Self-employment taxes are your responsibility when you have a handmade business. When you are self-employed, you are responsible for paying your own Federal Income Tax, State Income Tax, Self-employment tax (Social Security and Medicare), and perhaps even additional city or local taxes. You don’t have a choice and you can’t choose when you start contributing or paying these types of self-employment taxes.
Tax payments are a major part of running your handmade business – you have the Sales Tax payments to the State that you need to track and pay – PLUS – you’ll have self-employment taxes that you need to pay. A good rule of thumb is to set that money aside (in a separate bank account) so you aren’t tempted to spend it.
What is self-employment tax?
As self-employed business owners we don’t have FICA (Social Security) & Medicare taken out of our paychecks – simply because we don’t have paychecks like we would if we worked for someone else. Because of this our taxes at the end of the year tend to be higher and you need to hold onto some of the money that your business brings in so you aren’t sent into a state of panic when you file your tax return.
As a brief recap, self-employed individuals are classified by the IRS as:
- Carrying on a trade or business as a sole proprietor or an independent contractor
- Being a member of a partnership that carries on a trade or business
- Being otherwise in business for yourself – INCLUDING a part-time business
When you are self-employed, you are responsible for paying your own:
- Federal Income Tax
- State Income Tax
- Self-employment tax (also know as Social Security/FICA and Medicare)
- Perhaps an additional City or Local Tax
So, how do I figure out how much money to set aside and what I’ll be taxed on?
Well, that’s where it gets complicated – so bear with me.
- First, you have to determine the Net Income/Profit from your business – which is simply your Income MINUS expenses
- Then you have to determine your tax rate(s)
- Then you multiple your Net Income/Profit by the rate
You’re probably wondering – How do I figure out my tax rate(s)?
- The self-employment tax rate for EVERYONE is 15.3%
- You should be able to determine your Federal, State and any City or Local Tax rates by looking at last years tax return or by contacting your tax preparer.
- 33-35% of your Net Income/Profit is usually a good number to use, if you do NOT have a City or Local tax
Here are some guidelines and best practices to follow:
- Track your business income and expenses on a monthly basis – be focused and diligent about doing your bookkeeping
- At the end of each month determine your Net Income/Profit
- Multiply your Net Income/Profit for the month by the rate you determined
- Set that money aside – act like you don’t even have it!
Here is a simple example to help you:
You had $1,000.00 in sales with $500.00 in expenses for the previous month. This leaves you with $500.00 in Net Income/Profit. Now, multiple $500.00 by 33%, this equals $165.00 in self-employment tax. You should immediately transfer $165.00 out of your checking account and into a separate savings account that you use to hold tax money. This way you aren’t temped to spend it.
What if my expenses are more than my income?
As handmade business owners our sales and income often changes month by month. Some months you’ll make a profit and other months you’ll have a loss (a loss occurs when your expenses are more than your income), and that’s ok. For that month, you simply don’t set aside any money. This is also why it’s important to do the calculations every month, so you aren’t freaked out at the end of the year.
So, when does all this self-employment tax stuff apply to my handmade business?
This is strictly my opinion as a career bookkeeper.
My best advice, to all business owners or those of you who are thinking about taking that journey down the road to owning your own business, is to start tracking your expenses the very moment you decide that you want to own your own business. These initial expenses or costs are considered start-up costs and you are able (at this point) to deduct those start up costs when you file your tax return. It’s also important that you track those initial start-up costs separately from your normal monthly income and expenses once you start selling your finished product.
Now remember, I’m NOT a CPA and I’m NOT YOUR bookkeeper, but this is what I know from experience and research.
According to the IRS website, you need to file a business tax return when you have had $600.00 in revenue. However, a recent article I read said that if you had more than $400.00 – so there’s a little confusion there. I would suggest that YOU speak with y our tax preparer or someone from your local SBA (Small Business Administration) office.
As your business grows and you need to pay in more than $1,000.00 per year in taxes, you’ll need to make quarterly estimated tax payments – don’t worry, your tax preparer will let you know and tell you what you need to do at this point.
And, there is also this crazy little twist that your CPA will know about and understand:
While self-employment tax is based on your business profit, the IRS lets you count what would normally be the employer portion (if you worked for someone else) of 7.65% as a business deduction when calculating the tax.
So, that probably sounds insanely confusing – but that’s taxes for you – and it really does have a BIG impact, but NOT until the end of the year. Let’s look at an example:
At the end of the year, let’s say your handmade business had a net profit of $20,000.00. Your CPA will take the $20,000.00 and deduct 7.65% (or $1,530.00) which then gives you $18,470.00 and THEN multiply that by just the self-employment tax rate of 15.3% for a total of $2,825.91 in self-employment (FICA and Medicare) tax. Then they will calculate Federal, State, City and/or local taxes on top of that.
Don’t feel that you have to wrap your head around all of this, your tax preparer will know just what to do when it’s time to file your tax returns. The most important thing YOU need to remember – always set aside that money (using the 33-35% rule) and DO NOT SPEND IT! The government wants their money and they don’t want to hear any excuses!
Until next week, Happy Handmade!