Working for yourself is the American dream, right? There’s no demanding supervisor hovering over you, you can set your own hours, and — if you choose to work from home — you never have to contend with a grueling commute or even putting your shoes on some days.
However, despite the very American ideal of having the independence to be your own boss, there’s also the necessity of paying your dues to Uncle Sam. And for many people who decide to become self-employed, the issue of taxes can be a bit scary.
Dealing with taxes is difficult enough when you have a full-time job and have to deal with a W-2 each year. After all, you need to either file it yourself or hire a tax accountant.
But if you work for yourself, not only are you responsible for doing all of the tax paperwork that a company generally handles for its employees, but you don’t have the “luxury” of automatically having your estimated owed share withheld from your paycheck. You need to figure out how to save it on your own. Plus, you could get hit with a larger-than-expected tax bill thanks to the self-employment tax rate of 12.4% for Social Security and 2.9% for Medicare.
I Lowered My Tax Obligation
Although this seems terrifying and complicated, it’s doable. I should know — about a year and a half ago, I quit my full-time job to become a freelance writer and speaker.
I found that “complicated” doesn’t necessarily mean bad. In fact, self-employed workers can have more options for deductions. This means a lower tax obligation.
I made some significant changes to my business to save on taxes while staying compliant with the law. The biggest change was a shift from an LLC (limited liability company) to an S corporation. This limits my paying self-employment tax and can eventually save me an estimated $12,500 per year! But that isn’t the only change that can save you money on taxes while self-employed.
If you want to save time and money on taxes, here are some tips I’ve picked up along the way.
Do Some Bookkeeping
I’m a stickler for organization, receipt tracking and ensuring I can write off every possible dollar to legally lower my tax bill. Much of what helps me keep my taxes under control is just staying on top of things. Whether you handle your own books or prefer to hire a professional bookkeeper or accountant, it is vital to keep your books up to date so you have the best information about your business at your fingertips.
All business owners should keep their business finances separated from their personal finances for some legal and tax benefits. One often-overlooked benefit of separate finances is better information on your business. Separate, up-to-date books let you quickly glance at accounting reports to assess your business health and profitability.
Having your books up to date also makes tax filings much faster and easier. Whether it is time to send in your quarterly estimated taxes or your annual filing, up-to-date books mean you can print out the reports you need to easily get your taxes done.
Self-Employed Business Deductions
Keeping your books up to date can save you money on accountant costs, but it doesn’t do anything to directly lower your taxes. However, keeping track of every single business-related expense can help you lower your taxes.
When you run a business, you can deduct direct business expenses from your business revenue to lower your taxes. Taxes are paid on your business profit, not revenue. Capturing every possible expense will lower your taxes by about 25% of the value of the expense, depending on your tax bracket and business structure.
Some of the most common places you can find deductions for your small business include:
- Product supplies
- Business related travel
- Office supplies
- Computer equipment
- Internet and phone costs related to business (my business is online, so most of my costs are related to website hosting, online services, internet connections and computer equipment)
The big catch with taking business deductions is that you have to be profitable. If your business consistently loses money, the IRS considers it a hobby, not a business. There are some limitations to deductions for meals and other expenses. If in doubt, consult a tax professional.
You can read more about deductions — including ones you may not have thought of, such as expenses related to searching for jobs and clients — in this article.
And if you’re not a particularly organized person, there is a service called Shoeboxed that can help you digitize, store and keep track of your receipts. (Read our review here.)
Review Your Business Structure
The next place to look when considering tax saving strategies is your business structure. By default, every business starts as a sole proprietorship unless you register it as another form of business. For small side hustles, that is just fine. But as your business grows, you may want to consider registering as an LLC or an S corporation for legal and tax reasons.
When you operate as a sole proprietor, your business and personal finances are legally treated as one. All income you earn through the business is taxed at your ordinary income tax rate plus self-employment tax. (Self-employment tax is simply both halves of Social Security and Medicare taxes, the half normally paid by you if you have a full-time job and the other half paid by your employer.) If there is a legal dispute regarding your sole proprietorship business, you are personally liable.
An LLC is the next step in protecting yourself. Taxes are the same as with a sole proprietorship, but an LLC offers personal legal protection in the event your business is sued. In this case, taxes are treated as a pass-through, and your business does not have to file its own tax return. You just append a Schedule C to your personal taxes and everything is taken care of.
Once your business reaches around $30,000 to $40,000 in annual profit, you may be able to lower your self-employment taxes through S corp taxation. You have two options to get taxed as an S corp. First, an existing LLC can opt in to S corp taxation. Second, you can simply register your business as an S corp. But this works only if your business is in a position to pay you a regular paycheck.
Pay Yourself a Regular Salary
Both self-employed and full-time workers are subject to multiple layers of taxes. When you have a full-time job, you pay a portion of your taxes and your employer matches some of those taxes in an additional payment to the IRS. When you are self-employed, you have to pay both portions of the taxes.
Here’s where the S corp taxation kicks in. For your regular salary, taxes are the same as if you had a full-time job. The business pays some of the taxes and you pay some. But for profit above what you are paid, there is no Social Security or self-employment tax. This profit is paid to you as a distribution and is taxed at your regular income tax rate, without any Social Security or self-employment tax.
To make this work, the IRS requires you pay yourself a “reasonable” salary, which is subject to both sides of the tax equation. This is why S corp taxation starts to make sense only around that $30,000 to $40,000 range. That is a reasonable salary for many workers around the country.
I use a payroll service to pay myself a weekly salary, and the payroll provider takes care of my payroll taxes. At the end of the year, I get a W-2, additional forms for my S corp’s 1120S tax filing and a Schedule K-1 form to add to my personal tax return for business profits. In 2016, I saved about $5,000 on my taxes by filing as an S corp. The more the business earns, the more I’ll save.
Don’t Mess Up on Taxes
Taxes are a part of earning money, but you should never pay more than you truly owe. You should do everything you can to legally lower your tax bill. Large companies do it, the super wealthy do it, and you can do it too.
Just make sure you always keep good records and stay on the right side of the law. Cheating on taxes can land you big penalties and interest and even jail time, so make sure you do everything aboveboard and consult with a professional when in doubt.
But if you follow legal strategies like tracking your deductions and filing taxes as an S corp, you don’t have anything to worry about. I saved more than $5,000 on my taxes last year with legal tax strategies. If you do things right, you can save a lot more.