The decision to become an entrepreneur is filled with the satisfaction of becoming your own boss and the freedom to do what you passionately believe in, day in and day out. As Peter Parker’s Uncle Ben once said, “with great power comes great responsibility,” and that rings no truer than when tax time rolls around. However, with these simple steps to follow, you will be able to master the self-employed taxpayer responsibility that comes with being your own boss.
What It Means to Be Self-Employed
One of the most important factors to understand when filing your taxes is your business structure. While you may not have a brick and mortar business or even a website, the IRS considers any income received above $400 in exchange for goods or services to be income attributed to self-employment and this income is taxed differently than income received by employees. This includes income received from freelancing, independent contracting, sole proprietorship, partnership, or limited liability company (LLC).
In January, you will begin to receive tax forms from employers and those who have disbursed payments to you for your goods or services from the previous year. You will know how your income will be taxed based on the initial tax form you are asked to complete. If you complete Form W-4, you will be considered an employee for tax purposes and you will receive Form W-2 from your employer the next year. If you complete Form W-9, you will be considered an independent contractor for tax purposes and should expect to receive Form 1099-MISC form the next year. The Form 1099-MISC will generally reflect the income received in Box 7 as nonemployee compensation which means no taxes were withheld from the compensation. However, if you have paid any nonemployee more than $600 to perform services for your business, you will need to file Form 1099-MISC with the recipient before January 31 and the IRS before February 28. Nonemployee compensation can include medical and health care payments as well as payments to an attorney.
The IRS places the highest priority on accounting for the full income you have received during the tax year. It may seem like a no-brainer, but what is income? The IRS defines income as an undeniable accession to wealth clearly realized and over which the taxpayer has complete dominion and control. Put simply, income is any cash or property you receive with some guarantee that you will be able to keep the cash or property. Therefore, income can be cash, property, barter transactions, or even a legal obligation paid on our behalf by a third party. For example, a friend pays a baker’s rental insurance every month and because this is a legal obligation paid on behalf of the friend, the baker must treat these payments as taxable income.
For the taxpayer, expenses represent the most important accounting to ensure the tax liability is as close to zero as possible. The IRS defines “expenses” as all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. It is important that your taxable expenses meet the entirety of the IRS definition. For example, an entertainer may purchase a leather jacket for her upcoming performances, but the IRS will not consider the leather jacket to be “necessary” for the tax purposes of an expense because the entertainer would use the leather jacket even if she was not performing. Similarly, a law student who pays to sit for the bar exam cannot consider those expenses for tax purposes because the law student was not “carrying on any trade or business,” but merely attempting to enter the profession. Therefore, it is important to ensure your expenses meet every aspect of the IRS definition.
It is also important to know that the IRS draws a distinction between expenses and expenditures. Expenditures generally represent anything purchased for the business with a useful life greater than one year. Expenses naturally represent those purchases with a useful life less than a year. For example, if an artist purchases a paint brush, then the paint brush will represent an expense whereas a purchase of an art studio would represent an expenditure. Moreover, expenses are reflected as deductions on your Form 1040 Schedule C and expenditures will specifically reflect your depreciation deduction.
Once you have compiled your gross income and expenses from the tax year, you will be able to see which deductions you are eligible for and calculate your taxable income.
This first installment covers some of the foundational basics when it comes to getting ready for tax season as a self-employed entrepreneur. The next installment of our Tax Time series: all things deductions.