Self-Employment: Quick and Dirty Guide to Tax Issues and Savings
If you’re considering joining the Great Resignation and becoming self-employed to be in charge of yourself, pay attention. Before leaping, here are some things to consider regarding the tax implications. This self-employment thing may not be as rosy as it appears.
Here’s the big picture.
Don’t Believe the Hype
Despite what some may believe, becoming self-employed wonʼt allow you to:
Sorry about that.
While there are some tax advantages to being self-employed, they are underwhelming and should not be the main reason for deciding to go out on your own. We cover tax benefits later in this analysis.
The big non-tax disadvantage is you’ll have to pay for things that were formerly provided by your employer, such as:
Health insurance, retirement plan contributions,
A company car (if you were lucky),
Company-paid business trips that included elements of pleasure,
Meals when you worked late at the office, and, so forth.
And there is one big tax disadvantage: the dreaded Self-Employment Tax.
Now, some details on the tax issues most likely to affect you as a self-employed taxpayer.
The Dreaded Self-Employment Tax Can Be Really Expensive
The self-employment tax is how our beloved U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income (e.g., net income from Schedule C multiplied by 92.35 percent).
That 15.3 percent rate is comprised of:
Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9 percent Medicare tax continues before rising to 3.8 percent at higher self-employment income levels (above $200,000 if you’re unmarried or $250,000 if you’re a married joint-filer). The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.
Side Note: The additional Medicare tax applies to an employee’s W-2 income in the same manner that it applies to self-employment income. It kicks in at the $200,000/$250,000 levels.
Once you’re in the 3.8 percent bracket, it continues to hit your net self-employment income “up to infinity and beyond,” as Buzz Lightyear would say.
Key Point: When you were an employee, your employer paid half of the 12.4 percent Social Security tax and half of the 2.9 percent Medicare tax. You paid the other half. Your employer took what you paid from your salary. But now that you’re self-employed, you cover both halves out of your own pocket.
Bottom Line: If you make good money, the self-employment tax can be a big number. You’ll need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.
Example: Say you make a net profit of $200,000 from being self-employed in 2022. You’ll report your business income and deductible operating expenses on Schedule C of Form 1040.
Take the net income from Schedule C and multiply that figure by 92.35 percent. The result is $184,700. Technically, that’s your net earnings from self-employment and it’s the amount that’s subject to the self-employment tax.
For 2022, your self-employment tax bill will be a whopping $23,584. [($147,000 x 12.4 percent) + ($184,700 x 2.9 percent)].
Sadly, in calculating your net self-employment income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your self-employment tax, or the deduction for self-employed health insurance premiums.
Key Point: When you were an employee, your employer paid half of the 12.4 percent Social Security tax and half of the 2.9 percent Medicare tax. You paid the other half. Your employer took what you paid from your salary. But now that you’re self-employed, you cover both halves out of your own pocket.
Bottom Line: If you make good money, the self-employment tax can be a big number. You’ll need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.
The Self-Employment Tax Hit Will Only Get Worse and Worse
Every year, the Social Security tax ceiling goes up based on an inflation adjustment. In turn, it’s likely your self-employment tax bill will go up.
Last August, before inflation kicked in, the Social Security Administration issued its latest projected ceilings for future years.
The projected numbers are bad enough, but they don’t reflect the current rate of inflation. You have to bet that actual upcoming ceilings will be higher, perhaps much higher.
Scary Outlook: One proposed tax-law change that has been floated would restart the 12.4 percent Social Security tax on net self-employment income above $400,000. This is the so-called donut hole approach to increasing the Social Security Tax.
Over the years, the donut hole would gradually close as the lower edge of the hole is adjusted upward for inflation while the $400,000 upper edge of the hole remains static. Will this unfavorable change get made? Who knows?
Now for Some Good News
You Can Deduct Part of Your Self-Employment Tax Bill
You can write off half of the 12.4 percent Social Security tax component of the self-employment tax and half of the 2.9 percent Medicare tax component. You don’t need to itemize to claim this deduction.
But you can’t deduct any part of the additional 0.9 percent Medicare tax that’s imposed at higher levels of net self-employment income.
You Can Set Up an S Corporation to Mitigate the Self-Employment Tax
If you’re willing to go to some trouble to potentially minimize the self-employment tax bite, consider operating your new shop as an S corporation. There’s much to this strategy, and you can find more in Amplified: 10 Tax Strategies for S Corporations: What, How, Where.
You Can Deduct Contributions to a Self-Employed Retirement Plan
For the 2022 tax year, a self-employed individual can potentially make a deductible contribution of up to $61,000 to a tax-favored retirement plan. Maybe more if you set up a defined benefit pension plan.
Available plan options include a simplified employee pension (SEP), a Keogh profit-sharing plan, a solo 401(k) plan, a SIMPLE-IRA, and a defined benefit pension plan.
You Can Probably Deduct Self-Employed Health Insurance Premiums
You can probably claim an above-the-line deduction for health insurance premiums, including Medicare if you are:
But you can’t claim this write-off if you’re eligible for other subsidized health insurance, such as under your spouse’s employer-sponsored plan.
Key Point: If you qualify, you don’t need to itemize to get the tax-saving benefit of this deduction. It’s an above-the-line deduction.
You Can Deduct Business Meals, within Limits
For 2022, you can deduct 100 percent of the cost of business meals provided by restaurants. After this year, the deductible percentage will fall back to 50 percent unless Congress extends the 100 percent deal. We doubt that will happen, but you never know.
You Can Combine the Heavy SUV, Pickup, or Van with the Home Office for a Double Dip in Tax Savings
Thanks to the Tax Cuts and Jobs Act (TCJA), you can claim 100 percent first-year bonus depreciation for heavy
SUVs, pickups, and vans that are purchased (not leased) and placed in service between September 28, 2017, and December 31, 2022, and used over 50 percent for business. Both new and used vehicles can qualify.
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Big Depreciation Advantage for “Heavy” Vehicles
Heavy SUVs, pickups, and vans are exempt from the luxury auto depreciation limits because the tax code treats them as transportation equipment rather than passenger vehicles. Therefore, these heavy vehicles are eligible for first-year bonus depreciation, including 100 percent bonus depreciation when available. Nice!
But since the tax code classifies these vehicles as listed property (meaning something you can use for personal as well as business purposes), you must use that heavy vehicle over 50 percent for business to qualify for juicy first-year depreciation write-offs.
With 50 percent or less business use, you depreciate the business-use percentage of the heavy vehicle’s business cost using the straight-line method—where it will take six tax years to fully depreciate the cost.
Heavy Vehicle Definition
First-year bonus depreciation is available only when the SUV, pickup, or van has a manufacturer’s gross vehicle weight rating (GVWR) above 6,000 pounds.
Popular examples of heavy vehicles include some models of the Buick Enclave, Ford Explorer, Chevy Suburban, Jeep Grand Cherokee, and lots of full-size pickups.
Key Point: Verify a vehicle’s GVWR by checking the manufacturer’s label, which is usually found on the driver’s door or door frame. Don’t expect dealer sales personnel to know which vehicles have GVWRs above 6,000 pounds. Check for yourself!
Note: The first-year bonus depreciation percentage drops from 100 percent to 80 percent next year. But you may still be able to write off the entire business-use portion of a heavy vehicle’s cost under the Section 179 first-year depreciation break.
Key Point: You don’t need to purchase a vehicle today to qualify for the big deduction. You can place your personal vehicle in business service and qualify.
Then there is the home-office deduction angle. We will explain.
The Home-Office Angle
If you become self-employed, you could set up the right type of deductible office in your home and gain a big head start toward meeting the over-50 percent-business-use requirement for claiming a big first-year depreciation deduction for a heavy SUV, pickup, or van.
The home-office deduction is allowed if you use part of your residence during the tax year regularly and exclusively as: (1) a principal place of business or (2) a place to meet with customers or clients. Deductions are allowed for a separate structure such as a converted barn, pool house, or detached garage if you use the space regularly and exclusively for any business purpose.
Expenses directly allocable to your home office space, such as repair and maintenance costs, are fully deductible.
You can also deduct indirect home office expenses—such as utilities, property taxes, casualty insurance premiums, homeowner association fees, security monitoring, depreciation for a residence you own, rent for a rented residence, and so forth. A percentage of these expenses can be allocated to the home office space based on square footage or the number of rooms in the residence (assuming all the rooms are of similar size).
Key Point: You can deduct allowable expenses from a home you rent (including a percentage of the rent), as long as you meet the usage rules for the home office part of the residence. You need not own your residence to claim the home-office deduction.
You Need to Make the Home Office Your Principal Place of Business
A home office qualifies as your principal place of business if most of your income-earning activities occur there.
It can also be your principal place of business if you use it to conduct administrative or management functions (such as keeping the books and sending out invoices) and don’t conduct those functions at any other fixed location.
If you have a home office that qualifies as a principal place of business, your commuting miles from home to various temporary work locations (customer sites, office supply store, FedEx shipping office, etc.) count as business mileage.
Ditto for commuting mileage from your home to any regular place of business, such as an “official” office in town.
Finally, you can treat all the mileage between the “official” office in town (if there is one) and various temporary work locations (customer sites and so forth) as business mileage.
When your home office meets the definition of a principal place of business, it’s usually pretty easy to rack up lots of business mileage, making it much easier to clear the over-50 percent-business-use hurdle and thereby qualify for the generous first-year vehicle depreciation write-offs.
Observation: When your home office qualifies as a principal place of business, you can get a double-dip of tax savings:
Warning: Your allowable home office deduction is limited to the gross income from your business activity reduced by: (1) other expenses for which deductions are allowed in the absence of business use (such as home mortgage interest and real estate taxes) and (2) business deductions that are not allocable to the use of the home (such as advertising and supplies).
If this rule disallows some of your deductions, you carry forward the disallowed amount to the following tax year, subject to the same limitation in that following year.
You Likely Can Claim the Qualified Business Income Deduction
The Qualified Business Income (QBI) deduction was a centerpiece of the TCJA. For 2018-2025, the QBI deduction is available to eligible individuals.
The QBI deduction can be up to 20 percent of:
Pass-through business entities report their tax items to their owners who then take them into account on their owner-level returns.
The QBI deduction, when allowed, is then written off at the owner level on IRS Form 1040.8
Key Point: For 2022, unfavorable phase-out rules kick in when your taxable income, calculated before any QBI deduction, exceeds $340,100 if you’re a married joint-filer or $170,050 for any other filing status.
Takeaways
When you become self-employed, your tax bite becomes integral to your life because taxes come before your take-home pay. And that tax bite starts immediately with the self-employment tax.
The self-employment tax is no sissy. It’s 15.3 percent of your net earnings from self-employment, that can take a big chunk of your income.
The good news is that you now have business deductions—and they are valuable. For example, you buy a
$50,000 heavy SUV and write off up to $50,000 of its cost with 100 percent business use or $45,000 with 90 percent business use.
You have lots of business deductions that apply to you. We mentioned a few in this article. But the fact you are reading this article is a good sign because, at Morris + D’Angelo, we believe that Tax Optimization is one of the most empowering and responsible things you can do to protect your growing financial assets.
In the grand scheme, tax considerations may be secondary to the non-financial advantages of working for yourself instead of working for “The Man”. We’ll inform you on tax issues, and you decide about the rest.
With the potential of COVID cases on the rise and the possibility of “suggested” pandemic mandates and protocols in tow, this might be the tipping point for those of you considering Self-Employment.
But, before you leap, let’s consider the tax implications moving forward. This self-employment thing may not be as rosy as it appears for you.
If you have questions and need clarity, or need help to determine what’s important to pay attention to, to retain or maximize your gains as you consider this move, please contact us at Morris + D’Angelo. This is our Expertise!
At Morris + D’Angelo, we believe that Tax Optimization is one of the most empowering and responsible things you can do to protect your growing financial assets. Tax optimization looks at a multi-year approach to minimizing tax costs. Tax avoidance is integral to tax optimization.
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
Daniel frequently provides Media Content via Workshops, Podcasts, and Printed Articles on topics like Bitcoin and Cryptocurrency, Wealth Preservation and Planning, Global Banking, and many other high-level financial topics that serve and demonstrate the Value of our Global Network that should be of interest to those who need Private High-Wealth Services.
If you would like Daniel to speak to you or your Professional Group and bring clarity about the new frontier of the new business tax law changes. Please contact us.
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2yMaybe. Not everyone has the "self-starter" temperament required to be self-employed. And this this matter of getting customers and keeping them happy...