The Naked Truth About Self-employment and Taxes
What does it mean to be self-employed?
If you take money for your work and you are not an employee, you are self-employed. You don't work for anyone else. You work for yourself, which means you are the only person who can tell you what to do.
But there's more you need to know about this self-employment thing:
How self-employed individuals are paid and taxed
The major difference between being employed by someone else and being self-employed is that you don't get a paycheck. This also means that you must now deal with two tax issues that aren’t going to be handled by an employer:
1. You won’t have income tax withheld from your paycheck. Assuming your business will be profitable from the beginning (a reasonable assumption, I’m sure), you will have to pay income tax on the profits, according to the legal form you’ve chosen. If you are a sole proprietor (the default business ownership category if you don't elect another type of business) you will be filling out the Schedule C on your 1040. (See Chapter 7 for a discussion of your tax situation.)
2. You will not share the expense of Social Security and Medicare taxes with an employer. You will need to pay the full amount of these taxes, called “self-employment taxes,” based on the profit from your business. If you make no profit in a year, you won’t have to pay self-employment taxes. If you make, say, $10,000 profit, you’ll pay self-employment taxes on this amount. The current self-employment tax rate (in 2007) is 15.3%, so on that $10,000 profit you would owe $1,530 in self-employment tax.
The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (medical insurance).
You can deduct one half of your self employment tax in figuring your adjusted gross income, but you will still have to pay the full amount of the tax, in addition to any income tax you owe.
Self-employment vs. being employed: Another tax difference
Here is another important distinction between being employed and being self-employed, from a tax standpoint:
As an employee, you have received a Form W-2 each year showing your gross taxable income and other information. As a self-employed individual doing work for others, you receive a Form 1099-MISC from anyone who paid you more than $600 in a year. (By the way, just because you didn’t get paid $600, doesn’t mean you can forget about the income; ALL income must be reported.)
Self-employed individuals as legal entities
When you are self-employed, you don’t have the protections afforded to employees. Employees have some liability if their actions harm others, but only if they step beyond the limits of their employment. For example, if an employee accidentally injures a customer while performing her duties, she may have some liability, but her employer has more liability and is often the one being sued.
One way self-employed business owners limit their liability is by forming a Limited Liability Company (LLC) or a corporation. If you are concerned about liability, you might want to talk to an attorney about becoming a limited liability business entity.
Since you are in business for real, be sure you understand these tax and legal implications of being self-employed.