After years of daydreaming, you finally took the leap and launched your own business – now you work for yourself. You are one of more than 14 million U.S. workers who are self-employed: free to set your own hours, hire (or fire) anyone you please and take a day off without asking the boss. You have freedom and autonomy, but making the transition from being “employed” to being “self-employed” can be difficult if you don’t understand the tax implications.
As a W-2 employee, it’s likely that your tax situation was fairly simple. When tax season approached, your accountant helped you file or maybe you even filed online. Now that you are self-employed, you will find taxes a bit more complicated. Here is what you need to know to be prepared for taxes in your first year as an online seller.
Understand Different Types of Taxes
Federal taxes: You must pay federal income tax, along with Social Security and Medicare taxes. You pay income tax on everything that you make, but you pay Social Security tax only on the first $118,500 you make. You pay Medicare tax only on salaried income or simple distributions. The only tax burden that you can lighten at the federal level is the 2.9 percent (as of 2016) Medicare tax. All of your distributions would be taxed this additional 2.9 percent, in a simple LLC. You are considered an employee if your business is an S-Corp, so only your salaried income is taxed for Medicare, while your additional profit (above and beyond your salary) is not taxed. Talk to a professional if you need more information on federal income tax advice.
State taxes: Paying state income tax is required in most states, though some states (listed below) do not have this tax. How much you spend on state income tax can be controlled to some degree by living in a tax-friendly state. If you want to move your primary residence to Texas, for example, then you won’t have to pay state income taxes.
For those selling products online, sales tax can be a little tricky. You are only required to collect sales tax if you have a physical presence in a state (such as an office, store, warehouse, etc.). In legal jargon, your physical presence is known as a “nexus.” Since each state defines this term a little differently, it’s best to check with your state’s revenue agency. The discussion around online sales tax is evolving quickly – so it’s important to stay abreast of the latest developments. New Hampshire, Delaware, Hawaii, Alaska, Montana and Oregon are all states that do not charge sales tax. If you are an Amazon FBA seller, the sales tax issue can be even more complex. Amazon currently has fulfillment centers in 28 states, so you have a good chance that you will need to collect sales tax. A business-grade DIY tax software or a professional tax accountant can help you navigate this important area
No More Income Deductions
When you were a traditional W-2 employee you may not have given much thought to the wages being deducted from your paycheck. Since the U.S. has a “pay as you go” tax system, your employer deducted your taxes from your wage for you. Even though no one is deducting taxes from your profits, you still have to pay.
If you made more that $400 in net earnings from your business, you must file a Form 1040 (Schedule C). You should set aside approximately 30 percent of your income toward taxes. That’s a general figure and each business owner needs to take the complex set of figures into account for their unique situation. Though it may seem painful at first, it’s just another part of owning a business. Keep in mind, that if you expect to owe at least $1,000 for the current tax year, then you should be paying estimated quarterly payments to the IRS. Failure to make quarterly payments on time can lead to expensive penalties, fees and interest.
You are Responsible for Tracking Income and Expenses
In order to give the IRS accurate information (and more importantly) avoid an audit, you must maintain records of your income and expenses. You are able to deduct business expenses from the taxes that you owe, but you must document these expenses and be able to produce a receipt if necessary. Track every business expense and keep all receipts. Your expenses for travel, subcontractors, office equipment, utilities, office space, professional training and development, books – in short, virtually everything business related – are tax deductible. Tax deductions reduce your income and profits, thus lowering the amount of income you need to pay taxes on each year.
Everyone Makes Mistakes
Filing taxes as a small business owner can be complicated. Even the most careful and fastidious of business owners can make a mistake on their taxes – and even the IRS understands that. If you make a mistake when filing, you can always file an amended return (Form 1040X) if you believe you may have given incorrect information.
If tackling your taxes on your own seems daunting, don’t be afraid to ask for help. It makes sense to consult with professional tax advisors about payroll and taxes. Although you should be able to do all of your administration yourself, tax preparation and similar things are so tedious and time-consuming, or require such specialized skills, that you ought to pay someone else to do them. You can avoid audits and penalties by simply hiring an accountant or tax professional.
What lessons did you learn about tax management during your first year in business? Let us know in the comments below or join the conversation on one of Kabbage’s social media channels.