The self-employed face a number of tax traps which the traditionally-employed rarely consider. Foreknowledge of these pitfalls is important to avoiding significant tax burdens, interest and penalties. Two of the more common concerns involve the quarterly withholding of taxes and the home-office deduction.
One of the most important obligations for the self-employed is to pay estimated taxes during the year. Unlike a traditional employment situation where the employer withholds taxes from an employee's paycheck during each pay period, the self-employed must make their own withholdings. These withheld amounts are typically paid quarterly and must be paid both to the federal government and the state government.
When estimating these quarterly payments, the self-employed should keep two important considerations in mind. First, the taxpayer should estimate the tax rate not on the amount of the quarterly earnings, but on the projected annual amount of earnings. For the self-employed taxpayer with a growing business, this may mean using a higher tax rate, even on earlier, smaller earnings. A self-employed taxpayer whose income fluctuates seasonally – for example, a tax preparer whose business peaks between January and April – might use a lower tax rate during the busy season to offset lower earnings later in the year.
Second, the self-employed must be mindful of the separate, self-employment tax. The self-employment tax, which is approximately 15% of earnings, represents Medicare and Social Security payments. If this additional tax is not withheld by the self-employed, it could result in a serious shortfall at the end of the tax year. Where a significant shortfall occurs, the IRS, and the state, can impose penalties and interest on the amount underpaid.
Many self-employed persons work from home or use a personal vehicle, which leads to another area of frequent tax problems: home office and personal automobile deductions. A taxpayer may deduct as a business expense the pro-rated portion of their rent or mortgage payment, and utilities payments, which represents the area used for the home office. The home office, however, must be used exclusively for the business. Physically separating the area, such as using a specific room, is best for this. Also, if a personal vehicle is used for the business, the taxpayer must be sure to keep mileage records for the business use. Only the business miles can be deducted.
Finally, the self-employed should consult a tax professional familiar with both federal and state requirements in order to deal proactively with any potential tax issues.