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Understanding Tax Obligations for Self-Employed Individuals

Billie Anne Grigg

Billie Anne Grigg

Billie Anne Grigg has been a bookkeeper since before the turn of the century (yes, this one). She is a QuickBooks Online ProAdvisor, Xero Certified Advisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.
Billie Anne Grigg

Tax obligations for self-employed individuals can get very complicated, very quickly. Many consultants, freelancers, and other self-employed workers mistakenly believe their tax obligations won’t change much once they leave their 9 to 5 jobs. What these individuals often fail to understand is their tax obligations will likely increase, and failure to meet these obligations can have serious and costly ramifications.

What are the tax obligations for self-employed individuals? How do these obligations differ from the obligations they had while they were W-2 employees? What are some of the consequences of failing to meet these tax obligations? And how can consultants, freelancers, and other self-employed workers be sure they are avoiding all the potential tax pitfalls?

This article is for those self-employed individuals who are Schedule C tax filers. Regardless of your federal tax designation, though, nothing can replace the guidance of a tax professional with intimate knowledge of your business and personal tax situation.

Tax Obligations for Self-Employed Individuals vs. W-2 Employees

Think back to the first paycheck you got from your first “real” job. Chances are, you were a bit shocked by how much of your hard-earned money went to pay taxes. Even if no money was withheld for federal or state taxes, a portion of your paycheck was withheld for Social Security and Medicare.

One of the thrills of self-employment is being able to pay yourself without “losing” a chunk of your pay to taxes. If you decide you want to pay yourself $1,000 per week, you transfer $1,000 from your business bank account to your personal bank account and record it as a draw in your bookkeeping software. Taxes are only something you need to worry about in April, right?

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Though the mechanics of paying yourself without withholding taxes from the amount of your draw is correct as outlined above, your tax obligations as a self-employed individual are a little more complicated than most self-employed individuals think.

Following are the two obligations that most often take the newly self-employed by surprise:

  • Estimated tax payments. For most W-2 workers, making estimated tax payments is not necessary. Their employer withholds an amount from each paycheck based on information the employee provides on their W-4, and these withheld amounts are sent to the IRS and state tax agencies. At tax time, these withheld amounts—which are reported on the employee’s W-2—reduce the amount of tax the employee owes when they file their tax return. In many cases, the employee might even receive a refund for overpaid taxes.

    These withheld taxes fulfill the taxpayer’s obligation to make timely periodic tax payments. Most taxpayers are unaware of this obligation, because it is automatically handled for them from their very first job. However, self-employed workers do not have taxes withheld from their pay, and so they must pay estimated taxes on a quarterly basis. Failure to do so can result in underpayment penalties and interest charges if their tax liability exceeds $1,000 for the tax period.

    The IRS prefers that taxpayers who must make estimated tax payments to estimate their tax obligation for the year and then pay their taxes in equal quarterly installments. That said, if your business income fluctuates significantly during the course of the year, you can make higher payments for the quarters when your income is higher and lower payments for the quarters when it is lower. Be sure to keep accurate income records, as the IRS may want to see these to determine whether you are subject to any underpayment penalties.

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  • Employer’s portion of FICA and Medicare. When you are a W-2 employee, you only pay half of the amount due for FICA—or Social Security—and Medicare. Your employer pays the other half. When you are self-employed, you must cover the full amount due for FICA and Medicare (you do, however, get to claim a portion of this additional amount on your tax return.)

    Many newly self-employed individuals who are accustomed to not having a large tax liability while employed as a W-2 worker believe they do not need to make estimated tax payments. This is especially true if their income is about the same or even a bit lower than it was when they were a W-2 employee. As a result, they are often unpleasantly surprised with not only a large tax bill, but also an underpayment penalty when they file their tax returns.

Consequences of Failing to Meet Tax Obligations

It goes without saying that failing to meet your tax obligations for self-employed is not a good thing. While most of these failures won’t land you in jail for tax evasion, some of the consequences of not meeting your tax obligations are still pretty severe:

  • Penalties and interest. As mentioned above, failure to make estimated tax payments as required can lead to underpayment penalties and interest. The interest continues to accrue until the balance is paid in full, even if you set up a payment plan with the IRS.
  • Backup withholding. In some cases, the IRS or your state tax agency may determine you should be subject to backup withholding. When this happens, the tax agency sends a letter to anyone you have done business with in the past, instructing them to withhold a sizable percentage of any future payments due to you. This backup withholding amount must then be remitted by the business to the tax agency.

    Not only does this mean the payments for your work might be at least 28% smaller than the amount of your invoice, it can also lead your clients to look elsewhere for a consultant or freelancer.
  • Seizure of assets. Like incarceration, seizure of assets is a less common consequence of not meeting your tax obligations. Even though the IRS and your state tax agency prefer to avoid this step, they will enforce this consequence if the amount due is large enough or if you ignore their attempts to collect taxes due.

    The most common form of asset seizure is a lien on your bank account. If you owe a large amount of money for taxes and fail to make—and keep—arrangements to pay those taxes, the IRS and other tax agencies may instruct your bank to forward most or even all of the money in your bank accounts to them.

Avoiding Potential Tax Pitfalls

By now, you might be thinking tax obligations for self-employed workers is a veritable minefield. How on earth can you possibly navigate this landscape and avoid all the potential tax pitfalls?

While taxes can be complicated, you can do two simple things to make sure you navigate them successfully:

  • Work with an accountant. Businesses that work with an accountant are much more likely to succeed than businesses that don’t. An accountant who is privy to your entire financial situation, not just your business tax situation, can advise you on how to best fulfill your tax obligations.

    You might think you can’t afford an accountant, at least not in the early stages of self-employment. While accounting fees are not inexpensive, a good accountant can often help you employ tax strategies that save you more in taxes than what you are paying for their services.
  • Proactively save for taxes. It’s tempting to view money you collect for your services as “all yours.” However, a portion of each payment you receive is actually owed to the government in the form of taxes.

    Starting with the very first payment you receive from a client or customer, dedicate a percentage to a savings account for taxes. Your accountant can help you determine the appropriate amount to save, but 15% is a good starting point. This tax savings account will ensure you are able to make your estimated tax payments when they are due, rather than having to scramble to find the money.

From Complicated to Manageable

Tax obligations for self-employed individuals can be complicated. But they don’t have to sink your freelance or consulting business. Understanding your obligations and proactively planning to fulfill them can move your tax obligations as a self-employed individual from complicated to manageable. It just takes a bit of guidance and planning.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.
Billie Anne Grigg

Billie Anne Grigg

Billie Anne Grigg has been a bookkeeper since before the turn of the century (yes, this one). She is a QuickBooks Online ProAdvisor, Xero Certified Advisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.
Billie Anne Grigg

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