The Hazards of Self-Employment

Self-employment is the bridge between holding a job and owning a business.

There are safety nets in place for W-2 employees of which many workers are not even aware. For every paycheck you get, a portion of your money is withheld and paid to the IRS and state. This system was instituted in 1943 as part of the Roosevelt Administration's need to collect taxes more efficiently during World War II. Most are not even aware of the multiple kinds of tax bills they have because they all get smushed together on your tax return. In fact, your boss pays half of one of your tax bills out of their own pocket. There are two additional tax bills with their own returns that must be filed, and they are 100% paid for you, so you don’t even have to worry about them.

If you own your own job as a self-employed worker, then tax season is much more stressful, as you may soon find out, especially if you are a former W-2 worker going out on your own into the self-employed jungle. If you are a small business owner with employees, then tax season is every day, and if you knew what your boss knows, you would understand why they are so high strung. Well then, I am going to tell you everything I wish I knew that my accountant didn’t tell me. Depending on whether you use this information or not, it could save you tens of thousands of dollars, maybe more.

The Mechanics of Paying Tax

There are two primary methods of paying your federal tax obligations. 1) Withholding, and/or 2) Estimated Tax Payments. You see, our federal income tax system is a “pay-as-you-go system.” Many people think their taxes are due in one lump sum on April 15th. That’s not true. April 15th is just the last day for you to pay the entire amount of tax that’s shown, or will be shown, on your tax return, after withholding and estimated tax payments have been credited to your tax bill. If you request a 6-month extension of time-to-file (NOT time-to-pay), then you will be given one last opportunity to pay your future, yet-to-be-determined, tax bill. After that, extra penalties and interest start getting added to your balance. If you are a W-2 employee, your boss collects a predetermined amount of money every payday and regularly deposits it with the IRS. If the boss takes too much out of your paycheck compared to what you’ll eventually owe, then you will get it back at tax time as a refund. The average individual tax refund in 2023 was $3,101 ($258 per month) according to the IRS Data Book. The point is that employees' tax obligations are fulfilled without much awareness.

Estimated Tax payments are virtually unheard of in the pure W-2 world. Income reported on Forms 1099 has zero taxes withheld (except Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.), so those who are self-employed need to guess how much taxes they need to pay based on their income and send it to the IRS every quarter. Another word for “guess” is “estimate.” If you are late or underpay your estimated tax requirements, then you get to pay yet another penalty. Failure to pay estimated taxes is very common and is the #1 reason why people get behind with the IRS on their taxes.

If you are self-employed, I highly recommend that you use two separate checking accounts for your business. One account is for all the revenue and expenses related to your business. Take a percentage of all your revenue (20-30% depending on your state and tax bracket) and send it to your other checking account. Don’t touch it! It’s the government’s money, not yours. Use that account to pay all your different tax obligations, especially estimated tax. I sometimes call clients 1-2 weeks before an estimated tax payment due date and remind them to make a payment, even if it’s just a single dollar. You need to build muscle memory for making estimated tax payments, especially if you come from the W-2 world. It’s a learned behavior that you will get used to over time.

Personally, I use a method for controlling cash flow called the “Profit First Method,” which can be difficult to use with conventional banks because it requires multiple accounts and a system for transferring money between them based on an algorithm. I use a free financial technology product that is built to automate this entire process.

If you are a sole proprietor or a single-member LLC (SMLLC), then you will report all your self-employed revenue (or “gross receipts”) on Schedule C (Form 1040), Profit or Loss from Business. You will itemize all your business expenses (your “deductions”) on the same form. Whatever is left over at the bottom is called self-employment income, and that’s the amount on which you will pay ordinary income tax according to your tax bracket. But there is another insidious tax that you need to pay on self-employment income, on top of ordinary income tax. It’s creatively called self-employment tax (sometimes abbreviated as “SECA” for Self-Employment Contributions Act), which is calculated on Schedule SE, Self-Employment Tax. And you better have included it with your estimated tax payments!

The W-2 world was purposely designed to shelter employees from defaulting on tax obligations.

Remember when you looked carefully at your W-2? Underneath Box 2, Federal income tax withheld, there was Box 4, Social Security tax withheld, and Box 6, Medicare tax withheld. Those two taxes together are called FICA taxes (from the “Federal Insurance Contributions Act”) and are the same thing as SECA taxes. As an employee, you have 6.2% of your wages withheld for Social Security tax on the first $168,600 of 2024’s wages (called “wage base limit”) plus 1.45% of your wages withheld for Medicare tax, which has an unlimited wage base. Together, you as an employee pay 7.65% of your wages towards FICA taxes. Your boss is required to match you on FICA, dollar for dollar. So, they pay the other 7.65%. As a self-employed taxpayer, you pay the full 15.3% on your self-employment income. 

Again, not only does your self-employment income get hit with 15.3% SECA, but you also need to calculate your ordinary income tax liability according to your tax bracket. And that’s just at the federal level. By the way, employers also take care of withholding for their employee’s state income tax. Self-employed workers often forget about their state’s estimated tax payment requirements, which parallel the federal system.

Whenever I prepare a self-employed client’s tax return, and they owe a significant amount of taxes, I will calculate the amount of their four quarterly estimated tax payments (on Form 1040-ES, Estimated Tax for Individuals) for the following tax year. If they expect to make the same amount of income next year, they will need to make those payments to avoid the Underpayment of Estimated Tax Penalty (the IRC § 6654 penalty). In several cases, they nervously ask why I sent them four large “bills.” There is a serious problem in the 1099 world. Education on tax obligations is completely absent, forcing taxpayers to learn by paying “tuition” to the IRS via fines, penalties, and interest. Some mistakenly believe that they need to set up an LLC to take business deductions, which is patently false. Then they may miss important reporting requirements for their LLC. Some of which have fines of $500 per day plus jail time for noncompliance (see the Corporate Transparency Act). This is why you should either engage the services of a tax expert or become a bona fide tax expert yourself.

Sadly, many self-employed taxpayers try to DIY it when it comes to tax compliance. I am aware that CPAs and Enrolled Agents (EAs) are not cheap, but neither are IRS and state penalties and interest. The problem is that there are some self-employed business owners who hire professionals to keep them out of trouble, only to find their business’s books in shambles, unreconciled, comingled with personal transactions, and accountants who hide in a cave after each tax season, not to be seen again until next February. (Hint: a good tax professional will refuse to be associated with a business that is hellbent on continuing its bad habits. Why? Because they don't want the inevitable backlash and bad reviews from such business.) You see, spending money on professionals will not mitigate tax problems. It won’t guarantee that you will capture every tax deduction to which you are entitled. Only when you are sick and tired of being sick and tired, and start being the captain of your own ship will you be able to stop tipping the IRS thousands every year.

I’ve left out the state tax responsibilities because that would require 50 additional blog articles. California, Hawaii, and New York, are the top three highest tax burdens in the nation. I will do a separate blog article for Hawaii and possibly California another time.

The W-2 world is easy when it comes to taxes. The 1099 world has the opportunity to earn more, but it comes with added tax and administrative burdens that need to be mastered. Even more so, the small business employer has triple the amount of tax and administrative requirements compared to 1099 independent contractors. The key to success is professional guidance coupled with situational awareness and behavioral adaptation.