Self-employed Tax Deductions

People that run their own businesses are subject to the same federal income taxes as traditional employees. However, they are required to pay into the Social Security and Medicare programs at a much higher rate. Fortunately, self-employed tax deductions exist that can considerably reduce the obligation. Read on to learn more.

Key Points:

• Filing your taxes can be extremely frustrating and time-consuming, especially for self-employed people. As much as you’d like to, you can’t skip the process – or you’ll end up in a really bad spot, legally.
• If you own a business, think about getting some professional help with your taxes. It will cost a bit of money upfront, but it’s likely to save you much more over the long term.

Why Am I Paying Self-employment Tax? 

Self-employed people – freelancers, independent contractors and unincorporated, small business owners – are subject to a progressive income tax or small business taxes, just like traditional employees. However, there is a notable difference – the self-employment tax. 

Per the Federal Insurance Contributions Act (FICA) of 1935, workers must pay a tax on all earnings received and employers must pay a matching tax to fund the Social Security and Medicare programs. For the self-employed, this results in a double tax – one as the employee and one as the employer. Fortunately, deductions exist that can reduce the tax burden to a level that compares to that of traditional employees.

The Two Parts of the Self-employment Tax

For the 2022 tax year, 6.20% is automatically withheld from employee paychecks for the Social Security program and 1.45% is withheld for the Medicare program. Employers are obligated to match the withholdings. 

Self-employed individuals are on the hook for both the employee and employer portions, which amounts to a whopping 15.30%. Half of the total, 7.65%, reflects the self-employment tax. Fortunately, as noted previously, self-employed tax deductions can considerably reduce the tax burden. You might also wish to explore claiming a business loss on taxes.

Fast Fact:

For 2022, the Social Security tax is only applied against the first $147,000 of your taxable income. The Medicare tax is applied against all taxable income. Moreover, an additional 0.90% Medicare tax may apply to self-employment earnings above certain levels.

Who Must Pay Self-employment Tax? 

Per the Internal Revenue Service (IRS), a self-employed person is anyone that (1) carries on a trade or business as a sole proprietor or an independent contractor, (2) is a member of a partnership that carries on a trade business or (3) is otherwise in business for himself. If engaged in any of these arrangements, you must pay the self-employment tax, assuming either of the following circumstances hold true during a tax year: 

You have $400 or more of net earnings from self-employment (excluding anything you made as a church employee).

You have $108.28 or more of net earnings from church employment.

These guidelines are firm and apply regardless of age and retirement status.

How to Pay Self-employment Tax

The only requirement to make a payment is that you possess a social security number or an individual taxpayer identification number. Generally, all self-employed individuals who expect to owe more than $1,000 in self-employment tax are required to pay estimated taxes on at least a quarterly basis. Failing to do so can result in hefty penalties. You can estimate your tax payment requirements by utilizing IRS Form 1040-ES. 

See Publication 505, Tax Withholding and Estimated Tax for more details on how to pay your estimated self-employment tax. 

Self-employed Tax Deductions

When you are self-employed, there are a host of tax deductions that can benefit you. Here are some small business tax tips:

Self-employment tax – With this deduction, you can deduct half of your FICA tax from your net earnings when calculating taxable income. Essentially, this reduces your Social Security and Medicare tax obligations to a level that approximates that of traditional employees.

Home office – This is a complex deduction, covering the cost of any workspace expenses you incur regularly and exclusively for your business. This includes a portion of your rent or home depreciation, utilities, property insurance and repairs and maintenance expenses. 

Health insurance premiums – If you are self-employed, pay health insurance premiums and are not eligible to participate in a plan through your spouse’s employer, then you can deduct all of your qualified health, dental and long-term care insurance premiums. Additionally, certain medical and dental expenses above 7.5% of your adjusted gross income may be tax deductible.

Other expenses – In many cases, you may have deductions available that relate to a host of other business-related expenses, including liability insurance, advertising, travel, education, publications and subscriptions, loan interest and charitable contributions. 

Retirement savings contributions – Making contributions to an IRS-sponsored retirement account are another way to capture significant self-employed tax deductions. The most commonly used savings vehicles are described below.

          a) Simplified Employee Pension (SEP): A SEP is a retirement plan that provides businessowners a means to contribute toward their employees' retirement as well as their own. Contributions, which are limited to 25% of earnings, up to $305,000, are made to an individual retirement account (IRA) established for each plan participant.

          b) Traditional IRA: This option enables you to contribute up to $6,000 (if you’re under age 50) and $7,000 (if you’re 50 and over), subject to income limits. There is no age limit on making regular contributions to a traditional IRA, but all contributions must arise from earned income.

          c) Solo 401(k): This is a saving vehicle for small business owners who don't have any employees (apart from a spouse). It works like a traditional 401K; however, because plan sponsors act as both employer and employee, they can set aside more money each year than they could via a traditional plan. For 2022, the maximum annual contribution is $61,000.

The Tax Cuts and Jobs Act

In December 2017, former President Donald J. Trump signed a massive tax bill known as the Tax Cuts and Jobs Act (TCJA). It went into effect for the 2018 tax year. As its name implies, it cut tax rates for individuals, businesses and estates.

The legislative changes were substantial and many apply to self-employed individuals. We don’t attempt to disclose them here, but please visit the following IRS resource for an informative recap: TCJA Impact on Businesses.

How Do I Report Self-employment Taxes?

For self-employed people, filing taxes can be a very complicated process. It usually entails a variety of forms and deductions and the ability to make sense of multiple interdependent IRS guidelines. As a result, many self-employed filers enlist a tax professional to do the leg work. That said, if you’re a do-it-yourself type, some high-level guidance is outlined below.

1. Generally, you use IRS Schedule C to calculate your net earnings from self-employment.

2. You use IRS Schedule SE to calculate your self-employment tax obligation.

3. The information from the previous two schedules feeds IRS Form 1040, which is your individual income tax return.

In addition to these three key forms, other forms often come into play. At the top of the list are various 1099 forms, which are used to report income to the IRS. There are nearly two dozen types of 1099s, but those most often associated with self-employed individuals are Form 1099-K , Form 1099-MISC and Form 1099-NEC.

Conclusion

Running a self-employed business can be a liberating and lucrative endeavor, but it entails considerable challenges, including complicated tax filings. Taxation isn’t the most pleasant or easily understood aspect of business, but having a sound grasp of your finances and the self-employed tax deductions available to you is critical for success. 

Given the complexity and importance, you shouldn’t go it alone. If feasible, enlist a tax accountant to help you sort through the details. It will cost a bit upfront, but the time and money you’ll save over the long run could be substantial. 

Sources:

Internal Revenue Service. (2022, March 1). About Form 1040, U.S. Individual Income Tax Return. Retrieved from https://www.irs.gov/forms-pubs/about-form-1040

Internal Revenue Service. (2021, July 28). About Form 1040-ES, Estimated Tax for Individuals. Retrieved from https://www.irs.gov/forms-pubs/about-form-1040-es

Internal Revenue Service. (2022, February 3). About Form 1099-K, Payment Card and Third Party Network Transactions. Retrieved from https://www.irs.gov/forms-pubs/about-form-1099-k

Internal Revenue Service. (2021, June 7). About Form 1099-MISC, Miscellaneous Income. Retrieved from https://www.irs.gov/forms-pubs/about-form-1099-misc

Internal Revenue Service. (2022, February 3). About Form 1099-NEC, Nonemployee Compensation. Retrieved from https://www.irs.gov/forms-pubs/about-form-1099-nec

Internal Revenue Service. (2022, March 1). About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship). Retrieved from https://www.irs.gov/forms-pubs/about-schedule-c-form-1040

Internal Revenue Service. (2021, September 20). About Schedule SE (Form 1040), Self-employment Tax. Retrieved from https://www.irs.gov/forms-pubs/about-schedule-se-form-1040

Internal Revenue Service. (2021, April 13). Publication 505 (2021), Tax Withholding and Estimated Tax. Retrieved from https://www.irs.gov/publications/p505

Internal Revenue Service. (2022, January 19). Self-employment Tax (Social Security and Medicare Taxes). Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/Self-employment-tax-social-security-and-medicare-taxes

Internal Revenue Service. (2021, August 30). Tax Cuts and Jobs Act: A comparison for businesses. Retrieved from https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-a-comparison-for-businesses

Medicare.gov. (n.d.). Homepage. Retrieved from https://www.medicare.gov/

Social Security Administration. (n.d.). About Us. Retrieved from https://www.ssa.gov/agency/