What is it?
According to the IRS, you are self-employed if you carry on a trade or business as a sole proprietor, as an independent contractor, as a member of a partnership, or if you are otherwise in business for yourself. You can be a full-time employee and still have self-employment income from a side job. To determine whether particular income is self-employment income (rather than employee wages, for example), you should look at the source of your income and the extent of your involvement in the activity. For more information, see Self-Employment Income.
If you are self-employed, you should understand the self-employment tax. You should also be aware of certain tax planning opportunities.
You must pay self-employment tax if you have more than a minimal amount of self-employment income. If you file a Schedule C as a sole proprietor, independent contractor, or statutory nonemployee, the income listed on your Schedule C is self-employment income and must be included on Schedule SE, which is filed with your Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed. Self-employment tax is used by the federal government to fund Social Security and Medicare benefits.
The self-employment tax rate on net earnings is 15.3 percent (with 12.4 percent of this rate going to Social Security and 2.9 percent allotted to Medicare). All net earnings from self-employment in excess of $400 are subject to the Medicare portion of the self-employment tax. However, the Social Security portion of the self-employment tax applies only to net earnings from self-employment in excess of $400, up to and including $102,000 in 2008 ($97,500 in 2007). (The maximum is reduced if you have income from sources other than self-employment that has been subject to Social Security tax.) See Self-Employment Tax.
Employees generally have income tax, Social Security tax, and Medicare tax withheld from their paychecks. If you are self-employed, it is likely that no one is withholding federal and state taxes from your paychecks. Therefore, you should make estimated tax payments on your own to cover your federal income tax and self-employment tax liability. This will help you to avoid liability for penalties, interest, and substantial tax bills at the end of the year. For more information, see Estimated Tax Payments.
As a self-employed individual, you have a number of income tax planning opportunities, some of which are not available to employees. This discussion provides a brief overview of some of the tax planning opportunities you may wish to consider.
Shifting income/timing income
Shifting income to family members can be an important tax planning technique. If you run your own business, your ability to shift income to a family member who is in a lower marginal tax bracket can be a significant advantage. Your relative may benefit from the increased income, and you may benefit by the decreased tax liability. In addition, it's possible that the overall amount of federal income taxes paid by the two of you would be lower. However, be aware that the IRS could question compensation paid to a family member unless the compensation was reasonable in amount, considering the services actually provided by the family member.
As a self-employed taxpayer, you also have greater control and flexibility regarding timing the receipt of your income. This means that you have more control regarding when you pay tax on the income. For more information, see Shifting Income/Timing Income.
Establishing a retirement plan is another tax planning advantage for the self-employed. If you are self-employed and have no employees, a qualified retirement plan (such as a Keogh) may allow you to place pretax dollars into a retirement account to grow tax deferred until withdrawal. If you have employees, your business may have to provide coverage for them as well. The type of retirement plan that your business should establish depends on your specific circumstances. For more information, see Retirement Plans Most Appropriate for Self-Employed/Sole Proprietorship/Partnership.
Other benefit plans
Aside from retirement plans, there are certain other employee benefit plans--such as cafeteria plans and medical benefit plans--that are really intended to benefit your employees. Nevertheless, you may wish to have your business establish one or more such plans. Employee benefit plans play an important role in attracting and retaining employees. In addition, sole proprietors may derive certain limited benefits under these plans. See Benefit Plans That Apply.
Business expenses and other deductions
Verify that your business is taking advantage of all of the deductions to which it is entitled, including deductions for certain start-up costs. For instance, did you know that you may be able to deduct a portion of the expenses for a business trip even when the trip is combined with vacation? (For more information, see Business-Vacation Expenses.) While our discussions on deductions aren't exhaustive, we've tried to pick out some key items that you should consider, including the use of a home office, automobiles, and business assets.
One major area of concern for many self-employed individuals is the high cost of health insurance. Fortunately, some of your health-care related expenses may be tax deductible. For instance, you may be eligible for the self-employed health insurance deduction, which would enable you to deduct the cost of health insurance that you provide for yourself, your spouse, and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., "above-the-line") when computing your adjusted gross income, so it's available whether you itemize or not.
Contributions you make to a health savings account (HSA) are also deductible "above-the-line." An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside tax-free funds for health-care expenses.
Sometimes it is unclear whether you are engaged in a trade or business or whether you are merely deriving occasional income from a hobby. Although income generated from a trade or business activity is taxable, losses from such an activity are generally fully deductible. For this reason, taxpayers sometimes try to classify a hobby as a trade or business. Consequently, the IRS closely scrutinizes purported trade or business activities that regularly show losses. If your business consistently shows a loss, you should be aware of the IRS's rules for classifying activities as hobbies.
Copyright 2008 Forefield,Inc. All Rights Reserved
This article is for informational purposes
only and not intended as financial advice. Consult your financial
advisor to determine what is appropriate for your situation.
Past performance is no guarantee of future results.
If you have any comments, questions or suggestions concerning this
electronic newsletter, please email us at firstname.lastname@example.org.
here if you do not want to continue receiving Fragasso Financial Advisors
Visit Our Web site:
A REGISTERED INVESTMENT ADVISOR
The Retirement Planning and Wealth Preservation Specialists Since
610 Smithfield Street, Suite 400, Pittsburgh, PA 15222
Phone 412.227.3200, Fax 412.227.3210, Toll Free 1.800.900.4492
Fee-based investment management and securities offered through LPL Financial
©2008 The Fragasso Group, Inc., All Rights