Navigating Self-Employment Tax for Your Small Business

Oct 2

This article is for informative purposes only and should not replace seeking tax assistance and advice from a professional.

In our digital age, we have all the information we could ever want at our fingertips. This can be both a blessing and a curse. And when it comes to tax information, I've found that it feels mostly like a curse because it gets so confusing, so contradictory, and (understandably) most people refrain from making any definitive statements because taxes are so finicky—where you live, how much you make, what kind of work you do, what kinds of exemptions or special exceptions you can claim—all these things can influence how taxes work for you. It's overwhelming. I don't know why we don't all pay people to do our taxes. I don't know why I don't pay someone to do my taxes.

I've always done my own taxes, mostly by hand but sometimes using free programs. And when I first did some freelance work, I thought, “wow this complicates it so much!” But then I got used to the one extra form and realized it didn't change much about my tax experience. And the IRS never said I was doing anything wrong or owed them anything. (Just a note here: you are required to file a tax return if you earn $400 or more from your business.)

In the course of researching and writing “Empower Your Small Business For Tax Season,” I stumbled upon self-employment tax. Despite being a freelancer for upward of 10 years, self-employment tax was never on my radar. This was because I barely made any money off of it, not because I had malicious or criminal intent.

The more I researched, the more confused I became. It was clear that, as a small business owner/sole proprietor I am responsible for paying my share of medicare and social security taxes from my business income, which I hadn't known before. Any federal and state taxes I owed had always been small enough that withholdings from other W-2s covered it. I knew that for the 2022 tax year, I was going to owe for the medicare and social security portion, a whopping 15.3 percent of my freelance income.

And then I started reading about quarterly estimated payments. And how, in general, if a small business or sole proprietor is estimated to owe $1,000 or more, they are required to make quarterly payments. Naturally, when I calculated my tax liability for my freelance earnings it was just a little over $1,000 and I had been blissfully unaware of quarterly payments. So now, in addition to knowing I was going to owe instead of get a return, I had the delightful anxiety of wondering, am I going to be penalized for not making quarterly payments?

The more I looked into self-employment tax, the more it became clear that I needed to consult with a tax professional, if nothing else to get some clarity on my situation and how to do it right for the next year. So I scheduled an appointment with my local tax practitioner, Lori Stahl at Tip Top Tax.

Estimating Tax Payments

When it comes to estimated payments of self-employment tax, you've got two options for the 1040ES form: you can fill out the worksheet and submit it to the IRS with your tax return. This option locks you in to the estimated payments you list, regardless of income fluctuation or changes throughout the year. If you overpay, you get it back when you file your return the following year. Or, you can estimate payments each quarter based on your actual earnings and pay accordingly. This, Stahl told me, is ideal for my kind of work, because if my income varies quarter to quarter for any reason, I'm not stuck paying more than necessary or underpaying on my taxes.

Armed with this knowledge, I enthusiastically embarked on estimating my quarterly tax payments. Which was fine, except that the 1040ES felt way more complicated than an individual tax return. After revisiting it a couple different times, I finally gave up on using the fancy worksheet and decided to go with a simpler option (disclaimer: this route may result in me overpaying each quarter, but it's worth it to me for the ease of process).

I calculated how much I anticipated making during the quarter.

Next, I calculated my business expenses, including reviewing my phone and Internet use to calculate a reasonable percent of those bills that can be claimed as business expenses.

Then I subtracted the total business expenses from my income to come up with an adjusted income.

Finally, to come up with my estimated payment I multiplied the adjusted income by 15.3 percent (0.153) to get my self-employment tax payment. I also multiplied my income by 10 percent (0.1) to cover anticipated federal taxes.

This is by no means the most exact way to calculate your estimated tax payments. If you're able to hire a tax professional to do this for you, I recommend that you do.

Covering Tax Liability Through Other Withholdings

If you work another job that already takes out taxes on your behalf (or if you have a spouse who does), you do have the option of updating the W-4 to take out more in order to cover your federal and state tax liability. For some small business owners, this might be a good option. But just like the estimated tax payments, it's not great for everyone because it locks in the withholdings regardless of the income your business earns.

When I asked Stahl if I should have my husband's employer withhold enough to cover my federal and state taxes, she told me that, with the fluctuating nature of my work, she wouldn't advise it. If for any reason I entered a period where I was earning significantly less (or earning nothing at all), we'd be paying more in taxes unnecessarily.

So, while this is an option, it's one you probably only want to consider if your small business income is stable and consistent. And even then, you'll still have to calculate your self-employment tax percentages, so including federal and applicable state taxes may not be much more of a hassle.

Making Estimated Self-Employment Tax Payments

It's your responsibility as a small business owner/sole proprietor to keep a record of the payments you've submitted. The easiest way to do this, Stahl said, is to make an account through the IRS and make your payments online. This creates a digital record of your payments. Otherwise, if snail mail is preferable to you for any reason, you'll need to keep copies of your payment documents to prove, come tax time, that you did in fact make your payments. The 1040ES package includes a table you can use to keep track of your payments.

As a small business owner, there may be times where you miss a payment for one reason or another. This can lead to additional penalties, so you want to be as on-top of payments as possible. If you do miss a payment, pay as soon as possible, even if it is just a portion. Your outstanding balance and any penalties accrued will also gain interest, so you don't want to put off payments unless you absolutely have to.

Calculating Small Business Expenses

Business expenses serve a purpose secondary to getting a little more back on your return—one of establishing legitimacy. For me, I have a couple clients who have to provide me with 1099 independent contractor forms, so those serve as proof that I do in fact have a business income versus just a hobby income (we'll discuss this below).

Without these forms, however, proof of expenses can help establish the legitimacy of a business. If you have a business that doesn't generate tax documents but is used to claim different credits and/or write-offs, the IRS may choose to audit you to see if it really is a small business or a hobby. Stahl's advice is: if you have an expense, list it, even if it's something small.

Claiming expenses for a small business is a mixed bag. Some things are obvious, like office supplies, rent for a designated office space, and the utilities to keep your office space functioning. But for me, working out of my own home, I usually list my expenses as zero. After all, everything I use serves a double purpose and, once again, it gets confusing trying to understand what I can claim and what I can't.

Any supplies I buy for my work—paper, notebooks, pens, etc—are clearly work expenses.

But Stahl told me I can also calculate the portion of my Internet and phone bills that represent my work and claim those as business expenses. They may be only small percentages of my overall bills, but every little bit helps.

Differentiating Between a Hobby and a Small Business

Many small business owners and sole proprietors may find that what started as a hobby has grown into something more, which can lead them to wonder, do I have to report my earnings to the IRS?

Understanding when a hobby becomes a business can be difficult because, like most things tax-related, it can depend on different factors.

At it's most basic, something is considered a business if you participate with the intent to make money. So if you start selling baked goods, knitted clothes, or screen-printed tees with the intent of adding a little extra to your income, you should consider it a business. Additionally, the consistency and regularity with which you perform your activity weighs into whether it is a business or a hobby.

Why Does it Matter?

You may wonder why it matters if you run a small business or are just engaged in a hobby. The answer, of course, is taxes. Let's take a quick look.

If you are engaged in a not-for-profit hobby, you are still required to report that income on your annual tax return. Your expenses for this hobby are not eligible for deduction.

If you are running a small business you are also required to report your income on your annual tax return. However, your business expenses can be used as deductions. These expenses help to offset your income, thereby lowering the tax you owe.

The IRS uses nine questions to help determine if something is a hobby or a small business.

Is the activity carried out in a businesslike manner, with accurate books and records?
Does the time and effort input show an intention to make a profit?
Does the person depend on the income as part of their livelihood?
Are any losses outside the person's control or are they normal startup losses?
Has the person made any changes to operation to increase profits?
Does the person and any advisors have the knowledge necessary for a small business?
Has the person successfully made a profit from similar activities in the past?
Has the person made a profit in the past and how much?
Can the person expect to make a future profit from appreciation of assets?

If you need more time to prove that you are running a small business and not just participating in a hobby, you can file Form 5213 with the IRS to postpone a determination for three years. The IRS may audit and change a determination if it has concerns over whether an activity is properly classified, but determinations are always made on a case-by-case basis.

Navigating small business taxes and self-employment taxes can be overwhelming, to say the very least. If you can afford to hire a professional to assist you with the process, you should certainly at least consider it. If you can't, make sure you start your processes very early to give yourself ample time to wade through all the information out there.

Taxes can feel unforgiving, but the resources are out there to empower your small business for success.

Alisa O'Donnell