, the IRS doesn’t want to wait until April 15th to collect the taxes. You are required by the IRS to make quarterly estimated tax payments if you are self-employed and expect to owe $1,000 or more in taxes when you file your return. These estimated tax payments are used to pay your income tax and self-employment tax. If you do not pay enough tax through your estimated tax payments (and/or withholding), then you will be charged a penalty when you file your tax return.
Estimated tax payments are calculated and remitted by using Form 1040-ES based upon the lower of last year’s tax or 90% of this year’s tax. You may need to work with a tax accountant to see if you should raise or lower this amount based on your individual circumstances.
You can make these payments via check, money order, or by using a credit card, debit card, or electronic withdrawal online. Any worksheets you use to come up with your estimated tax amounts should be kept for your records. You will have to send in payment vouchers to the IRS if you choose to pay via check or money order. You do not need to mail these vouchers if you pay online.
|Voucher #||Income Period||Due Date|
|1||January 1 – March 31||April 15|
|2||January 1 – May 31 (less 1st payment)||June 15|
|3||January 1 – August 31 (less 1st and 2nd payment)||September 15|
|4||January 1 – December 31 (less 1st, 2nd, and 3rd payment)||January 15|
Why Do My Taxes Seem Higher When I’m Self-Employed?
You may be surprised that your income taxes seem much higher as a self-employed individual. There are two reasons why this is true:
1. Self-employment taxes are added to income taxes on your personal tax return. Also, your taxes are in fact higher because as a self-employed individual, you pay the Social Security Administration twice the amount as you did as an employee. This is because you had 7.65% withheld from your paycheck as an employee and your employer also paid 7.65% of your behalf. As a self-employed individual, you are now the employee and employer, and accordingly, you pay double the tax.
TIP: Business deductions are very important for a self-employed individual because they reduce income taxes and self-employment taxes.
2. Your taxes may seem higher because you may not have any withholding from a paycheck, as you did as an employee. You will find it much harder to write a check for a large lump-sum either when you pay your estimated taxes or pay with your tax return.
Remember to File State Taxes as Well
You may also owe state taxes. State income tax rates will vary from state to state, so make sure to look up what is required by your state. Quarterly estimated state income tax payments are typically due at the same time as the federal payments. For California residents, however, the state requires 30% in the first quarter, 40% in the second quarter, 0% in the third quarter, and 30% in the fourth quarter. You need to remember to do both.
Are You Required to File an Information Return?
You may also be required to file an information return to the IRS if you made a payment as an independent contractor. You can view the many situations in which you will need to file an information return here.
Tax Cuts & Jobs Act: 5 Things Affecting Small Business Owners
1. Lower C Corporate Tax Rates
The Tax Cuts and Jobs Act of 2017 replaced the previous graduated tax structure of four brackets (15%, 25%, 34%, 35%) with one single flat corporate tax rate of 21%. It also permanently repealed the corporate alternative minimum tax (AMT), which could collectively save companies billions over the coming years.
2. New 20% Qualified Business Income (QBI) Deduction for Small Business Owners from the Tax Cuts and Jobs Act of 2017 (199A)
If you are a business owners or real estate investor, you may be able to deduct up to 20% of your qualified business income, defined as the net income (after expenses) in your domestic business or real estate investment. This is such an important and complicated change that we’ve broken it out into its own section – click here to skip to the Qualified Business Income Deduction rules and strategies.
3. Higher Equipment Deductions (179 Deduction)
Small businesses can expense the cost of qualified property instead of recovering those costs through depreciation deductions under IRA Section 179. The good news is that the Tax Cuts and Job Act increases the amount that can be expensed from $500,000 in 2017 to $1,000,000 in 2018. The phase-out deductions also increased from $2,000,000 to $2,500,000. Keep in mind that both the $1,000,000 and $2,500,000 amounts will be indexed for inflation after 2018.
4. More Depreciation Options
The Tax Cuts and Jobs Act gave business owners an additional or “bonus” first-year depreciation. 100% of the adjusted basis of the qualified property that is both acquired and placed in service after September 27, 2017, can be deducted in the year the property was first placed in service.
The first-year 100% bonus depreciation is reduced by 20% each year beginning in 2023 until it is eliminated in 2027.
5. Entertainment Expense Deduction Repealed
Gone are the days of writing off your entertainment expenses on the company. Under the new tax reform, these expenses were eliminated. Included in this category are golf outings, fishing trips, sporting events, and theater tickets. Although, you can still write off 50% of qualifying business meals.
The Qualified Business Income (QBI) Deduction
Those who receive business income from small businesses (such as sole proprietors, partnerships, LLCs, or S corporations) report their net business income on their individual income tax returns and are thus taxed at individual tax rates.
During tax years 2018 through 2025, those individuals can use a new deduction that allows them to deduct 20% of Qualified Business Income from small business entities. This deduction is not available for C corporations. Several limitations make the QBI deduction quite tricky.
The QBI deduction is limited to the lower of 20% of net income or 20% of taxable income.
If your taxable income for 2018 is under $157,500 ($315,000 married), you can claim the full 20% QBI deduction.
Above these taxable income levels, the QBI deduction calculation becomes more complex and can be limited. At these income levels, a business must determine if it’s a service or non-service business.
- If you have a service business, your QBI deduction is fully phased out at certain taxable income levels (Single: taxable income above $207,500; Married: taxable income above $415,000)
- If your taxable income is between $157,500 and $207,500 (or between $315,000 and $415,000 married) you may be able to claim a partial deduction if you meet the following limitations:
- Service businesses are defined as businesses that involve the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the asset is the reputation or skill of one or more of the employees.
- If you have a non-service business, the QBI is not phased out, but there is another potential limitation on the QBI deduction of the greater of:
- 50% of all wages & salaries paid
- 25% of all wages & salaries paid plus 2.5% of the original cost basis of depreciable property
Can professionals in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services ever benefit from the tax reform business deduction?
Yes! As long as your taxable income does not exceed $157,500 ($315,000 married) you can claim the full 20% deduction amount.
The rules around the Qualified Business Income Deduction are extremely complicated and competent professional advice is recommended.
Small Business Retirement Plans
Trying to build retirement savings while you foster your business can be challenging. Luckily, we’ve laid out some different retirement plan options for small business owners to ease the process of choosing a plan that’s right for your needs.
A retirement plan can offer many benefits for both you and your business. Not only will you have a sense of financial security, but you also receive a tax advantage when you have a retirement plan in place.
We will explore available retirement-savings tools from ROTH IRAs to SEP IRAs and beyond. Small-business owners have access to a variety of vehicles for building retirement savings, so let’s see if any of the following is right for you.
TRADITIONAL OR ROTH IRA
Is This Account Right for You:
IRAs can be a good plan for those just starting to save for retirement or are planning on saving less than $5,500 a year. It is one of the simplest retirement accounts to start, as there are no special requirements. As for employees, IRAs are individual accounts, so you can use them if you have employees or not. Your employees will just need to set up and contribute to their IRA account on their own.
Who Can Contribute:
You can contribute to these retirement plans even if you participate in any additional plans.
For a Roth IRA, there are additional eligibility requirements. In 2019, you cannot contribute to a Roth IRA if your income exceeds $137,000 for single filers (phase-out starts at $122,000) and $203,000 for married filing jointly filers (phase-out starts at $193,000).
Again, it is an individual plan, so if you have employees, they can set up their IRA and contribute on their own.
The contribution limit in 2018 for your traditional and Roth IRAs is $5,500, with a $1,000 catch-up if you are 50 years old or older. In 2019, the annual limit increases to $6,000 with a $1,000 catch-up if you are 50 years old or older.
|Roth IRA Contribution Limit||$6,000||$5,500|
|Roth IRA Contribution Limit if 50 or over||$7,000||$6,500|
|Traditional IRA Contribution Limit||$6,000||$5,500|
|Traditional IRA Contribution Limit if 50 or over||$7,000||$6,500|
|Roth IRA Income Limits (for single filers)||Phase-out starts at $122,000;
ineligible at $137,000
|Phase-out starts at $120,000;
ineligible at $135,000
|Roth IRA Income Limits (for married filing jointly and qualifying widow(er) filers)||Phase-out starts at $193,000;
ineligible at $203,000
|Phase-out starts at $189,000;
ineligible at $199,000
The contribution limits for your IRAs don’t apply for rollover contributions. Since there is a lower contribution limit, this type of IRA is not recommended for people who want to save a substantial amount annually.
For traditional IRAs, you receive a deduction on your contributions. Roth IRAs do not have this deduction; however, withdrawals on a Roth IRA are tax-free if certain criteria are met.
Another tax advantage of a Roth IRA is that you can still contribute after you reach 70 ½ and can leave amounts in it for the rest of your life. Unlike a traditional IRA, with a Roth IRA, you can name a beneficiary to receive the remaining tax-free balance of your account after you pass if you owned the account for more than five years. Your beneficiaries can stretch out the distributions from your Roth IRA over their lifetime, which is a significant tax benefit.
What is a Solo 401(k):
The Solo 401(k), or “Solo K” for short, is a retirement account for a self-employed individual that gives them the opportunity to make contributions and build their retirement savings with a variety of investment options.
Is This Account Right for You:
This type of retirement plan is for a business owner who doesn’t have any employees.
Solo 401(k)s have certain advantages such as high contribution limits, flexibility in determining contribution amounts, and the availability of plan loans. This plan is a good option if you want to save a significant amount of money or if you expect to have years where your contributions fluctuate depending on how your business performs.
Who Can Contribute:
Those who are self-employed can use the Solo 401(k) as a convenient and cost-effective way to establish a 401(k) with profit sharing. You must be the only full-time employee of the business, but an exception exists for your spouse if they are also working in your business.
Contribution limits for Solo 401(k)s are high relative to other account types. Since you, the business owner, is the only employee, you can contribute to the plan as both the employer and employee. The business owner can contribute:
- Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
- $19,000 in 2019, or $25,000 in 2019 if age 50 or over ($18,500 in 2018, or $24,500 in 2018 if age 50 or over); plus
- Employer nonelective contributions up to:
- 25% of compensation as defined by the plan, or
- For self-employed individuals, see discussion below
In 2018, the total limits of combined employee contribution and the profit-sharing component are $55,000 ($56,000 for 2019), plus an additional $6,000 catch-up contribution for those aged 50 or older.
The compensation limit used in determining employer and employee contributions is $275,000 for 2018 ($280,000 in 2019).
If you are self-employed, there is a special calculation you must do to figure out the maximum elective deferrals and nonelective contributions you can make for yourself. Click here for the calculation from the IRS.
|Solo 401(k) Contribution Limit||$19,000||$18,500|
|Solo 401(k) Contribution Limit if 50 or over||$25,000||$24,500|
|25% of compensation as defined by the plan, or other rules for self-employed individuals|
|Annual contributions to all of your accounts (includes elective deferrals, employee contributions, employer matching, and discretionary contributions and allocations of forfeitures to your accounts) may not exceed the lesser of 100% of your compensation or||$56,000||$55,000|
Important! Contribution limits for Solo 401(k) plans are per person, NOT per account. So, the contribution limit applies to the sum of all your 401(k) contributions.
The cost to create the plan is deductible, as are any contributions the business makes to the plan. Keep in mind that Solo 401(k)s are pre-tax contributions, which means that once you turn 70 ½ years old you will be taxed on your required minimum distributions (RMDs).
Select a custodian to open your account. You might base this decision on convenience, cost, or a desire for specific investments. You will need to establish the account by December 31st of the year in which you’d like to make contributions, but you will have until the tax-filing deadline (April 15th, 2019 for example) to contribute.
Be sure to verify all expenses associated with the plan at the custodian you select. Although substantially less expensive than full 401(k) plans, there may be annual administrative or account management fees in addition to those associated with the investments you select. This may make the account more expensive than some retirement account types such as IRAs.
Those who have previously established retirement accounts may wish to consolidate them by rolling their balances into the Solo 401(k). This can prove administratively convenient and potentially reduce the cost of maintaining multiple accounts.
Solo 401(k) plans can offer loans to participants, although not all custodians of Solo 401(k) plans offer this as a feature. If your custodian does provide a plan loan, it will likely be at a competitive interest rate with convenient payment options, although there are limitations. You can take a loan of the lesser of $50,000 or one half of your account balance.
For example, a saver with a balance of $30,000 could take a loan of no more than $15,000. A saver with a $200,000 balance would be limited to the $50,000 maximum, not the half of balance limitation.
Keep in mind that your plan’s custodian may have additional limits beyond those stated for plan loans, as well as potential transactions costs for initiating a loan. As is the case with loans from all retirement account types, this should not be a first source of funds in an emergency. Your emergency savings account or unsecured lines of credit unassociated with your retirement savings may be a more advantageous source of funds if available.
There are limitations to consider. The most relevant limitation, inherent in the account title, is the restriction on some employees. Only one full-time employee, plus an additional spouse, is allowed. If more full-time employees are hired, another retirement account type should be selected.
There is also some red tape, although much less than a standard 401(k). Keeping up with ERISA requirements as well as IRS annual contribution limitations will be the main tasks.
What is a SEP IRA:
A Simplified Employee Pension or SEP IRA is the simplest retirement plan for self-employed individuals or small business owners.
Is This Account Right for You:
This type of plan is best for small business owners that may only have one or a few employees or people who depend on a freelance income. However, a business of any size is eligible to open a SEP IRA.
If you’re a small business owner, SEP IRAs are appealing because they are easy and inexpensive to set up, and contributions are tax deductible. A SEP IRA’s funding flexibility is also a draw. If you have a tough year financially, you can choose not to contribute to the plan. If you have a great year, you can fund the plan with a more considerable contribution than you’d originally intended.
Who Can Contribute:
In a SEP IRA, only employers can contribute – not employees. For employers, you will have to contribute an equal percentage of salary (aka match) for all eligible employees. You as the owner are also considered an employee in a SEP IRA. This can be costly if you want to save a large amount in your own retirement account because you are also required to contribute that same percentage amount to each eligible employee.
Example: If you contribute 6% of your income then you will need to contribute 6% for all employees.
It’s important to note, employer contributions made under a SEP plan do not affect the amount you can contribute to a different IRA on your behalf.
The contributions you make to each employee’s SEP-IRA each year cannot exceed the lesser of either:
- 25% of compensation
- $55,000 for 2018 ($56,000 for 2019)
These limits apply to contributions you make for your employees to all defined contribution plans, which includes SEPs. Up to $275,000 in 2018 ($280,000 in 2019 and subject to cost-of-living adjustments for later years) of an employee’s compensation may be considered. If you’re self-employed, use a special calculation to determine contributions for yourself.
Also, there is no catch-up contribution for SEP IRAs and contributions must be made in cash; you cannot contribute property.
|SEP IRA Contributions cannot exceed the lesser of either:||2019||2018|
|25% of compensation OR||25% of compensation||25% of compensation|
|SEP IRA Contribution Limit||$56,000||$55,000|
Similar to a traditional IRA, the money in a SEP IRA is not taxable until withdrawn.
You can open one at virtually any bank, mutual fund company, or brokerage firm, and pay low or no annual account fees.
Note: Distributions in retirement will be taxed at ordinary income rates.
What is a Simple IRA:
A Simple IRA, or Savings Incentive Match Plan for Employees, is a type of traditional IRA for mid-size businesses and self-employed individuals.
Is This Account Right for You:
This plan can be good for employers with fewer than 100 employees. This plan uses a simplified method to contribute to their employees’ and their retirement savings.
Who Can Contribute:
A self-employed person or an employee can contribute up to $12,500 in 2018 ($13,000 in 2019). Individuals 50 or older can make catch-up contributions for a SIMPLE IRA up to $3,000. Total employee elective deferral contributions to a Simple IRA and any other employer plans cannot exceed $18,500 collectively.
Unlike Solo 401(k)s, employees can contribute portions of their salary to a Simple IRA. The employer is generally required to match contributions to an employee’s account up to 3% of their compensation. However, an employer could elect to make non-elective contributions instead. If an employer chose to make non-elective contributions, they would need to make 2% contributions for all eligible employees.
Up to $12,500 in 2018 ($13,000 in 2019). The compensation limit for determining contributions is $275,000 for 2018 ($280,000 for 2019).
|Simple IRA Contribution Limit||$13,000||$12,500|
|Simple IRA Contribution Limit if 50 or over||$3,000||$3,000|
|Simple IRA Compensation Limit||$280,000||$275,000|
As with most traditional IRAs, your contributions are tax-deductible, and your investments grow tax-deferred until you are ready to make withdrawals in retirement.
SIMPLE IRA contributions are also inflexible. Early withdrawals from your IRA plan would require an individual to pay an additional 10% tax. If you are under 59 ½ (and have no other penalty exception) and you withdraw from a traditional IRA, that is deemed an early distribution. If you take an early distribution from a SIMPLE IRA within the first two years of plan participation, the additional tax is 25%.
DEFINED BENEFIT PLAN
What is a Defined Benefit Plan:
A Defined Benefit Plan is a type of fixed benefit for employees. It’s one way to set up your own individual form of a pension plan –providing you with a pre-established benefit.
Is This Account Right for You:
This plan is a bit more complicated and can be costly to create and maintain. However, businesses can usually contribute and deduct more annually than other retirement plans. For the self-employed person, your business can also be any size.
While this can be a good option for you when it comes to retirement, you are able to have other retirement plans in addition to a Defined Benefit Plan.
This plan is also good if you need to accrue a substantial benefit within a short amount of time.
Who Can Contribute:
While the employer usually makes contributions to a Defined Benefit Plan, some plans require contributions from the employee.
Defined Benefit Plan contributions cannot exceed the lesser of either:
- 100% of the average compensation of your highest three consecutive years
- $220,000 for 2018 ($225,000 for 2019)
|Defined Benefit Limit||$225,000||$220,000|
Contributions are generally tax deductible, and distributions in retirement are taxed as ordinary income. An actuary must figure your deduction limit, which adds an administrative layer.
Contributions can be fairly large because employers have the option to contribute much more to this plan as compared to other retirement plans.
However, an excise tax applies if you exceed contributions to the plan or if you don’t meet the minimum contribution requirement.
Small business tax filing is a lengthy and complicated topic. How to file your small business taxes, how the Tax Cuts and Jobs Act of 2017 will affect your company, the impact of the Qualified Business Income Deduction on your small business taxes, and choosing the right small business retirement plan are important considerations for every small business owner. Please schedule an appointment with one of our financial advisors to help craft a retirement plan based on the best interest of your small business and your financial goals, and to make sure you’re making the most of the options available to you when it’s time to file your small business taxes.
Intended for educational purposes. This guide does not take into account your personal situation or disclose all of the risks and details of these aspects of financial planning. Before implementing any strategies discussed you should consult your tax and financial advisors.