Are you dreaming of kicking your job to the curb and becoming self-employed? Well, you might benefit from doing so.
There are a lot of perks that come with managing your own business. You’ll be able to determine your own working hours, and there is no limit on the amount of income you can earn.
However, being your own boss comes with a few challenges too. For one, you’ll be responsible for handling your tax affairs yourself. As a self-employed individual, you are generally liable to pay self-employment tax (SE tax) as well as income tax.
To ensure smooth sailing when it comes to filing and paying your taxes, you should familiarize yourself with the tax pitfalls that independent businesspeople often fall into. Below is a list of common self-employment tax traps you should avoid:
1. Failing to file a return
Whether it’s intentional or otherwise, not filing mandatory returns is a serious matter. Defaulters often end up facing penalties in the shape of bank levies, fines, and even imprisonment.
This is why you need to familiarize yourself with the filing requirements for self-employed individuals. As a self-employed individual, you are required by law to file an income tax return if your net income is $400 or more.
To calculate your net income, simply deduct your business expenses from your business earnings. If your net income is less than $400, you don’t need to file an income tax return unless you meet any other filing requirements as determined by the IRS.
2. Failing to report all income
Don’t think that the IRS has too much on its plate to notice if you don’t report all of your earnings. The IRS requires you to report any and all forms of income, even if some of it comes from a hobby.
The IRS uses special software called the Discriminant Inventory Function (DIF) system to monitor all returns for inconsistencies. If, for example, the ratio between the deductions you list on your Schedule C and the amount of income on your tax return looks suspicious, the IRS will investigate the reason behind this.
If you have a small business, there are various free bookkeeping tools you can use to keep track of your income and expenses, such as Wave.
3. Overstating or understating deductions
Many small business owners make the mistake of either listing too many deductions on their Schedule C, or not taking advantage of some valid deductions such as office supplies. Here are a few lawful write-offs you can include when filing your own taxes:
- Home office: Be careful of this one, as the IRS has a few restrictions on what counts as a home office. They have two basic requirements: It should be used regularly and exclusively for business, and it should be the principal place of your business. There are special formulas for calculating how much you can deduct, based on the square footage of your home office in relation to your entire home.
- Health insurance premiums: As a self-employed individual, you are responsible for paying your own health insurance premiums if you do not qualify for a plan through your spouse’s employer. These premiums qualify as valid deductions, and you may include them on your Schedule C.
- Business meals: Though you can’t deduct meal expenses for the lunch you eat alone at home, you can deduct 50% of meal expenses when you are traveling for business or meeting with a client. The only catch is that the meal may not be extravagant, and you need to either keep your receipts as proof, or keep accurate records of the time, place, and purpose of the meeting/travel.
- Marketing expenses: If you pay to advertise your business, you can legally deduct these costs on your Schedule C. Examples of paid advertising include Facebook ads, your website, and even printed signs or flyers that promote your business.
4. Hiring tax preparers that are not proficient in self-employed taxes
When hiring a professional to prepare your taxes for you, you should properly research them to determine whether they have experience in filing self-employed taxes.
Self-employed taxes are a whole different ball game than regular taxes, and not understanding the ins and outs correctly may result in heavy penalties from the IRS or other problems that could have been avoided.
5. Not paying enough estimated taxes
Staying up to date with your taxes is so much easier when your employer deducts it from your monthly salary and pays it directly to the IRS on your behalf. When you are self-employed, the IRS requires that you pay estimated taxes every quarter.
If you don’t pay enough estimated taxes throughout the year, you may come up short at the end of the financial year and be subject to penalties.
As a self-employed individual, you should calculate the amount of estimated taxes based on the amount of income you receive.
6. Mixing business with pleasure
Using your business account to take care of personal expenses is a big no-no. Not only does it make it difficult to keep track of business transactions for the calculation of taxes, it can also put you at a legal disadvantage in the event of your business getting sued. It’s best if you create a different account for personal use, and never mix the two.
As a self-employed individual, you will enjoy many freedoms and possibilities, but you will also carry many responsibilities on your shoulders. To be successful, you need to be self-motivated, self-disciplined, and highly organized. You’ll need to implement sufficient recordkeeping measures to stay on top of your taxes and ensure that Uncle Sam doesn’t come after you with his arsenal of harsh penalties.