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

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

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