The majority of small business we deal with operate either as sole-proprietorships or single-member LLCs (SMLLCs). This form of business ownership has a big advantage as it is simple and doesn’t require the filing of a separate tax return for the business entity. The business income of a sole proprietor or the owner of an SMLLC is reported on Schedule C of the individual’s return and self-employment tax is paid as part of filing the individual’s Form 1040.
However, new business owners are often surprised by their tax bill when they make a switch from being an employee to being self-employed. The reason people are surprised is due to two things. First, employees receive wages and they receive their income net of both their employment and their income taxes. Self-employed persons must make estimated payments to cover their taxes (see blog post on Estimated Taxes here) and in the initial year of operations they often make the choice, sometimes out of necessity, to keep money in their business rather than make their required quarterly payments. Second, employees only pay one-half of their employment taxes – their employer pays the other half. Self-employed people pay 100% of their employment taxes. The combined effect of the change from employed to self-employed is that there is often a significant amount of tax due with a self-employed person’s first post-employment tax return.
The current self-employment tax rate is 15.3% on the first $118,500 of SE income. After you earn more than $118,500, the rate drops to 2.9%, just the medicare tax portion of the tax.
To illustrate the impact of being self-employed relative to being an employee, let’s assume we have two taxpayers, one self-employed and one an employee. Our hypothetical taxpayers are both single individuals and they do not itemize deductions. Let’s assume the W-2 employee receives a W-2 reporting 25k in wage income and our self-employed individual reports 25k of business income net of business expenses. The following chart shows the amount of tax (income and employment) paid by each individual.
|Income||Tax if SE||Tax if Wages*||Difference|
*Income tax plus taxpayer’s share of social security and medicare tax
As you can see, in every case the self-employed person is paying more out in taxes – due to the fact that the self-employed person is paying 100% of their employment related taxes. The additional $1,349 in tax that the self-employed person pays is 5.4% of their annual income. In addition, as mentioned earlier, the worker that is receiving wages probably had most of their tax withheld from their salary whereas the self-employed person will have zero withholding so the tax bill due on April 15th can come as quite a shock if they haven’t planned for it.
However, the news is not always bad for self-employed people. Being self-employed allows self-employed people to be able to create and fund retirement accounts that will allow them to save more than most employed people. For example:
Self-employed persons also are able to deduct all expenses related to their business. For instance, if the self-employed person uses a portion of their home exclusively for their business they may qualify to take a deduction for office-in-home. As a general rule, employees are not eligible for the home office deduction and in the case where they are, the deduction is subject to a limitation based on their AGI.
If the self-employed person purchases office supplies to use in their business, those supplies can be deducted from their business income. If an employee buys office supplies for use at their job and the employer does not reimburse them for their purchase, then they are allowed to take an employee business expenses deduction BUT that deduction is generally limited to amounts over 2% of their AGI. If the employee’s AGI is 25k, that would mean that the employee would have to spend over $500 on office supplies before they could deduct even a dollar.
If a self-employed person purchases health insurance for themselves, the health insurance is deductible for regular income tax purposes (but not SE tax). If an employee is not covered by a company health insurance plan and must purchase their own health insurance the deduction for health insurance is only allowed as an itemized deduction and the combined medical/health insurance expense must exceed 10% of AGI. For a taxpayer that does not itemize deductions, being able to deduct health insurance is not a benefit and due to the 10% AGI limitation applied to determine the deductible portion of medical expenses, there usually isn’t any tax deduction associated with health insurance.
In short, there are plusses and minuses to being self-employed rather than a W-2 employee. The moral of the story for self-employed individuals is that if you are a single, self-employed individual you should plan on saving a percentage of your income each quarter to pay estimated tax payments as follows:
|Net Business Income||Combined Income & SE Tax||Tax as a % of Income|
The table above shows the results for a single individual which would, most likely, give you a fairly low tax rate. In a future post we will discuss what happens if your tax status is married filing joint and your spouse also has income. The answer, in short, is that the tax as a percentage of income will be higher.