Tax Strategies for the Self-Employed

By Calley Bjorkman, CPA | Feb 07, 2024 |

Deciding to leave your steady job and start your own business is a big step with significant tax implications. You need tax strategies for the self-employed.

As you transition from reliable employee to solo entrepreneur, understand how your taxes will change and how to take advantage of deductions and other savings specific to the self-employed.

It’s not about what you make but what you keep. Let Brighton Jones help.

Shifting tax obligations

When you collect a regular paycheck, your employer pays income taxes on your behalf. They withhold federal and state taxes from each check and remit payments to the IRS and state revenue agencies.

As a business owner, taxes don’t automatically come from your income. You are responsible for calculating, reporting, and paying your quarterly income taxes through estimated payments. If you fail to pay enough throughout the year, you could face underpayment penalties from the IRS. With today’s high inflation pushing rates up, that penalty is currently a steep 8% of any underpaid tax.

Another significant change is that you go from paying just your portion of payroll taxes (Social Security and Medicare) to delivering both the employee and employer halves. This means you pay nearly double the self-employment tax compared to payroll tax as a W-2 employee.

Your tax filing gets more complex with new forms and schedules to report your business income, expenses, deductions, and self-employment tax liability. Common new filings include:

Schedule C – Business income and expenses
Schedule SE – Calculation of self-employment tax
Form 8995 – Qualified business income deduction
Form 4562 – Depreciation of business assets

You’ll also need to handle all of your income/expense tracking, bookkeeping, and backups to support the figures on your tax return. As an employee, you may submit expense reports for reimbursement but likely don’t deal with full-scale accounting and financial statements.

The upside of this added complexity is that you open up more options for legal tax deductions only available to business owners.

Which tax deductions can the self-employed leverage?

Operating your own business introduces many potential tax deductions not accessible as a W-2 employee. Here are some common examples:

Partial Home Office Deduction – If you work from home, some household costs, like rent, utilities, insurance, maintenance, etc., may be deductible if that space is used regularly and exclusively for business.
Vehicle Mileage – The IRS lets you deduct 65.5 cents per mile driven for business purposes in 2023. Taking this standard mileage rate typically results in a higher tax deduction than tallying the actual expenses (gas, maintenance, insurance, etc.) applied to the percentage of business use of your vehicle.
Cell Phone/Internet – Since you need these tools to operate your business, you can deduct a portion of your monthly cell and internet bills.
Tax Preparation Fees – Your business taxes and filings can require additional preparation work and are tax-deductible as a necessary business expense.
Retirement Savings – Special “self-employed” retirement plans let you contribute pre-tax income and lower your taxable business profit. More on this shortly!
Business Meals – Meals with clients or otherwise business-related can be partly or fully deductible. Make sure to track participants and purpose.
Depreciation Expense – If you purchase assets over $2,500 for your business, you can deduct a portion of the cost each year based on IRS depreciation schedules.
Self-Employment Tax Deduction – You can deduct 50% of the self-employment tax paid.
Health Insurance – Premiums paid for yourself and dependents are deductible, including qualified long-term care premiums. Medicare premiums also qualify.
Qualified Business Income (QBI) Deduction – You may deduct up to 20% of net business income, subject to income phase-outs and limitations.

The key is keeping detailed records and receipts to back up these deductions on your tax return. Work closely with your CPA or tax advisor to ensure you claim all eligible deductions and provide adequate documentation. You leave money on the table when you do not claim deductions. And don’t forget there are benefits to choosing an integrated wealth management team.

Funding retirement and reducing taxes

Another way self-employed individuals can realize major tax savings is through retirement plans designed for small business owners.

Contributing to one of these plans lowers your taxable business income in the current year while building retirement savings for the future. It keeps funds out of the IRS’s hands now and delivers them down the road when you withdraw the money in retirement.

Top options include SEP IRA, Solo 401(k)/Individual 401(k), SIMPLE IRA, and defined benefit pension.

Choosing a business entity: Tax and legal considerations

When starting a business, you’ll also need to choose what type of legal entity to form. This decision carries both tax and legal implications. Here are some key options to consider:

Sole Proprietorship – The simplest option where no separate business entity is created. You and the business are one and the same for legal and tax purposes. Income is reported on your personal return using Schedule C.
Single Member LLC – Creates legal separation between you and your business. Provides liability protection as creditors go after the LLC’s assets before yours personally. Taxed the same as a sole proprietorship with passthrough to your personal returns. Minimal extra administration.
S Corporation – Separate legal entity that files its own business return. Requires more rigorous bookkeeping and administration, like payroll processing. Allows you to take some income as non-self-employment earnings. May impact retirement plan options.
Partnership – If you opt to co-own a business with one or more partners, this can provide flexibility on profit/loss allocation for tax purposes. More complex administration.
C Corporation – Rarely used for small businesses due to double taxation of profits and heavy administrative issues.

For most solopreneurs and independent contractors, operating as a sole proprietor or forming a single-member LLC tends to be the best tax-wise fit. The LLC provides liability protections the sole proprietorship lacks without much extra administration burden.

Analyze your business activities and risks to decide if forming an LLC is beneficial. An LLC also gives you more flexibility to take on partners or even convert to an S corporation down the road. Consult legal and tax advisors to ensure you choose the optimal structure.