Tax Tips: The joys (and woes) of self employment

As the economy continues to stumble along with uncertainty, many are starting to look at the self-employment option as the way to get ahead.
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For some, the allure of being self-employed is the solution for gaining economic independence in a job market where new employee applications seem to get lost in a twilight zone. For others, the decision to become so-called sole proprietors may have been forced upon them because of a strapped employer needing to trim down skyrocketing payroll costs and choosing instead to hire selected sub-contractors - often on a part-time basis.

Regardless of your reason, if you happen to be an aspiring entrepreneur seeking to go out on your own, you need to look closely at the entire picture (after taxes) before you can know if you will be better off economically as an independent contractor.

Clearly, there could be many advantages in self employment which, at the very minimum, could include a sense of independence and flexibility, not to mention a possible higher earning potential. For some, this is enough to trade off those fringe benefits like the medical, retirement and other plans that might be offered in an employee setting.

However, before anyone jumps into business as an independent contractor, they need to be fully aware of all the tax implications involved.
Tax advantages

It is common knowledge the IRS has grown increasingly stingy over the years in allowing tax deductions for expenses paid by ordinary employees even if those expenses were clearly associated with their business or profession.

Because of ever-tightening threshold requirements, ordinary employees rarely have enough business or professional deductions to provide any tax savings. And, when they do, they are often concerned those employee write-offs will only raise a red flag with IRS.

On the other hand, those that carry on their business as a sole proprietor, as an LLC or otherwise, will find that they could be entitled to a wide array of business deductions, oftentimes producing a substantial tax savings.

For these independent proprietors, the tax write-offs are viewed as "above-the-line" deductions by IRS. This, in turn, allows them to be deducted in full without the usual, strict limitations that are imposed on ordinary working employees.

More important, these (above-the-line) business deductions are less likely to raise the risk of audit because of an old familiar section in the tax code that states, essentially, that any business owner has the authority to deduct all the "ordinary and necessary" expenses that have been paid or incurred in carrying on his or her trade or business.

As long as these deductions are reasonable in amount, they are viewed as commonplace for a sole proprietor and will not raise the proverbial "red flag" as with the ordinary employee.

Let's take a look at some of these "ordinary and necessary" deductions that could be found on a form Schedule C filed by sole proprietors: professional dues, business subscriptions, professional books and journals, office supplies, postage, continuing education, technical training, travel expense, business mileage, depreciation on business equipment, including computers and accessories.
The "not-so-good" news

The one major downside that confronts all sole proprietors is the required "self employment tax" (the SE Tax). The SE tax refers to the proprietor's Social Security and Medicare tax amounting to a whopping combined tax rate of 15.3 percent.

Although this tax rate is applied to the proprietor's net earnings after allowable deductions, many consider the cost to be debilitating. This could well be the case, especially since it is an out-of-pocket cost that can't be split with an employer.
Now the ugly part

This part applies to those taxpayers who have an inherent aversion to record-keeping and having to deal with the IRS any more than they have to. They sometimes find it to be an intrusion to be required to keep records, to track expenses, record business mileage, etc.

Worst of all, they will not appreciate having to sit down and pre-determine their estimated tax liability every year. This is a chore that must be followed with timely tax payments every three months in order to ward off potential penalties and interest.

On a final note: Questions about record-keeping and estimated tax requirements should be discussed with a competent tax adviser. He or she will, more than likely, allay any of your fears or concerns by providing an easy-to-follow plan strategy that can be followed year after year.