Being self-employed is one of the most wonderful things you can ever do for yourself when you have a passion and want to turn it into a money-making venture.
You can enjoy a better work-life balance and flexibility while doing something you love.
However, if there’s one thing that many self-employed people struggle with, it’s organizing and filing their taxes.
A lack of understanding and urgency means they’re at risk of making serious errors!
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9 Common Tax Mistakes to Avoid When You’re Self-Employed
If you’re self-employed, here are nine common tax mistakes that other sole traders make and what you can do instead.
1. Doing It By Yourself When You Lack Experience
When there are resources like FileTax.com – Online Tax Filing, it’s surprising that new self-employed business owners with no previous business experience attempt to organize and file their taxes themselves.
However, it happens frequently. In an effort to save money or because they feel confident in their abilities, they go full steam ahead with the filing process.
There’s nothing wrong with filing your taxes yourself, but it pays to have guidance from the experts.
It’s also especially important to seek help when it’s your first year as a self-employed person, and you’re unsure whether filing paperwork and requirements have changed.
It’s not uncommon for the IRS to issue penalties and fees for improper and inaccurate filing.
What to do instead: Research the best online or in-person tax professionals who can assist with filing your taxes.
If you need help with recordkeeping, deductions, and quarterly payments, ask tax professionals for assistance with these before the end of the tax season.
Accounting software and financial apps are also helpful for ensuring greater organization and a smoother tax preparation process.
2. Not Setting Money Aside for Taxes
When you’re employed by a business, they withhold taxes from your earnings.
You don’t need to worry about setting aside money from your paycheck to give to the IRS.
However, that all changes when you become self-employed, and not everyone is aware of this.
Unfortunately, it becomes apparent when tax season starts, and you’re faced with the prospect of an overwhelming bill.
What to do instead: You likely want to avoid a hefty tax bill that you can’t comfortably pay.
When you become self-employed, set aside around 30% of your income, or more if you live in a high-tax state like Hawaii, New York, California, or Vermont, for federal taxes.
Keep this money in a separate account, and transfer the necessary percentage after each payment you receive.
Also, watch this video about 5 legal steps to start a business.
3. Not Making Quarterly Estimated Tax Payments
Quarterly estimated tax payments are essentially a pay-as-you-go tax payment method for income that isn’t subject to withholding.
Forms of income that fit into this category are self-employed funds, dividends, rent, and interest.
You need to make quarterly estimated tax payments if you expect to owe $1,000 or more in taxes for the year, and you’re a self-employed person, sole proprietor, partner, or S corporation shareholder.
There can be penalties if you don’t make these payments or underpay.
If you underpay, the federal short-term interest rate is 7% per year.
The failure-to-pay penalty is a separate penalty of 0.5% of the unpaid taxes for each month or part of a month that you haven’t paid the tax, up to 25%.
Interest is also charged on unpaid balances and penalties, compounding from the original due date until it’s paid in full.
What to do instead: Make your quarterly estimated tax payment to avoid penalties and fees.
Mark your calendar for the due dates in April, June, September, and January, and use IRS Form 1040-ES to calculate the payments you must make.
4. Mixing Your Business and Personal Finances
Mixing your business and personal finances is easy to do when your business starts as a hobby.
You pay for your passions out of your own money because you aren’t making any income from them.
Over time, you’ll have a thriving business that’s intertwined with your personal funds.
While it’s understandable how you get to that point, you must make a conscious effort to change it as soon as possible.
Otherwise, it can have serious tax consequences. One account for everything causes messy records, missed opportunities for tax deductions, and even an increased risk of an IRS audit.
What to do instead: As soon as you decide that you’re going to start your own business, open a separate business checking account.
Use a dedicated card attached to it for all business expenses. You might even consider using accounting software that can automatically categorize your spending.
5. Not Tracking Your Business Expenses
As a self-employed business owner, you’re busy.
You’re not just the face of the business; you’re also the cleaner, the marketing guru, the accountant, and the customer service representative. At times, it can get overwhelming, and crucial tasks fall by the wayside.
Tracking business expenses is often one of them.
While not keeping track of your expenditure may not seem like a big deal, it can be from a tax deduction perspective. The fewer the expenses you track, the fewer you can deduct from your taxes.
What to do instead: Tracking your expenses doesn’t have to be complicated or time-consuming.
Start by keeping your receipts and tracking all costs weekly to avoid falling behind.
Examples of deductible self-employed costs include home office, the business portion of your internet and phone costs, software subscriptions, and equipment and supplies.
6. Not Knowing About Self-Employed Taxes
There are so many taxes to keep up with that it’s common for self-employed individuals to forget the self-employment (SE) tax.
This is the self-employed version of the FICA tax paid by standard employers and employees.
The SE tax is a 15.3% tax that covers the Social Security and Medicare components of your earnings up to a specific limit. Many self-employed people only become aware of it on filing day.
What to do instead: Don’t be caught out by a tax you haven’t budgeted for. Use the IRS Schedule SE Form 1040 to calculate the SE tax you’ll need to pay, and incorporate it into your quarterly tax estimates.
7. Filing Late
Every year since 1955, Tax Day has been on or just after April 15.
This is the day you must submit your annual self-employed tax return and pay any taxes owed. You can also file for a six-month extension and extend your filing date until October 15.
Many small businesses fail to meet filing deadlines due to a lack of awareness, poor recordkeeping and disorganization, and being overwhelmed by day-to-day operations.
Financial difficulties, technical issues, and general forgetfulness are also common reasons.
Although it is common, late filing can have serious repercussions.
For individuals and most businesses, the penalty is 5% of the tax due for every month or partial month that it’s late, up to 25%. The IRS also charges interest on penalties.
What to do instead: Filing on time is the best way to avoid penalties and fees.
If you need more time to file, apply for a free automatic extension using Form 4868.
This provides you with more time, but it doesn’t extend the payment deadline. If your reason for not filing is due to financial difficulty, file your return and contact the IRS to set up a payment plan.
8. Not Deducting Health Insurance Premiums
You might assume that because health insurance doesn’t seem business-related, you can’t deduct it.
As a result, many self-employed people don’t. However, you can claim the Self-Employed Health Insurance Deduction on your personal income tax return Form 1040, Schedule 1. It’s deducted as an adjustment to your income.
What to do instead: Claim health insurance premiums for yourself, your spouse, and dependents if your business is producing a net profit and you don’t already have an employer-subsidized health plan through another job or your spouse’s job.
9. Making Tax Mistakes When Hiring Workers
Your own tax obligations can be overwhelming enough to understand, but they can get even more confusing when you hire help.
Suddenly, you have to worry about ensuring that your employee or contractor is paying the correct taxes.
Self-employed people often accidentally misclassify their workers as contractors or employees, or vice versa. This mistake can trigger IRS penalties.
What to do instead: Familiarize yourself with the definition of an employee and a contractor.
A contractor is a business that works with another company under a contract to provide services.
They are responsible for their own self-employment tax and receive 1099-NEC payments for earnings over $600. Contractors also file W-9s.
In contrast, an employee works for a business, with the employer controlling what they do and when they do it.
The employer withholds income, Medicare, and Social Security taxes and files a W-2. When in doubt, review the IRS guidelines or file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Final Thoughts on Common Tax Mistakes Self Employed People Make
When you’ve never filed self-employed taxes before, it’s only natural to make mistakes.
However, awareness of the most common mistakes can make you less likely to make them. Keep these errors in mind as filing day fast approaches.
