When you're first starting a business, one of your biggest questions is likely to be how this new venture will affect your tax status. Here's what you need to know regarding self-employment taxes:

1. What makes up the self-employment tax?

Self-employment taxes are assessed based on the income you generate in your business, independent contractor, or freelance work. The self-employment tax was created as a result of the 1954 Self-Employed Contributions Act, which requires self-employed individuals to contribute toward Social Security and Medicare. The total self-employment tax rate is 15.3% and is divided into two parts. The Social Security portion represents a 12.4% tax on self-employment income. Law dictates that a limit be placed on the amount of income subject to the Social Security Tax. For 2019, this amount was $132,900. Any earnings in excess of this amount are not subject to the Social Security tax.

The second portion of the self-employment tax is the Medicare tax, which represents a 2.9% tax on self-employment earnings. There is no limit on the income subject to this tax. For higher income earners, an additional 0.9% tax is assessed. The income threshold is $250,000 for those filing a joint return, $200,000 for single taxpayers, and $125,000 for those who are married and filing a separate return.

2. What expenses can I deduct?

The IRS maintains that deductible expenses must be ordinary and necessary in order to conduct business. The cost of goods sold (e.g., inventory costs) should not be included as a business expense. Some examples of deductible business expenses include:

  • Advertising and marketing expenses
  • Utilities
  • Professional development expenses
  • Self-employed health insurance
  • Home office expenses

Making unlawful or incorrect deductions can trigger a tax audit, so it may be helpful to seek the guidance of a CPA or accountant.

3. How does the home office deduction work?

If you have a home office, you may be able to take a deduction for the related costs. In order to qualify for the home office deduction, your home office must be your principal place of business, exclusively and regularly. If qualified, you may be able to deduct a portion of the mortgage (or rent), utilities, depreciation, property taxes, and insurance as a business expense. The IRS allows you to choose between two methods for determining the amount of the deduction: The simplified method or actual expenses. 

The simplified method allows you to take a deduction of $5 for each square foot of your home office. Actual expenses are allocated between business and personal use based on the square footage of the home. When calculating using either method, it is important to note that the amount of the deduction may not exceed the gross income for your business.

4. When do I pay my taxes?

When you're an employee, your employer withholds a certain amount for taxes from each paycheck and sends that amount to the IRS on your behalf. However, when you are self-employed, there is no one to withhold those taxes for you. 

In order to avoid interest and penalties, the IRS requires that you make estimated quarterly tax payments based on the amount of self-employment income you earn for that quarter. Estimated taxes are due on the following days for calendar-year taxpayers.

  • April 15th
  • June 15th
  • September 15th
  • January 15th of the following year

Any balance due for the current tax year should be paid by the original due date of your tax return (April 15th for calendar year taxpayers). Don't forget to check with your state and local government to determine their estimated tax requirements.

5. Are meals and entertainment a deductible business expense?

Starting with the 2018 tax year and beyond, entertainment expenses are no longer eligible as a tax-deductible line item. The costs of taking a client or potential client to a sporting event, concert, etc. have been eliminated.

The costs of business meals, however, are still eligible for a deduction. Eligible meals paid for during business travel, client meetings or during a business event are deductible at 50%. The costs of food served at an entertainment event is eligible for a deduction if the amount can be separated from the overall cost of attending. 

6. Do I need a federal tax identification number?

If you operate as a sole proprietor, you're not required to have a federal tax ID number and can use your Social Security number instead. However, without a tax ID or Employer Identification Number (EIN), you will not be able to do certain things that may be beneficial to your business, such as hire employees or create certain retirement accounts. As your business grows, it may be beneficial to go through the process of obtaining a federal tax ID. 

As a new business owner, self-employment taxes can be an overwhelming thought. If you have questions about starting or running your small business, including managing taxes, ask a lawyer for help today.