As of 2020 in the United States, there are 24.8 million self-employed individuals. Another 6 million self-employed owners have small businesses that employ other people. Obviously, we Americans love being our own boss.
This article will supply you with a framework to decide whether self-employment is right for you, including the advantages, disadvantages, tax implications, and more.
What is Self Employment?
The common definition of self-employment is that you work for yourself, full-time or part-time. You earn money from customers or clients who pay you, instead of earning wages or salary from an employer.
The Internal Revenue Service’s definition of self-employed is that you carry on a trade or business as a sole proprietor or independent contractor. The IRS also considers you self-employed if you are a partner in a business partnership, or if you are otherwise in business for yourself.
What are the Types of Self-Employment?
The IRS expressly includes a worker in the gig economy among the types of self-employment. Gig workers include Uber or Lyft drivers, delivery persons using platforms like DoorDash, freelancers on digital platforms like Fiverr or Upwork, as well as those who sell crafts and handmade items on marketplaces like Etsy.
Other terms used to describe self-employed roles include independent contractors, entrepreneurs and small business owners.
Advantages and Disadvantages of Self-Employment
The advantages of self-employment include independence, autonomy and flexibility:
- You are in charge and make all decisions.
- You establish your own hours and workplace.
- Your earnings opportunity is limited only by your ability and performance.
The disadvantages of self-employment include risks and uncertainties:
- Your earnings may fluctuate.
- You are responsible for acquiring new clients or customers and generating all revenues.
- Tax compliance is more complex. You must pay the self-employment tax (i.e., the full social security and medicare tax). It is essential to keep accurate records.
How Do I Qualify to Be Self-Employed?
Anyone in the United States can be self-employed. The only criteria are your own skills and desires.
- Am I enough of a self-starter to seek out customers and revenue on my own?
- Am I willing to do whatever it takes, including emptying the trash and keeping the books?
- Can my family and I live without a steady paycheck, knowing my income may be uncertain at first?
You may answer yes to each question but still feel uncertain. That’s normal. Most people recognize they are taking a risk. But they are motivated enough to try.
Benefits of Self-Employment
Self-employed individuals enjoy many intangible benefits including independence and flexibility. However, when you work for yourself you do not get fringe benefits such as paid sick leave, disability insurance and health insurance — unless you purchase them out of your own pocket. You can deduct the cost of paying for health insurance premiums for you and your dependents.
Can You Be Employed and Self-Employed at the Same Time?
Yes. Many people are employees in jobs and also operate part-time or side businesses. If this describes you, your income is reported in two different ways for tax purposes.
- For employee income from a job, your employer will issue W-2 forms showing your earnings and withholding amounts. Your employer withholds income tax, Social Security and Medicare tax, and any benefit contributions.
- For self-employed income, you will have to track and report income yourself. You are also responsible for paying estimated quarterly taxes and self-employment tax (i.e., Social Security and Medicare tax).
Business Structures for the Self Employed
There are five common types of legal structures for self-employed business owners, and each has tax implications:
1. Sole Proprietorship: Most freelancers, gig workers and other self-employed are unincorporated sole proprietors and report income tax on their personal tax returns by attaching Schedule C showing net earnings from a trade or business.
2. Limited Liability Company: A self-employed person can form an LLC to limit liability. LLC income and expenses are typically reported on Schedule C.
3. C-corp or C-Corporation: A corporation is a separate entity subject to corporate tax rates.
5. S-corp: An S-corp is a tax election with the IRS. It enables you to treat earnings from a corporation or LLC as pass-through income on individual tax returns. Subchapter S provides owners with special tax advantages.
Read more: Business Structure Tax Comparison.
Self-Employment Tax Filing Requirements
A self-employed person has several tax obligations including the requirement to:
- File a Federal tax return each year reporting net earnings, and pay all taxes due.
- Pay self-employment tax, which the IRS defines as Social Security and Medicare taxes, on net earnings. The self-employment tax rate is 15.3%, of which 12.4% goes toward Social Security and 2.9% toward Medicare taxes. A self-employed person must pay both the employer and employee portion of Social Security and Medicare taxes. You figure self-employment tax using Schedule SE.
- Pay estimated tax payments quarterly. Calculate estimated tax amounts carefully, as there are penalties for underpaying.
- File state and local tax returns, if applicable.
A self-employed individual often can write off business expenses as small business tax deductions. However, you must keep detailed records to substantiate expenses.
How Do the Self-Employed File Taxes?
To file their Federal taxes, sole proprietors and most LLCs will complete Form 1040, “Individual Tax Return. ” Include Schedule C “Profit or Loss From Business” to report expenses and net earnings from a trade or business. Also, Schedule SE is used to figure the self-employment tax to pay Social Security and Medicare taxes.
Partnerships must include Form 1065, “U.S. Return Of Partnership Income.”
Corporations file Form 1120, “U.S. Corporation Income Tax Return.” Taxpayers that have elected Subchapter S status, must file Form 1120S, “U.S. Income Tax Return for an S Corporation.”
If you own a business that has employees, you must also submit IRS Form 940, “Employer’s Annual Federal Unemployment Tax Return.” Also, include IRS Form 941, “Employer’s Quarterly Federal Tax Return.”
Hobby vs Business?
For tax purposes, it’s important to distinguish between a self-employed business and a hobby (what the IRS calls a not-for-profit activity). If it is a hobby, you cannot use losses from it to offset income on your taxes. The IRS looks at several factors to determine if an activity is a business and not a hobby, including whether you:
- operate in a businesslike manner,
- depend on the income for your livelihood,
- make a profit in 3 out of 5 years.
See the full hobby vs. business test outlined in IRS Publication 535. 4
Is an Independent Contractor Self Employed?
If your business hires others to perform work, carefully assess whether to treat any such person as an independent contractor versus an employee. By definition an independent contractor is not an employee. But the individual must meet the IRS’s test to be considered an independent contractor. The test is based on the degree of control you have, the financial arrangements and the type of relationship.
If your worker meets the independent contractor test, that person must pay their own self-employment tax. For tax reporting purposes, you provide a Form 1099 instead of a W2 to independent contractors. You do not withhold social security or other taxes for independent contractors.
Do I Need to Register as Self Employed?
In the United States you do not need to register. However, you may need a license depending on your industry and location. For instance, many consumer-facing businesses such as food preparation or pest control require licenses or permits. Check with your municipality, county or state.
In conclusion, there’s a lot to consider to become self-employed. If you are someone frustrated with cubicle life, working for yourself may give you more autonomy. Remember, though, as a business owner you ultimately answer to customers or clients and must satisfy them.
IRS. “Gig Economy Tax Center”
IRS. “Publication 535”