In a traditional employee-employer relationship, the employer issues a paycheck on a regular basis to cover the employee’s earnings after deductions, including taxes. At year-end, each employee receives a W-2 to use when filing income tax returns. However, if you have income from self-employment, you may have clients or customers, but you do not have an employer. You typically receive the full amount for which you invoiced your client, with no taxes withheld at the time of payment. At year-end, you receive a Form 1099 from clients to use when filing your return. If you are self-employed, there are certain tax benefits you can claim that are more generous than those available to W-2 employees.
Partial Credit for Household Expenses
If you dedicate part of your home for business purposes, you can deduct the portion of your household expenses that relate to your business operations. You must prorate costs based on how much space is reserved solely for business. For example, if you have a 2,000 square foot home and use 200 square feet as an office, you can deduct 10 percent of qualified expenses. Qualified expenses include rent, electricity and fuel oil. The area must be used only for business reasons, such as to meet with clients or prepare shipments.
Social Security and Medicare Taxes
Although it is true that you are subject to both the employee and employer portions of Social Security and Medicare taxes if you operate your business as a sole proprietorship, you can deduct the employer portion. The Internal Revenue Service refers to the combined totals as self-employment tax. The limit for self-employment tax is the same as the limit for W-2 employees, which was $106,800 for 2011. However, you compute self-employment tax on your net 1099 income, not your gross.
Health Insurance Premiums
Self-employed taxpayers might be able to deduct all or part of the premiums they pay for health insurance to cover themselves, their spouses and their dependents without having to itemize deductions. You can cover children up to the age of 27 even if you cannot claim them as dependents. You must show a net profit from your business activities for the tax year. If you, your dependents or your spouse were eligible for coverage from an employer that paid part of the costs, you cannot claim the self-employed deduction for the months you could have obtained coverage under that plan. The limit is the lesser of your actual premiums or your net profits minus your deductions for self-employment tax and contributions to SIMPLE or SEP retirement plan. If your premiums exceed your profits, you can include the balance with your itemized medical expenses.
Delay in Paying Taxes
If you are a W-2 employee, your employer must withhold income tax, Social Security and Medicare from every paycheck, and if withholdings are too high, you cannot get them back until you file a return for the year. Typically, no taxes are withheld from 1099 earnings, although you may be subject to backup withholding under certain conditions, such as if you do not furnish a Form W-9 to a client. If you expect that you will owe at least $1,000 in income and self-employment taxes at year-end, the IRS requires you to make quarterly payments based on your estimated liability. Use the IRS Form 1040-ES to compute your estimated tax liability. If your estimate is less than $1,000, you have the option of paying your taxes when you file your return for the year.
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