Taxes for Small Business Owners (Including Independent Music Studios/Schools)
MTNA Business Digest, Volume 2, Issue 1
As a tax preparer and enrolled agent, I am asked quite often about taxes related to small businesses. Here are some of the most frequent questions that I’m asked pertaining to small business owner taxes.
- What is the difference between an employee and an independent contractor in terms of my taxes? The fundamental difference between being an employee and an independent contractor is that independent contractors are responsible for all of their own taxes. As an employee, your employer is required to withhold federal, social security, Medicare and state taxes from your compensation. As an independent contractor, you are responsible for calculating and remitting your taxes to the government.
- As an independent contractor, how do I report my income for my taxes? The good news is that an independent contractor does not need to file a separate tax return. An independent contractor reports their income on a schedule C which gets included with the annual personal tax return (form 1040).
- What information must be reported on a schedule C? The schedule C has two parts. The first part reports your total revenue collected during the year (assuming you are reporting your income on a cash basis). The second part itemizes all of your business expenses related to earning your compensation. These business expenses are subtracted from the gross revenue to determine the net taxable income to report on your personal tax return.
- Can I wait until I file my personal tax return to pay the income taxes for my independent contractor business? The answer is no. At a minimum, you need to calculate and pay your estimated tax on a quarterly basis. Failure to pay your estimated taxes related to your business could result in the IRS assessing an under-withholding penalty.
- So, if I must pay my taxes quarterly, how do I do that? Once you have calculated your estimated tax liability for the quarter, you pay your tax by filing a schedule ES. This form includes your name, mailing address, social security number and the amount you are remitting to the government for the quarter. This form can be mailed or can be filed electronically on the IRS website (www.irs.gov). The preferred method of filing is electronically, given you can obtain a confirmation number for the filing and payment of the estimated tax for the quarter.
- If I have a second job (with W2 withholding) do I still have to file quarterly tax? The answer depends on how much tax liability you expect from being an independent contractor. If you expect your balance due on your annually filed tax return (form 1040) to exceed $1,000, then you will need to consider making quarterly ES payments. The potential for an under-withholding penalty is triggered when the net balance due exceeds $1,000. The only way to avoid a penalty when your balance due exceeds $1,000 is to make sure that 1) your total payments (W-2 withholding plus ES tax payments) pays at least 90% of the current year total tax or 2) your total payments exceed 100% of your prior year total tax liability (110% of prior year total tax liability if prior year income greater than $150,000 for a married filing joint tax return). The simple rule of thumb is to avoid a balance due of greater than $1,000 to avoid any possibility of an IRS penalty!
- Do independent contractors pay more tax than employees? Not necessarily, but there are some differences to note. First of all, both employees and independent contractors must pay the employee’s share of social security and Medicare tax which totals 7.65% of compensation. However, independent contractors must also pay the employer’s share of social security and Medicare tax which also totals 7.65% of net taxable compensation. Employees don’t pay the employer’s share of social security and Medicare tax. Although independent contractors must pay both the employee and employer share of social security and Medicare tax, an independent contractor gets to first subtract their business expenses from their gross compensation to determine their net taxable compensation. By having the ability to only pay tax on the net compensation, an independent contractor might not pay more tax than an employee.
- Is there any reason from a tax perspective to incorporate my independent contractor business? This is a very hot topic for small business owners. The answer to this question depends on the total expected net taxable income from the business. As an independent contractor, you must pay the employee and employer share of social security and Medicare tax on all of the net taxable business income. As an incorporated business, the business owner must draw a W-2 salary from gross revenue. The total social security and Medicare tax liability is only paid on the amount taken as a W-2 salary. Any additional money drawn from the incorporated business (assuming the business owner has chosen the S-corporation as the entity type) is considered a distribution of profits and is not subject to social security and Medicare tax. The business owner effectively has the ability to reduce their tax burden by limiting the social security and Medicare tax liability to the amount drawn as salary. The important fact to note is that it is imperative that the business owner draw a salary that is “reasonable.” In other words, you cannot take an unreasonably low salary to minimize the tax liability. The business owner has to consider how much they would pay someone to do what they do to determine a salary that would be commensurate with the services rendered by the business owner. The other factor to consider in this decision is the fact that an incorporated business must file a separate corporate tax return and must file quarterly payroll tax reports. This will result in substantially higher accounting costs which might negate the tax savings of the corporate tax structure. There has to be enough net taxable revenue to justify the additional accounting expense. My general rule of thumb is that there must be at least $20,000 of net taxable income to consider incorporation.
- Are there any tax reference resources available to independent contractors? Yes, the IRS website has an entire page devoted to small business called “Small Business and Self-Employed Tax Center.”
David Walker has provided both income tax preparation and investment/financial planning services over his 32-year career. He has prepared over 7,000 tax returns and is proficient in advising on tax matters for people of all professions.