Working for Yourself or Working to Pay Taxes?

Are you self-employed? According to the IRS you are classified as self-employed if one of these three situations apply to you:

  1. “You carry on a trade or business as a sole proprietor or an independent contractor”

  2. “You are a member of a partnership that carries on a trade or business

“You are otherwise in business for yourself (including a part-time business)” (Self-Employed Individuals Tax Center, 2017)

So what is the big deal about being considered self-employed? Self-employed individuals, apart from being taxed at their individual income tax rate, also have an additional tax of 15.3% of their net profit from their business. That’s a big deal!

The net profit or net loss from a business is calculated by subtracting the business expenses from the business income. If the expenses are more than the income then the business has a net loss and there is no self-employment tax. If the expenses are less than the income then the business has a net profit and that profit will be subject to the self-employment tax of 15.3%.

Here is a simple example of how the net profit or loss would be calculated:

Let’s say that Fred owns a sole proprietor lawn care business. In 2016 Fred was paid $50,000 by customers. In 2016 Fred paid $1,000 for advertising on the radio, $15,000 to two employees, $500 for bookkeeping fees, $2,000 for repairs, $1,000 for supplies, and $1,148 for payroll taxes. Fred also paid $7,000 for expenses related to the company truck (fuel, maintenance, and insurance) and the company truck was driven 20,000 miles for work.

$50,000 Income

-$1,000 Advertising

-$15,000 Wages

-$500 bookkeeping fees

-$2,000 repairs

-$1,000 supplies

-$1,148 payroll taxes

-$7,000 truck expenses

=$22,352 Net Profit

So how will Fred’s net profit be taxed? If Fred is in the 15% federal income tax bracket the estimated tax will be $3,353 for federal taxes and $3,158 for self-employment taxes.

How could Fred have reduced the amount of self-employment tax he owed? One way would be to make sure all applicable deductions are being utilized. In Fred’s case he could have used the standard mileage rate ($.54 per mile for 2016) for a deduction of $10,800 (20,000 miles X .54) instead of actual truck expenses of $7,000. If Fred has a child under age 18 he could potentially take advantage of favorable rules regarding paying qualifying children. Other possible deductions Fred may have missed could include the home office deduction, depreciation on equipment, the fuel tax credit, and other local incentives.

Another way Fred could save a significant amount on self-employment taxes would be to change the entity type of the business. If Fred were married he could potentially structure a partnership LLC with his wife that could save him up to 50% on self-employment taxes every year! Another entity type that could save him a significant amount is the S-corporation.

There are pros and cons to each type of entity structure available. It always pays to consult a professional when making this kind of decision. At Davis & Bott CPA’s we specialize in helping you start your business in the most advantageous way, improve your current tax situation, and plan for the future to help you reach your goals. Give us a call and let us help you get your business on the fast track to reduced taxes and greater success!

Self-Employed Individuals Tax Center. (2017, June 30). Retrieved from www.irs.gov: https://www.irs.gov/individuals/self-employed

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