Profits and Pitfalls of Self-Employment

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Subcontractor Sole Proprietor Contract Worker Independent Contractor

It does not matter what you call it. All these terms refer to self-employed individuals who earn a living under their own direction and control without creating a separate business entity. In the internal revenue service’s ideal world, everyone would be an employee of someone else’s traditional corporation. We would not have these “messy” partnerships, LLCS, s corporations and, worst of all IRS nightmares, sole proprietorships. Employees tend to report all of their income. And, most of the time, business expenses paid by employees do not generate any tax savings. Employee status makes life easier for the IRS.

The IRS spends a lot of time and energy evaluating and pursuing self-employed individuals and the companies that hire them. In many cases, the pursuit is justified. There are actual and perceived abuses in the reporting of income and deductions by self-employed individuals. For example:

John Smith, who shows up every day at the same place, gets his paycheck on Friday and does what Jane Doe, the boss, tells him while using the company’s equipment, is not self-employed as defined under IRS guidelines. However, Jane’s company would love it if john could be treated as if he were self-employed. Her company would not have to pay half of john’s social security and Medicare taxes nor offer him the employee benefits that her other employees receive.

If he could be treated as self-employed, however, John might get a nasty surprise at tax time when he realizes that in addition to his income tax, he has to pay 12.6 percent for social security tax on the first $109,000 he earned plus another 2.9 percent for Medicare tax on everything he earned. on top of that, john has to pay his taxes in quarterly installments known as estimated tax payments. And, the quarterly ending dates do not even fall on real calendar quarters! If Joe fails to make timely or accurate payments based on IRS rules, he will also get to pay a penalty for underpayment.

Sam Smart also works for Jane’s company, but he was hired to provide a specific service that he is also allowed and expected to offer to other companies. It can be regular and ongoing; he can even get paid every Friday. But Sam has to control the work process, provide his own equipment, hire and train his assistants, and have an economic risk of loss.

The determination of whether a person is an employee or a self-employed person is of immense interest to the IRS. It is currently staffing an initiative for the purpose of determining the employment status of individuals who received forms 1099-misc that reported nonemployee compensation. The initiative will conduct selective audits of companies that issued forms 1099- misc in 2007, 2008 and 2009.

Now why is the IRS so focused on self-employed taxpayers? Tax benefits, of course!

Self-employed taxpayers operating as a sole proprietorship:

  1. Can deduct their business expenses directly from their business income. This could include the business use portion of a home office and a personal vehicle. Net losses of the business are deductible directly against other taxable income..
  2. Pay Social Security and Medicare taxes on the net amount of their earnings after deducting business expenses.
  3. Can set up a retirement plan for the business and deduct the amount contributed. The deductible contribution limits are significantly higher than a traditional IRA and are not limited by adjusted gross income or marital status. The contribution can be made as late as October 15 of the following year and still be deducted on the prior year’s tax
return.
  4. Can deduct health insurance premiums for themselves and their families, including long-term care insurance
premiums, without regard to the itemized deduction limit on other medical expenses.
  5. Can hire their children under age 18 and pay no payroll taxes on the child’s wages. The wages paid might escape
the “Kiddie Tax” by being taxed at the child’s lower rate. The child may also be eligible to contribute to a deductible
IRA.
  6. Can later elect to convert to another form of entity, generally without incurring tax on the transaction.
  7. Do not have to file a separate tax return for the business.
  8. Are not subject to Texas Franchise tax registration, filing of returns or payment of tax.
  9. Avoid double taxation on the gain from the sale of the business.
  10. Can rely on simplified bookkeeping records.

Since the net income of the business is included on the individual’s personal income tax return, their filing status, number of dependents, and other income, deductions and credits affect the amount of tax owed on the business net income. the combined amount of income tax and self-employment tax that a self-employed person owes is usually payable in four quarterly estimated tax payments that are due by April 15, June 15, and September 15 of the current year, and January 15 of the following year. the calculation of the correct amount to pay each quarter can be complex. As a rule of thumb, the business owner should set aside 25 to 40 percent of net income (income less deductible expenses). For the record, payments to owners are not deductible in arriving at net income. To assure avoidance of underpayment penalties, your cPa should be consulted regarding the calculation of estimated tax payments.

Because the business of sole proprietors is not a separate legal entity, the owner bears the full risk of losses, lawsuits and defaults. This is why many owners choose to operate under a separate legal entity that offers liability protection, such as a corporation or limited liability company (LLC).

An LLC owner is considered to be self-employed and the LLC entity offers many of the same tax benefits. The LLC can be considered a disregarded entity if it has only one owner. This means that it does not have to file a separate tax return, but it is subject to Texas Franchise tax filing,

A corporation owner/worker is considered a shareholder and is usually an officer and an employee of the corporation. as such, they are not self-employed, but there may be other advantages in being a corporate business and an employee.

Choosing your business entity is one of the most important choices a business owner makes. It can have lasting financial consequences, even beyond the death of the owner. A detailed entity selection discussion is beyond the scope of this article. Before starting the business, decisions regarding entity choice should be discussed with your CPA and your attorney.

©Copyright 2010 Janet C. Hagy
Janet is a shareholder in Hagy & associates, PC, Certified Public accountants, a CPA firm that has offered tax planning and compliance services to individuals and small businesses in Austin for more than 30 years.

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