Tax Tips for the Self-Employed (& others with non-W2 earnings)

January 25, 2011

The latest tax tips from the IRS focus on self-employed individuals. As usual, I’ve added some of my own comments below. This time, there were many directions I could go with my comments, but I’ve decided to focus on individuals who aren’t sure if they qualify as self-employed. First, the IRS tips:

IRS Tax Tip 2011-16, January 24, 2011

If you are in business for yourself, or carry on a trade or business as a sole proprietor or an independent contractor, you generally would consider yourself self-employed and you would file IRS Schedule C, Profit or Loss From Business or Schedule C-EZ, Net Profit From Business with your Form 1040.

Here are six things the IRS wants you to know about self-employment:

  1. Self-employment can include work in addition to your regular full-time business activities, such as part-time work you do at home or in addition to your regular job. 

  2. If you are self-employed you generally have to pay Self-employment Tax. Self-employment tax is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. You figure SE tax yourself using a Form 1040 Schedule SE. Also, you can deduct half of your self-employment tax in figuring your adjusted gross income.
  3. If you are self-employed you generally have to make estimated tax payments. This applies even if you also have a full-time or part-time job and your employer withholds taxes from your wages. Estimated tax is the method used to pay tax on income that is not subject to withholding. If you don’t make quarterly payments you may be penalized for underpayment at the end of the tax year.
  4. You can deduct the costs of running your business. These costs are known as business expenses. These are costs you do not have to capitalize or include in the cost of goods sold but can deduct in the current year.
  5. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.
  6. For more information see IRS Publication 334, Tax Guide for Small Business, IRS Publication 535, Business Expenses and Publication 505, Tax Withholding and Estimated Tax, available at http://www.irs.gov or by calling the IRS forms and publications order line at 800-TAX-FORM (800-829-3676).

Links:

  • Publication 334, Tax Guide for Small Business ( PDF)
  • Publication 535, Business Expenses ( PDF)
  • Publication 505, Tax Withholding and Estimated Tax ( PDF)

IRS publications often don’t recognize the complexity of many real-world situations. And in the area of self-employment, this is definitely the case. The IRS is cracking down on businesses to make sure they’re reporting payments they make to individuals, resulting in many more individuals receiving 1099’s for side jobs that were previously just paid as cash with no reporting. In addition, as a result of the unsteady employment market, many more individuals are taking on side jobs outside of their normal employment. So a lot of individuals are receiving Form 1099-Misc, with earnings reported in Box 7, and they don’t know what to do with this information.

The standard practice in the eyes of the IRS, and the standard practice of many tax preparers, is that receiving a 1099-Misc with Box 7 automatically makes you self-employed for purposes of the tax code. This can result in taxpayers owing self-employment tax in addition to regular income tax. (For middle-income filers, this can result in a marginal tax rate of over 40% on these earnings. Ouch!) However, this “standard practice” is not always the best practice.

Sometimes taxpayers who are employees and receive a W2 each year will take a “one off” assignment or project. If a taxpayer doesn’t take these assignments on a regular basis, and in fact in many years does not take any of these assignments, there is a good chance this individual is not “self-employed”, and therefore not subject to the ~15% Self-Employment Tax. The authority for this is right in the Internal Revenue Code itself. Section 1402(h) defines “regular basis”  as having “net earnings from self-employment (…) in at least two of the three consecutive taxable years” preceding the current taxable year. If you do not have net self-employment earnings in at least 2 of the 3 prior years, then according to the tax Code you haven’t met the definition of engaging in business on a “regular basis”.

However, you should be aware there is more to determining whether one is self-employed than just the “regular basis” test. But if you do not meet the criteria for this test, then it’s certainly worth reviewing your situation with a professional to see if you’re truly self-employed. If you are not self-employed, and therefore you are eligible to treat 1099-Misc amounts as “other income” instead of “self-employment income”, you could see a significant savings on your taxes. It’s impossible to generalize because of all the complexities involved in the classification, but it’s well worth consulting a professional if you think these rules may affect you.

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Tip Income and Taxes

January 21, 2011

Yes, tips are taxable income. But that’s not necessarily bad news, as I’ll explain below. First, here is some information from the IRS about reporting tip income:

If you work in an occupation where tips are part of your total compensation, you need to be aware of several facts relating to your federal income taxes. Here are four things the IRS wants you to know about tip income:

1. Tips are taxable. Tips are subject to federal income, Social Security and Medicare taxes. The value of non–cash tips, such as tickets, passes or other items of value, is also income and subject to tax.

2. Include tips on your tax return. You must include in gross income all cash tips you receive directly from customers, tips added to credit cards, and your share of any tips you receive under a tip–splitting arrangement with fellow employees.

3. Report tips to your employer. If you receive $20 or more in tips in any one month, you should report all of your tips to your employer. Your employer is required to withhold federal income, Social Security and Medicare taxes.

4. Keep a running daily log of your tip income. You can use IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer, to record your tip income.

For more information see IRS Publication 531, Reporting Tip Income and Publication 1244 which are available at http://www.irs.gov or can be ordered by calling 800-TAX-FORM (800-829-3676)

Many employees who receive tip income think they’re better off if they don’t report tips. Obviously, the fact this is illegal should be reason enough to report tips. But the truth is, it’s often in the best interest of a tipped employee to report the income, for several reason.

First, many employees who receive tips do not make enough money to have any tax liability, even with the tips. However, the extra income may increase the amount of money the taxpayer receives as a result of Earned Income Credit, especially if the taxpayer has any qualifying dependents. As a result, just from a tax perspective, the employee might be better off, or at least no worse off, as a result of reporting tips.

Second, employees who receive tips often do not have a lot of job security, and may receive unemployment as a significant source of income. Unemployment compensation is calculated based on earnings, and the more you earn, the more unemployment you are eligible to receive. So having higher earnings will increase your unemployment compensation if you experience a period of unemployment. In addition, if the employee becomes disabled and unable to work, once again the amount of disability pay an employee is eligible to receive is based on earnings.

Finally, higher income increases eligibility for loans. If you need to take out a loan for a car or a house–or an emergency–a bank will want to see proof of income. (Not too long ago this stopped being the case…but after the financial crisis banks are once again requiring proof of income.) This proof of income comes from pay-stubs and filed tax returns. So reporting this income will make it easier to borrow money if the need arises.

Sure, it’s entirely possible that reporting tips will make you worse off financially. But of course it’s something that must be done because it’s simply the law. Hopefully you can feel a little better about it knowing that you may very well benefit from reporting those tips.


Who to claim as a dependent

January 12, 2011

Determining who you can claim as a dependent will have a big impact on your tax return. All dependents will generally allow you to deduct $3,650 from your taxable income in 2010. Certain dependents also make you eligible for additional credits that can be worth thousands of dollars. So make sure you don’t miss somebody who can be claimed.

Here’s a few tips from the IRS about who you can claim as a dependent (followed by a couple tips of my own):

Some tax rules affect every person who may have to file a federal income tax return – these rules include dependents and exemptions. Here are six important facts the IRS wants you to know about dependents and exemptions that will help you file your 2010 tax return:

  1. Exemptions reduce your taxable income. There are two types of exemptions: personal exemptions and exemptions for dependents. For each exemption you can deduct $3,650 on your 2010 tax return.

  2. Your spouse is never considered your dependent. On a joint return, you may claim one exemption for yourself and one for your spouse. If you’re filing a separate return, you may claim the exemption for your spouse only if they had no gross income, are not filing a joint return, and were not the dependent of another taxpayer.
  3. Exemptions for dependents. You generally can take an exemption for each of your dependents. A dependent is your qualifying child or qualifying relative. You must list the social security number of any dependent for whom you claim an exemption.
  4. If someone else claims you as a dependent, you may still be required to file your own tax return. Whether you must file a return depends on several factors including the amount of your unearned, earned or gross income, your marital status, any special taxes you owe and any advance Earned Income Tax Credit payments you received.
  5. If you are a dependent, you may not claim an exemption. If someone else – such as your parent – claims you as a dependent, you may not claim your personal exemption on your own tax return.
  6. Some people cannot be claimed as your dependent. Generally, you may not claim a married person as a dependent if they file a joint return with their spouse. Also, to claim someone as a dependent, that person must be a U.S. citizen, U.S. resident alien, U.S. national or resident of Canada or Mexico for some part of the year. There is an exception to this rule for certain adopted children. See IRS Publication 501, Exemptions, Standard Deduction, and Filing Information for additional tests to determine who can be claimed as a dependent.

For more information on exemptions, dependents and whether you or your dependent needs to file a tax return, see IRS Publication 501.

And a couple additional tips…

7. A dependent may only be claimed by one person. If a person is eligible to be claimed as a dependent, only one person may claim that dependent. This can get confusing when parents are separated, or when another person such as a family member provides a home or support to a dependent. Certain tie-breaker rules apply in certain cases, but these can vary depending on the situation. It’s a good idea to seek professional advice when a dependent may potentially be claimed by more than one person.

8. “What if somebody claimed my dependent who was not legally allowed to do so?” This question is, unfortunately, far too common. Many people attempt to e-file their tax return, but get an error message indicating a dependent on the return has already been claimed. Usually it’s a case where an authorized person, such as a parent who is no longer in the picture, has filed a return claiming the dependent. Unfortunately, when this happens, the person who has the legal right to claim the dependent will have to file their return by mailing a paper copy. The SSN has already been “used” in the IRS e-file system and can’t be used again. The IRS will process the paper return, and frequently process a refund when it is present, but then both parties who claimed the dependent will receive letters from the IRS demanding proof that the child is actually a dependent. It will take some time, but the situation will get sorted out by the IRS…and the person who wrongfully claimed the dependent will have a lot of problems.


California and the IRS want to buy you an electric car

January 8, 2011

Did you know you can receive up to $12,500 from the IRS and California FTB if you buy a qualifying electric vehicle?

The IRS currently offers a tax credit of up to $7,500 for qualifying electric and plug-in hybrid vehicles. Details about what purchases qualify and for how much can be found at this website: http://www.fueleconomy.gov/feg/taxcenter.shtml. (Note that many of the credits discussed at this page for hybrids and other alternative fuel vehicles ended Dec. 31, 2010.)

California is willing to throw in another $5,000 for purchases of qualifying vehicles. Of course, the list of qualifying vehicles and steps you must take to claim the credit are not the same for California and Federal purposes, so you’ll have to do your research and fill out various forms twice. But $12,500 isn’t a bad return for jumping through some bureaucratic hoops. Details on the California credit can be found here: https://energycenter.org/index.php/incentive-programs/clean-vehicle-rebate-project. It should be noted that the credit in California is only available on a first-come-first-served basis until the funding runs out. You must apply for the credit after you’ve purchased your vehicle (but before filing your tax return…way before), so you’ll probably need to purchase your vehicle and apply for the credit early in the year.

This raises the question in my mind as to whether the government should be offering so much money to people who buy electric vehicles. Don’t get me wrong, I think anybody who qualifies for these credits should claim anything they’re eligible for. But in the big picture, is this good policy? Considering the high sticker price on many electric cars (especially the Tesla Roadster, which can run into six figures!), I’m guessing the typical electric car buyer is probably fairly affluent. Does this represent an unfair benefit to those who are already doing better financially than most Americans? And there’s the question of whether it’s a good idea for the government to distort the market by offering these additional incentives. The argument is often made whenever the government subsidizes something that products that can’t support themselves without subsidies shouldn’t be produced.

On the other hand, there is a long history in America and most developed nations of government providing support for new technologies to get these things off the ground. For example, the first computers cost a fortune, were hideously slow by modern standards, and probably wouldn’t exist without government buying them up for various defense applications and storing massive volumes of data that only government needed to deal with. Countless other technologies such as the Internet, satellites (for both communications and GPS), and even radio communication probably wouldn’t exist, or would exist in far more rudimentary form, if government hadn’t provided considerable subsidies for these products early on. If America doesn’t provide subsidies for new technologies to meet our transportation needs, undoubtedly other countries will support these technologies at the government level. If these technologies experience the same success as computers, satellites, and other major technologies, America will have a lot of catching up to do.

So what do you think? Does it make sense to provide these large subsidies to electric vehicles? (This is my first poll in WordPress…we’ll see how this goes.)


Tax Filing Deadline Extended…Some Taxpayers Must Wait to File

January 5, 2011

The normal tax filing deadline falls a little later than usual this year. Because April 15 falls on a Friday that happens to be a holiday in some states, the IRS has extended the deadline to the next business day, April 18. Of course, extensions until mid-October are easy to obtain…and for many people it makes more sense to file on extension. I’ll post something in March explaining why it often makes sense to NOT file by the normal deadline.

On the other side of the coin, some individuals MUST wait to file until mid-February. As a result of tax law updates made very late in the year — the final bill modifying the 2010 tax law wasn’t passed until December 17 — some taxpayers will have to wait longer than usual before filing their returns. An IRS release outlining who is affected is quoted below. The largest group impacted will be people who itemize their tax deductions–generally, this is people who have mortgages, and some other groups with large deductible expenses. These individuals and others affected by the late changes will have to wait until mid- to late-February before the IRS will accept their returns.

Some taxpayers – including those who itemize deductions on Form 1040 Schedule A – will need to wait to file. This includes taxpayers impacted by any of three tax provisions that expired at the end of 2009 and were renewed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act Of 2010 enacted Dec. 17. Those who need to wait to file include:

  • Taxpayers Claiming Itemized Deductions on Schedule A. Itemized deductions include mortgage interest, charitable deductions, medical and dental expenses as well as state and local taxes (add link to Schedule A). In addition, itemized deductions include the state and local general sales tax deduction that was also extended and which primarily benefits people living in areas without state and local income taxes. Because of late Congressional action to enact tax law changes, anyone who itemizes and files a Schedule A will need to wait to file until mid- to late February.
  • Taxpayers Claiming the Higher Education Tuition and Fees Deduction. This deduction for parents and students – covering up to $4,000 of tuition and fees paid to a post-secondary institution – is claimed on Form 8917. However, the IRS emphasized that there will be no delays for millions of parents and students who claim other education credits, including the American Opportunity Tax Credit extended last month and the Lifetime Learning Credit.
  • Taxpayers Claiming the Educator Expense Deduction. This deduction is for kindergarten through grade 12 educators with out-of-pocket classroom expenses of up to $250. The educator expense deduction is claimed on Form 1040, Line 23 and Form 1040A, Line 16

 


Eager to get that big tax refund? Don’t be.

January 3, 2011

The new year typically brings a barrage of advertisements from tax chains claiming to get you your tax refund FAST, FAST, FAST! One week, next day, and even same-day refunds are promised…for a price. If you typically get a big tax refund, or are expecting one this year, it might be tempting to rush out TODAY and get your refund. But it’s usually a bad idea for a couple reasons.

  • Same-day and next day refund loans always charge hefty fees…in most cases well over 100% when looked at on an annual basis. E-filing your return and having your refund direct deposited typically results in receiving your refund in under two weeks. Unless you absolutely can’t live without your refund for a couple weeks, and can’t find any other way to access money, paying to get your refund a little sooner is usually a terrible deal.
  • Tax returns filed in January are far more likely to contain errors. Tax law is frequently not finalized until the very end of the tax year…sometimes even later. This leaves tax software companies scrambling to make sure everything works. Virtually every year there are several errors in popular tax programs that affect large numbers of people. This means you may have to deal with the hassle of amending later…or worse, never find out you missed a deduction or credit that could have saved you a lot of money.

You’re generally much better off waiting until at least the beginning of February to file your return, unless your return is very simple. But your best move is to make sure you do NOT get a big refund each year. That’s right, a big refund is something to avoid!

When you receive a large refund, that means you’ve given the government too much money during the previous year. In essence, you’ve given the government a loan, and you’re going to get the money back a year later without interest.

Instead of rushing out to get your refund as fast as possible, what you should actually do is plan ahead and adjust your withholding (“withholding” is what you pay to the government out of each paycheck). If you withhold the right amount through the year, you’ll make more money all year long. Rather than waiting to get a refund sometime after the end of the year, you’ll keep more of your hard-earned money when you earn it. Then you can have the extra money direct-deposited in a savings account throughout the year, and you’ll have access to it when you need it…instead of having to wait to file a return and pay fat fees for a refund loan.

If you’re somewhat savvy about taxes and your finances, you can use online tools to find out how to complete your W4 with your employer so you have the right amount withheld. One of the best tools is actually the Withholding Calculator available at the IRS website. Of course, if you’re not a numbers person, or you just have an unusually complex situation, you can always enlist the help of a good preparer. If your current tax preparer doesn’t offer to provide this service as part of preparing your tax return, then you should ask for it…or maybe shop around.