What is Self Employment Tax?

Self Employment tax is the combination of two different taxes that are normally deducted from your paycheck, Social Security and Medicare.  As an employee you and your employer share the burden of these taxes, each of you pays half of the amount through payroll taxes.  If you look on your paystub you will see these deductions (sometimes called FICA - Federal Insurance Contribution Act).  When you are self employed there is no paycheck for these taxes to be deducted from.  The rate you are taxed on your Self Employed income is 15.3%, which is 12.4% for Social Security and 2.9% for Medicare.  These taxes are due on your self employed income regardless of any other itemized deductions you might have.  You will also owe the federal income tax on your earnings in addition to your self employed taxes.

What does it mean to itemize deductions vs taking the standard deduction?

Each year the IRS determines an amount to assign to the “cost of living” and grants every taxpayer this amount as a standard deduction from their income for the year.  This lowers your taxable income and thus the amount of tax owed.  However, the IRS recognizes that there can be additional expenses in life.  If these add up to more than the standard deduction you can take these instead as “itemized deductions”.  These include major medical expenses, mortgage interest, taxes paid to state or property tax, and charitable donations.

How are business expenses different from Itemized deductions?

When you make self employed income you can claim all the expenses it took to generate that income.  These are listed on your Schedule C (the IRS form used to report self employed income and expenses) and help lower the total self employed income you will pay taxes on.  This will establish the Self Employed taxes you owe.  If you then have additional expenses that can be itemized as deductions, this will lower your total taxable income and the amount of Federal and State income tax you will owe. 

What is the difference between an LLC and an S Corporation?

Both of these are a form of protection for you, the owner, against liability incurred by the business activities you or your employees engage in.  An LLC is a Limited Liability Company, which in the eyes of the IRS is what is called a “disregarded entity”.  This means tax wise there is no difference to the IRS between you making money as a self employed individual and making money as an LLC.  You will still pay self employment tax on all earnings of an LLC.  It costs nothing to form an LLC with the IRS and there is no annual fee. Each state has a required filing with the Secretary of State and these fees range from $25-$100 a year.  Some states have an additional fee when you file the tax return, California is the highest I have encountered which is an $800 minimum fee.

An S Corporation on the other hand, is a separate entity recognized by the IRS.  The business files a tax return for all of the income made and the profit flows to the owner on a statement of income called a K-1.  This income is then taxed on the personal level on your 1040 income tax return.  The benefit however is there is no self employment tax levied on the profit on your K-1.  An S Corp also registers with the Secretary of State and each state has their own S Corp taxation level.  Oregon has a flat fee of $150 regardless of income and California again has a minimum $800, and then 1.5% of your income whenever that figure exceeds the $800 minimum payment ($53,000 of profit).

Do I have to be an LLC or S Corp to have my own business?

No you do not have to be an LLC or an S Corp to start your own business!  The IRS accepts a social security number as a business number on your Schedule C. Make sure to check with your state and city of the requirements to operate a business in your area.  Most will require you to register for a business license if there is intent to provide services or products and make a profit.  If you wish to use a name other than your legal given name, register for a DBA with your state.