Fundbox Guest Post: 7 Tax Terms Entrepreneurs Should Know
August 1, 2018
Important tax terms that self-employed business owners must know, and more importantly, why they’re critical to understand.
When you first decided to start your own business, friends and family members might have made comments like, “Wow, you’re going to be able to take so many tax deductions!” or, “You’ll be able to write off a fancy car.”
For the new entrepreneur, the promise of significant tax savings can be exciting or tempting. If only it were that simple!
The truth is, there are some important differences between filing taxes as a self-employed freelancer, independent contractor, or solopreneur, and filing taxes as an employee. In order to minimize your tax bill as a business owner, you’ve got to understand a few key tax concepts.
In this blog post, I’ll define some important tax terms that self-employed business owners must know, and more importantly, why they’re critical to understand.
1. Taxable Income
Your taxable income is the total amount of income that’s subject to taxes.
As an employee, you fill out a W-4 form that tells your employer how much of your wages to withhold for tax purposes. Employers withhold federal income taxes and Federal Insurance Contribution Act (FICA) taxes, which include Social Security and Medicare contributions. Different states also have their own withholding rules.
As an independent contractor or freelancer, there is no employer to withhold these taxes for you. Instead, you’ll need to calculate and pay self-employment tax (a Social Security and Medicare tax for the self-employed), as well as federal and state income taxes.
If you expect to owe $1,000 or more on your federal income taxes, and you own a sole proprietorship, partnership or S corporation, you don’t wait until April 15 to pay your taxes in full. Instead, you make estimated income tax payments each quarter. Use to calculate your estimated tax, and make your payments on April 15, June 15, September 15 and January 15.
An adjustment to your income is any expense that legitimately reduces your total (gross) income. These are reported on your IRS Form 1040 and subtracted from your gross income to arrive at your adjusted gross income (AGI). A tax deduction is a type of adjustment.
4. Audit Potential
Audit potential refers to the risk that tax returns may be unusual or incorrect. The IRS has several ways to determine whether your returns have audit potential. For example, taxpayers who fill out Schedule C forms (that is, self-employed entrepreneurs), taxpayers who claim excessive deductions relative to their business income or above the average for their industry, and tax returns with errors may be flagged for an audit.
You also have higher audit potential if your business has a lot of cash income, such as a bar or restaurant, vending machine business, or laundromat. This is because many such business owners don’t report all of their cash income.
5. Tax Exemption
Tax exemptions are given to specific types of organizations, such as nonprofits. In order to get a tax exemption as a self-employed person, you need to be an ordained clergy member or a member of certain religious communities that object to receiving money from the government. You can apply for a tax exemption using IRS Form 4361.
6. Tax Deductions vs. Tax Credits
One of the biggest misconceptions about taxes is that tax deductions and tax credits are interchangeable terms.
A tax deduction is deducted from your taxable income. A tax credit is deducted from your tax bill. What’s the difference? It can be substantial. For example, suppose your taxable income is $100,000, and you qualify for a $2,000 tax deduction. This reduces your taxable income to $98,000, which may also reduce your tax bill, but probably not by much.
However, suppose your taxable income is $100,000 and you owe $10,000 in taxes, but you qualify for a $2,000 tax credit. Since the tax credit is subtracted directly from your tax bill, your tax bill is reduced to $8,000.
The difference between tax credits and tax deductions is important to understand before making purchases or investments that are tax-deductible.
7. Types of Tax Deductions
The IRS sets standard deductions that everyone can claim. These deductions are subtracted from your AGI. The government’s goal here is to exempt a certain base level of income from taxation. The Tax Cuts and Jobs Act passed in 2017 increases the standard deduction for 2018 to $12,000 per person.
Using our previous example, suppose you are a single freelancer with AGI of $100,000. The easiest approach to filing taxes would be to take the standard deduction of $12,000, reducing your taxable income to $88,000.
But what if you spent $20,000 on business expenses that are tax deductible? In that case, itemizing your expenses (listing them in separate categories on your tax return) would allow you to subtract these deductions from your taxable income, reducing your taxable income to just $80,000.
You can either take a standard deduction or itemize your deductions; you can’t do both.
The made some significant changes to business deductions. Some of the most popular business tax deductions, such as costs for entertaining or meals in the course of doing business, have been reduced or eliminated altogether.
Instead, sole proprietorships, as corporations and partnerships can simply deduct 20% from the total income they report to the IRS. This is in addition to the standard deduction.
Go back to our example of the freelancer with AGI of $100,000 who takes the standard $12,000 deduction and has taxable income of $88,000. By taking a deduction of 20% of $88,000 ($17,600) his or her taxable income shrinks to $70,400.
Get Help When You Need It
Understanding these essential tax terms will help you get a head start on your business taxes as a freelancer.
If you’re worried about being able to pay your bills come tax time, and you’re currently financially stable, you might consider applying for a now, so you have a cushion of funds ready when you need them.
If you have any confusion about taxes, it’s always helpful to seek professional advice from an accountant or tax preparer who specializes in freelancers or small businesses like yours. With many new changes to the tax laws for 2018, getting professional help can really pay off this year.
Disclaimer: The information in this blog doesn’t replace the advice of a tax or legal expert. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. If you have any questions about your small business tax situation, talk to a professional.