Tax Tips for Small Businesses and Freelancers
This advice is meant for people with annual incomes between $50,000 and $80,000, but higher earners also may find some useful advice
Tax season has rolled around again, adding to the work and worry loads of America's small-business owners, more than half of whom are aged 50 or above, according to data from the U.S. Census and Guidant Financial surveys.
For small-business owners — and freelance workers — who turned a profit, finding appropriate deductions for 2023 while also looking for ideas that might mitigate future income tax bills can be a bit overwhelming.
If, while calculating your earnings, you realize that, hey, wow, you actually did OK (or more than OK) while simultaneously concluding that you are going to have a higher tax bill than you prepared for, don't panic. First, congratulate yourself on running a successful enterprise (which is no small feat).
Second, take a breath and consider the following strategies and advice. Some may offer relief on your 2023 tax bill while others could help you in the future as you continue to grow your business.
Quarterlies and Penalties
Generally, if you expect to owe more than $1,000 when you file your return for 2023, you will be required to pay estimated taxes on a quarterly basis starting this year. If you didn't do this or paid too little, you might also be subject to an underpayment penalty.
In order to minimize penalties, you should pay at least 90% of what you expect to owe, says Lee Reams Sr., co-founder of the tax-advice website TaxBuzz.
"A retirement plan is the best tax shelter there is."
Luckily, the IRS considers a taxpayer to have paid within a reasonable time as long as they do so by April 15 of the current year for the previous year's return (so, by April 15, 2024, for the tax year 2023). This means, if you have the funds, pay your estimated taxes now.
Another way to avoid the penalty is to file for first-time abatement penalty relief, which allows people who have been compliant in the prior three years to have their penalty forgiven, Reams explained.
As a self-employed person or business owner you may feel as if you're paying more in taxes than if you were a traditional W-2 employee. You probably are. This is because of a little thing called self-employment taxes.
Self-Employment Tax
Self-employment tax is a combination of the Social Security and Medicare payments made by both an employee and employer (technically you're both), says Jane Ditelberg, director of tax planning at Northern Trust Wealth Management. When you are employed by someone else, they pay half of that tax and you pay the other half.
For 2024, the total percentage equals 15.3%.
If you're like me, you've probably wondered if there is any way to reduce your self-employment tax bill. Potentially, there is: you could elect to change your business structure or the way your business is taxed, though this will not be feasible for a previous year nor is it necessarily advisable for everyone and every business.
Small Business Structures and Tax Rules
Most people who start businesses do so as sole proprietors and report their business income and expenses on their personal Form 1040 tax returns. They will pay the full self-employment tax as well as any ordinary income tax they may owe.
If you own a business entity with, say, your sister, you can minimize your self-employment tax by electing to be an S corporation, explained Ditelberg. These corporations pass corporate income, losses, deductions and credits through to their shareholders, who report it all on their personal tax returns.
Unlike most partnership income, S corporation income isn't self-employment income and isn't subject to self-employment tax, according to the IRS. S corporations were created so that owners of small, incorporated companies would not be double taxed by paying corporate and personal income tax. There are lots of rules for S corporations, including the types and numbers of shareholders allowed.
Incorporation Options Take Work
Another option, becoming a limited liability company (LLC), offers businesses flexibility of a partnership while shielding shareholders' personal assets from being seized to settle the LLC's debts or legal obligations. At most, LLC shareholder can lose only the amount they invest in the company.
"You can't be casual about it."
LLCs can be taxed as partnerships if there are two owners or as "a disregarded entity" if they are a single-member LLC. Robert Morris, a partner at Pullman & Comley Law Firm, said such companies receive liability protection but do not file a separate business tax return.
Regardless of the number of people at any limited-liability company, it must include the "LLC" descriptor on any letterhead or business card. (If you're an S corporation, you must use "Inc.")
"You can't be casual about it," explained Morris, "Announce to the world that you're using a limited liability company or corporation."
Tax Savings May Be Significant
As an LLC, you can also elect Subchapter S as your tax status, meaning you want to be taxed as an S corporation.
Potentially, this tax classification could save you thousands of dollars, Hooman Radfar, CEO of Collective, a finance platform for fulltime freelancers, said. This is because S corporations split earnings between payroll and business profits, the latter of which is not subject to self-employment tax.
"Once a business is making over $60,000 a year, that can add up to a lot of money."
"Once a business is making over $60,000 a year, that can add up to a lot of money," he said.
Before deciding to change your business structure, consult a tax professional or accountant to make sure you understand the paperwork and documentation you would be required to file. Most importantly, you must pay yourself a reasonable salary report it on both an IRS Form W-2 and on a Form K-1, which allocates profits and losses to each business owner.
It breaks down like this: Say you made $50,000 as an LLC. All of it is subject to self-employment tax. If you were an S corporation and paid yourself a salary of $10,000, only your salary would be subject to income tax and FICA withholdings. (And, as both employee and employer, you'd pay the entire 15.3%.)
"The difference is," explained Morris, "the remaining $40,000 would be S corporation income that flows through to you but is not subject to self-employment tax."
Always Be Cautious
Don't get too excited, though. He went on to explain that "the IRS appropriately takes the position that you have to decide how much of that $50,000 would be considered reasonable compensation is for the owner.
So, if the entity earns $50,000 and the owner does all the work, the IRS might say that $10,000 is an unreasonably low salary, recognizing that you are paying yourself so little only to avoid paying self-employment tax — which, of course, would be true.
And, said Morris, "You need to do this in advance. If you are going to take a salary, you have to do it by December 31."
As well as payroll forms, S corporations must have complete financial statements, including profit and loss data and documented assets, liabilities and equities.
For some, all of this added paperwork may not be worth the potential savings. Incorporating yourself may have other consequences on the state level. States could require unemployment insurance contributions or franchise tax payments for the right to do business within their jurisdiction. Forming an S corporation also means you will have to file a separate business tax return (Form 1120-S), said Reams.
Tax-Reduction Tips
"A retirement plan is the best tax shelter there is," said Morris — as long as you don't need access to that money until you reach retirement.
You can contribute to a retirement plan for the previous year through April 15 of the current year. And, Radfar said, self-employed retirement plans like SEP-IRAs or Solo 401(k)s allow maximum contribution limits more than double that of traditional employee plans: 25% of your income to a maximum $69,000 in 2024.
"If your business's cash flow can sustain it, this is one of the best ways for solopreneurs to reduce their tax bill and fund their future."
"If your business's cash flow can sustain it, this is one of the best ways for solopreneurs to reduce their tax bill and fund their future," he said.
If your business is an S corporation, the most you can contribute to an IRA or other tax-deferred retirement savings plan is based on your personal income as reported on IRS Form W-2 and not on your business's profit, said Ditelberg.
This distinction may not matter if you also have a corporate job with a retirement plan; you may just want to have the lower self-employment tax.
"On the other hand," she continued, "if your business is your main gig and you'd like to be able to save more for retirement, you might prefer an LLC." Because, while you will owe self-employment tax on all of the LLC's earnings, all of the corporation's earnings will count when determining how much you can contribute to your retirement plan.
Deductions and Expenses
Aside from retirement plans, Reams also suggested electing to take the entire deduction for any equipment purchased in one year rather than spreading it out over a few years if you need to reduce your tax bill.
"One of the most common deductions self-employed workers take is the home office deduction," said Radfar, "but it's often misused."
"One of the most common deductions self-employed workers take is the home office deduction."
The rules state that you must use a portion of your home regularly and exclusively for business to be eligible. That means, he explained, if you have anything personal in your office, "like an exercise bike or daybed for guests, you cannot use the entire square footage."
Once you calculate the percentage of your home dedicated to your business, you can also deduct that percentage of expenses including mortgage interest, property tax, insurance, depreciation, utilities, repairs and phone and internet costs. Like all business expenses, make sure to keep detailed records.
And don't forget charitable donations, said Radfar, even if you elect to be taxed as an S corporation. When filing an S corporation tax return, qualified charitable contributions are shown separately on a line of the owner's K-1 tax form, he explained, which means the charitable contribution flows through to Schedule A, where itemized deductions are reported.
