April 15, 2024
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Tax Terms You Should Know: Self-Employed Edition

Navigating tax law is not a simple task. The rules and regulations are dense and complicated, and there are a ton of them. And a general tax knowledge may not be enough since many times there are rules that specifically affect your industry. Take, for example, the taxability of criminals. In the landmark case of United States v. Sullivan in 1927, the defendant was convicted for failing to report his income from illegal activities. Note that he wasn’t convicted for the illegal activities themselves, only because he didn’t pay taxes on this income.

This seems consistent with the IRS’s thinking when they came out with IRS Publication 17, which helps taxpayers determine how to report their income. In the “Other Income” section you’ll find some good stuff. Some of the classics are: “If you steal property, you must report its fair market value in your income in the year you steal it unless in the same year, you return it to its rightful owner”; “If you receive a bribe, include it in your income”; and “Income from illegal activities, such as money from dealing illegal drugs, must be included in your income.”

Isn’t the IRS so cute sometimes? Maybe I’m just jaded or just have the wrong clientele, but is there really a demographic of the criminal population that are so scrupulous when it comes to filing their tax returns? Oh, I have to remember to enter that stolen Jeep into QuickBooks today and make an estimated tax payment. That Uncle Sam is a thief, I tell you!

Who could be so dumb, right? Well, that’s what I thought until I read about the following instance: A business owner paid an arsonist $10,000 to burn down his store so he could collect $500,000 of insurance proceeds. But he didn’t stop there. He then tried to deduct the arsonist’s fees as a business consulting expense. There are clearly bigger idiots out there than I realized initially.

So there’s a lot of rules you need to know. Your accountant will do most of the heavy lifting for you but it’s always good to understand basic concepts at the very least. This is especially true when you’re either self-employed or have a side business, because that is when you have the most wiggle room to really have an impact on your taxable income. Even if you’re not self-employed, you may find that knowing these terms will make you more likeable at dinner parties. Look, your worldly knowledge may consist of this article, a headline you saw on Fox News as you walked past the TV in the gym, and a Snoopy comic you read last Sunday. But with the right presentation, you can have people thinking you know everything that’s going on in the world. (Just keep the conversation short.)

So without further ado, I give you five terms that every person should know, especially if you’re self-employed.

Business Expenses: This term may seem self-explanatory but it’s actually more technical than you may think. Tax law requires that, in order to be a deductible business expense, the expense must be both “ordinary” and “necessary.” Ordinary means something that is common and accepted in your trade or business. Necessary means something that is helpful and appropriate for your trade or business. So it’s not “necessary” in the normal sense of the word, rather just something that’s helpful.

To put this to an example, an artist attempted to deduct a vacation to Brazil for him and his entire family. He claimed it was a business expense because he purchased a couple of painting spatulas while he was there. Not surprising, the IRS denied the trip expense as they stated it was not necessary to go to Brazil for paint supplies instead of one of the several thousand local places he could have gone to.

Self-Employment Tax: Whenever you have earned income, you pay Social Security and Medicare taxes. When you’re an employee, your employer is handling this for you when they run payroll. The employer pays half (which amounts to 7.65 percent of the wages) and you pay half (another 7.65 percent). But when you have income from self-employment, there’s no boss to handle this for you anymore. Instead you’re the employer that’s paying half as well as the employee that’s paying the other half. So that comes out to 12.4 percent of Social Security taxes and 2.9 percent of Medicare taxes. Don’t confuse this with the federal and state income tax you must pay. This is in additional amount of taxes to cover your Social Security and Medicare. For 2018, the maximum amount of income you pay Social Security tax is $128,400, whereas Medicare has no ceiling.

Estimated Tax: The U.S. tax system is a pay-as-you-go system. Or as the IRS states so eloquently on their website, “Pay As You Go, So You Won’t Owe.” They’re like a young Snoop Dogg dropping rhymes on taxpayers. This means that as you earn the income, the IRS wants you to pay them their share. They’re not interested in waiting until year-end to get their money. That’s why when you’re an employee, the taxes are withheld from your paycheck. When you earn self-employment income, it’s your responsibility to make the payments at four intervals during the year. If you don’t make estimated tax payments during the year and owe a significant sum at year-end, you could be hit with penalties.

Limited Liability Company (LLC): An LLC is probably the most well-known choice of business entities. One of the main reasons is because the owners have limited personal liability in relation to the LLC’s activities. How an LLC is taxed depends largely on the ownership structure. If there are two or more owners, then the default is that the LLC is taxed as a partnership. If there is only one owner, then there is no difference in terms of taxation than if the LLC was not formed. Meaning, either way, whether it’s an incorporated LLC or unincorporated sole proprietorship, the income and expenses will be reported on Schedule C of the personal tax return. This is a common misunderstanding I hear a lot, so just note that the LLC alone does nothing to avoid any taxation—neither income taxes nor self-employment taxes. However, it does offer some legal protection of personal assets and you do have the option to elect to tax the LLC as an S Corporation.

Home Office Deduction: Every self-employed business owner should at least consider the home office deduction. This amazing little deduction allows you to convert what is otherwise personal nondeductible expenses into legitimate deductible business expenses. Imagine being able to use your PSE&G bill that you pay anyway to minimize both your income taxes and self-employment taxes. To qualify for this deduction, you must use a separately distinguishable part of your home (not necessarily an entire room) regularly and exclusively (no personal use) for the business.

By Daniel Magence, CPA

Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether it’s tax returns, bookkeeping, payroll services or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.

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