Self-Employment Taxes – Things You Must Know
If you are already self-employed or just launching out on your own, taxes can be one of the most intimidating items, especially if all you’ve previously known is a simply W-2 from an employer. If you leave a cushy corporate job for self-employment, the first tax year is the trickiest. You may have earned a larger salary and paid quite a bit in federal taxes. Or, like many you used downsizing or a severance package to fund your start up. If that is the case, it becomes even dicier because your prior year taxes will be even higher than normal and then suddenly, boom, you’re in the self-employed ranks attempting to make a go of it. The tax man doesn’t care. Uncle Sam will hit you with stiff penalties if you are not careful.
I recently met with another CPA to get a second opinion on my own finances. Since I fall into this dicy boat, I want to make sure that I am not sitting here shell shocked next April and most certainly want to avoid fines and penalties because I underpaid taxes. I was very surprised at what I found out.
There are 2 approaches to avoiding wicked penalties and they include: Prior Year Safe Harbor and Quarterly Estimated Taxes.
There is a good explanation of prior year safe harbor at “Tycoons, taxes, and the time-value-of-money” :
However, the IRS has created various safe harbor provisions, under which one pays no penalty at all, so long as one has withheld some minimum amount of taxes over the course of the year.
Safe harbor 1:If you have remarkable foresight, and can thus predict what your total tax burden will be for this year, pay exactly 90% of that amount and no more.
Safe harbor 2:If your prior year adjusted gross income (AGI) was less than $150,000, pay your prior year tax amount.
Safe harbor 3:If your prior year adjusted gross income (AGI) was greater than $150,000, pay 110% of your prior year tax amount.
The safe harbor thing is all fine and dandy except if you paid tens of thousands of dollars in tax in your last year of employment and then are building a business slowly on a shoestring. It doesn’t make sense (and who has the cash flow??) to make a no interest loan of tens of thousands of dollars to the IRS?
Your next approach is to make quarterly estimated tax payments sufficient enough to cover your income in that quarter. In the most excellent article “Six Things You Must Know About Self-Employment Taxes” at Web Worker Daily http://webworkerdaily.com/ Anne Zelenka has this to say about estimated taxes:
Estimated taxes. Life was easier when your employer bought your health insurance, paid half your social security obligation, and withheld taxes all year so that you stayed in the good graces of the IRS. Once you’re in business for yourself you have to pay taxes as you go. The IRS is not about to give you a free loan until next April 15th rolls around.
If you expect to owe tax of $1,000 or more when you file your return, you likely need to pay estimated taxes four times a year. There is a loophole though-see “safe harbor” below.
How do you compute your estimated taxes? IRS Publication 505, Tax Withholding and Estimated Tax gives you all the gory details. If you find that too daunting as a starting point, review the IRS summary page on estimated taxes. Or do like I do, and hire an accountant. It’s worth the money if it lets you get back to money-making work.
I don’t even begin to wade through the IRS publications because I’ll spend more time doing that than working in my business. Thus why I have gone the “accountant please help me” route even though I have a good understanding of accounting (I did manage a BS in Honors at one point).
As we move toward the end of the 3rd Quarter of the 2008 tax year it is the ideal time to revisit these numbers for yourself to ensure you are not setting yourself up for a big spanking come tax time.
Paula Gregorowicz, owner of The Paula G. Company, works with women who are ready to create their lives and businesses in a way that fits who they are rather than how they were told they “should”. Get the free 12 part eCourse “How to Be Comfortable in Your Own Skin” http://www.coaching4lesbians.com and start taking charge of your own success.