When you work for someone else, your employer takes care of tax withholdings for you. When you work for yourself, you are responsible for the withholding and payment of these same taxes.
In California, you are not just responsible for federal taxes; you are also required to pay state employment tax. Here is a rundown of the things you need to know to stay out of trouble with the IRS and the Franchise Tax Board of California.
According to the IRS, you are self-employed if you:
- Carry on a trade or business as a sole proprietor or an independent contractor.
- Are a member of a partnership that carries on a trade or business.
- Are otherwise in business for yourself (including a part-time business).
There are many types of self-employment: freelancing as a writer or designer, practicing as a lawyer or physician, a tutor, or anyone else in business for themselves who is not an employee of an organization.
A Little About Taxing Agencies
Most of you are familiar with the Internal Revenue Service, or IRS. It is the tax collection agency for the federal government. It administers the Internal Revenue Code as enacted by Congress. This is the agency to which you file your income taxes every year on or around April 15.
The Franchise Tax Board (FTB) collects personal income tax and corporate income tax for the State of California. It also administers other tax programs for the state as well.
Types of Businesses, Explained
Specific business type designations are used by the IRS and the FTB to determine what type of taxable entity you are.
- Sole Proprietorship: an unincorporated business with one owner who pays personal income tax on profits from the business.
- Partnership: a business or firm owned by two or more partners.
- Corporation: a group of people that has been authorized to act as a single entity by law. A corporation is legally a person.
- S-Corporation: meets IRS requirements to be taxed under Subchapter S of the internal revenue code. It allows a group with 100 or fewer shareholders to incorporate while being taxed as a partnership.
- Limited Liability Corporation, or LLC: a private, limited company with a business structure combining the pass-through taxation of a partnership or sole proprietorship with the limited liability of corporations.
The Ins and Outs of Paying Self-Employment Taxes
Determining If You Owe Self-Employment Taxes
Self-employment taxes are Social Security and Medicare only. The term does not apply to any other taxes.
Who must pay?
- Sole proprietors with a net profit of $400.00 or more annually
- Individuals with a net profit of $400.00 annually from a partnership or LLC
To calculate the net profit (or loss) from your business, subtract your business expenses from your business income. If expenses are less than income, you have a net profit which is taxable according to the instructions for IRS Form 1040.
If expenses are more than income, the difference is a net loss, which might be deductible from gross income.
Estimated Tax Payments
Federal and state income tax is “pay as you go.” An employer pays withholdings to the taxing agencies throughout the year. As a self-employed individual, you are required to do the same, typically as an estimated quarterly tax.
They are called estimated taxes because they are based on a best-guess of your annual income for the year in question. Many self-employed people do not have a regular income that can be determined ahead of time. However, since taxes must be paid in full, you must estimate what your final annual income will be and pay part of it quarterly.
You must make estimated payments if you expect to owe at least $500.00 in taxes. There are additional provisions: you expect withholding and credits to be less than:
- 90% of the tax shown on your 2016 return
- 100% of the tax shown on your 2015 return
…whichever of these amounts is smaller.
When, Where, and How to Make Payments
The schedule for making quarterly payments for both the IRS and the Franchise Tax Board for 2016 is as follows:
- First quarter: 30% is due on April 18, 2016
- Second quarter: 40% is due on June 15, 2016
- Third quarter: no estimated payment is due on September 15, 2016
- Fourth quarter: remaining 30% is due on January 17, 2017
IRS Form 1040-ES and FTB form 540-ES come with payment vouchers for use by mail. You can also use the Electronic Federal Tax Payment System (EFTPS). The FTB provides for free online filing on Calfile.
Even though you paid quarterly taxes, you must still file an annual tax return. Use Schedule C to report income. Use Forms 1040-ES and 540-ES Schedule SE to report self-employment tax.
Take Advantage of These Deductions
As a self-employed person, you can deduct not only the employer share of your Social Security and Medicare taxes, you can take other deductions such as home office, educational, or auto expenses.
2016 Tax Rates for the Self-Employed
For 2016, the Social Security rate is %12.4 on the first $118,500.00 of covered wages. Medicare is paid at 2% of all wages. As a self-employed individual, you can deduct the employer portion of these taxes.
Use California Estimated Tax Worksheet Instructions for Form 540-ES can help you calculate your state withholding and deductions. For the IRS, use Form 1040-ES.
Penalties and Abatements
If you don't make your estimated tax payments during the year, and the amount you have withheld from other income is less than 90% of your tax bill, you will be charged a penalty based on percentage owed.
The IRS charges 5% of the unpaid tax due on that date plus 1/2 of 1% for each month or partial month that remains unpaid. They cannot charge for more than 40 months, and the maximum penalty is 25% of the total unpaid tax. Interest is charged on any delinquent payment from the original due date to the date paid and the interest compounds daily.
You can also be penalized for:
- A check returned for insufficient funds
- Negligence in payment
- Substantial underpayment of the tax owed
- Failure to pay the tax shown on the return by the due date (April 18, 2016, for the tax year 2015)
Important note: An extension of time to file does not extend the time to pay. You must pay your taxes on the April due date even if you have obtained an extension to file your return at a later date.
An abatement is a reduction or elimination of interest penalties under specific circumstances:
- Extreme financial hardship due to catastrophic circumstances or significant disability
- Erroneous refund
- Reliance on formal written advice
- Disaster loss
- Military personnel stationed outside the U.S.
- IRS or FTB delay or error
There is a First-Time Penalty Abatement Program that can be applied to a first-time penalty charge based on the taxpayer’s history.
We hope this demystifies self-employment taxes if you work in California. As always, if you have any questions it is best to seek professional help.