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Paying Taxes When You’re Self-Employed

Thinking of shifting to self-employment? If you’re thinking about starting a business and being your own boss, one of the things you need to do is figure out how to pay taxes. The transition from W-2 work to self-employment significantly alters the tax landscape. 

Below I discuss the taxes self-employed solopreneurs are subject to and how to pay them. As always, the below is for educational purposes only and is not tax advice for any particular taxpayer. 

Taxes Paid by the Self-Employed

Federal Income Tax

The first tax is the exact same tax you paid as a W-2 worker: federal income tax. The determination of how much of your income is subject to this tax is a bit different. As a W-2 employee, you received a Form W-2, and, generally speaking, Box 1 of Form W-2 told you how much of your income was subject to federal income taxes. 

As a self-employed individual, you now need to track the income and expenses of your business. Solopreneurs should strongly consider practices such as having a separate bank account for the business and hiring a bookkeeper, possibly a virtual one. 

Income and expenses of the solopreneur’s business are reported annually on a Schedule C filed with Form 1040 every year. The amount of income computed on Schedule C is taxable on Form 1040.

Federal Self-Employment Tax

Congratulations on the transition to self-employment! You just signed up for a new tax: the federal self-employment tax. It’s actually (roughly speaking) the same FICA tax you paid as a W-2 employee, but now you pay it yourself (instead of through employer W-2 withholding), and you pay both halves of it. 

Here is an example of federal self-employment tax:

Leslie reports self-employment income of $80,000 on her Schedule C. Leslie has no W-2 income. Her self-employment tax is $11,304, computed as 14.13 percent of $80,000.

One’s self-employment tax will not always be approximately 14.13 percent of self-employment income. That said, in many cases 14.13 percent will be the approximate percentage. Self-employment tax is computed and reported annually on Schedule SE. Schedule SE is filed with the annual Form 1040. 

To account for the fact that the self-employed pay both halves of the payroll tax (the employee side and the employer side), they receive an income tax deduction (from adjusted gross income) on Schedule 1, line 14 for the “employer” half of the payroll tax. 

State Income Tax

Most states have an income tax, and the self-employed must pay it too, no different than when one is a W-2 employee. 

Local Taxes

Localities have various taxes solopreneurs may be subject to. First, there may be a general business tax which is often either a flat annual fee or a small percentage of revenue. Especially with the latter, there may be an exemption amount (usually, a revenue threshold) below which the solopreneur does not owe the tax. It is usually important to register with your locality to be able to claim any exemption from these taxes.

Second, localities sometimes impose a separate sales tax on particular industries or goods.

It is best to look into these taxes upfront. Localities know that sometimes small businesses miss these taxes and are usually willing to work with those who apply for relief for any missed filings or payments.

Paying Taxes

Now that we’ve discussed the broad categories of taxes the self-employed are subject to, the next step is to determine how and when to pay those taxes.

Federal Income Tax and Self-Employment Tax

This is one stop shopping. The federal tax rules require the self-employed to pay estimated taxes in quarterly payments (referred to as estimated tax payments). The dates they are due for each quarter of the year are as follows (assume the estimated tax payments account for Year 1):

QuarterDate Estimated Tax Payment is Due
First QuarterApril 15, Year 1
Second QuarterJune 15, Year 1
Third QuarterSeptember 15, Year 1
Fourth QuarterJanuary 15, Year 2

Note that if a payment due date occurs on a weekend or federal holiday, generally the due date is moved to the next day that is not a weekend and/or a federal holiday.

Generally speaking, the estimated tax payment must include both the estimated income tax due and the estimated self-employment tax due. Further, it must account for all taxable income (interest, dividends, capital gains, etc.), not just self-employment income.

Failure to pay in sufficient amounts on time can lead to an underpayment penalty computed on Form 2210. Usually, the amount required to avoid an underpayment penalty is the lesser of (i) 90 percent of the current year tax due (paid in timely, equal payments) or (ii) 110 percent of the previous year tax due (paid in timely, equal payments). These two standards are often referred to as safe harbors.

Note that if previous year adjusted gross income was less than $150,000, the 110 percent safe harbor drops to 100 percent. 

For those with growing incomes, the 110 percent safe harbor often works best. Those who have filed your Year 1 tax return by April 15, Year 2 (or at least have it just about ready to go) can take the total tax due number from the Form 1040, multiply it by 1.1, and divide it by 4 to get the amount of the required quarterly estimated tax payment to be good to go. Here is an example:

Josh is self-employed and filed his Year 1 tax return on April 1, Year 2. His business is growing. His total federal tax for Year 1 (including income tax and self-employment tax) was $45,000. Josh believes that his self-employment income could significantly increase in Year 2, so he has decided to rely upon the 110 percent safe harbor to pay his estimated tax. He multiplies $45,000 by 1.1 and then divides that product ($49,500) by 4 to get his quarterly estimated tax payment of $12,375). He makes four $12,375 payments to the IRS no later than April 15, Year 2, June 15, Year 2, September 15, Year 2, and January 15, Year 3.

The nice thing about this strategy is that Josh is now protected against the underpayment penalty even if he wins the lottery during Year 2. He simply makes those estimated payments and then, with his Year 2 Form 1040, he pays the IRS the balance due, which could be quite large. But regardless of the balance due, Josh’s underpayment penalty is $0. 

Taxpayers who might be subject to the underpayment penalty can request relief from it on the Form 2210 and/or “annualize” their income on Form 2210 to prove that the majority of their income came from later in the year (and thus estimated taxes paid later in year are sufficient for the current year’s estimated tax). Using the 110 percent safe harbor generally eliminates the need to look to mitigation tactics. 

Paying the IRS

Solopreneurs can mail estimated taxes to the IRS with a Form 1040-ES. Alternatively, solopreneurs can use the IRS DirectPay system and pay electronically at this IRS website. 

State Income Taxes

States with income taxes also generally require periodic or quarterly estimated tax payments. Many follow some or all of the IRS rules. My home state of California has its own timing rules for estimated tax payments. It generally requires taxpayers to pay 30 percent of their estimated income tax liability during the first quarter (April 15th due date), the next 40 percent of their estimated income tax liability during the second quarter (June 15th) and the remaining 30 percent after the end of the fourth quarter (the following January 15th). 

States, like the IRS, generally have website portals where solopreneurs can make estimated tax payments. 

The Transition Year

Transitions from W-2 work to solopreneurship presents many challenges and opportunities. One potential opportunity is the need to pay less or possibly no estimated taxes for the year of the transition. This can be true for several reasons. 

It may be that based on the W-2 withholding collected prior to leaving full time employment, the new solopreneur had enough withheld to cover the tax on their annual income. W-2 withholding generally assumes a full year of employment, but if one leaves full time employment and experiences start-up expenses and lower self-employment income as they build a business, it may be the case that they need to make little or no estimated tax payments in that first year.

Another source of tax payments is spousal W-2 withholding. If filing jointly with a spouse, the spouse’s W-2 withholding combined with the new solopreneur’s partial year W-2 withholding might be enough to cover the estimated taxes for the transition year. 

EINs and Forms 1099

In most cases, it makes sense for sole proprietors to obtain an employer identification number (“EIN”) from the IRS for their sole proprietorship. This EIN is used on the business’s Schedule C. Further, this number is used (instead of a Social Security number) to file any required Forms 1099s paid with respect to the business. Forms 1099 (such as the Form 1099-NEC) are required for cash payments of $600 or more during the year to individuals in the course of business. 

The IRS has an internet portal here for taxpayers to apply online for EINs. 

Tax Planning

The transition from W-2 employment to self-employment can provide several tax planning challenges and opportunities. Here is a brief overview of several challenges and opportunities.

Qualified Business Income Deduction

The Section 199A qualified business income deduction is a relatively new deduction for small businesses, including solopreneurs. I have previously blogged about this deduction here and here. 

Roth Conversions for the Self-Employed

The transition to self-employment may present Roth conversion opportunities, for two reasons. First, as a business starts up, the soloprenuer’s taxable income might be very low, and thus a start up year might be a great time to execute a Roth conversion (i.e., moving amounts from traditional IRAs/401(k)s etc. to Roth accounts) and enjoy a low marginal federal income tax rate on the converted amount.

Second, there are instances where Roth conversions by the self-employed can benefit from the Section 199A qualified business income deduction. I blogged about that opportunity here. 

S Corporations

Many solopreneurs will have the opportunity to operate out of what is referred to as an “S corporation” for U.S. federal tax purposes. There are several advantages to operating out of an S corporation, but there are also some disadvantages. 

Next month’s blog post discusses S corporations and some of the planning considerations involved. 

Solo 401(k)s

Solopreneurs are responsible for their own workplace retirement account. The Solo 401(k) is a great opportunity for many solopreneurs to stash significant amounts into tax-advantaged retirement accounts. 

As I announced in March, I’m currently working on a book about Solo 401(k)s, which is tentatively set to be published in early 2022. 

Hiring Professionals

To my mind, the shift from W-2 employment to self-employment often signals the need to hire a tax return preparer, and possibly a (virtual) bookkeeper as well. Self-employment significantly increases the complexity of one’s tax return and thus it is often wise for the self-employed to hire a tax return preparer and a bookkeeper.

Conclusion

The shift to self-employment is both exciting and challenging. Yes, the self-employed have a more complicated tax picture. But with some intentional planning, managing and ultimately optimizing the tax picture is very much possible. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Understanding Your Form 1099-DIV

If you’re reading this in the Winter of 2024, you may have already received a bill from your financial institution. It’s called a Form 1099-DIV. Oddly, the financial institution isn’t demanding a penny of payment. Rather, your 1099-DIV prompts the IRS and your state tax agency (in most states) to expect the payment of income tax with respect to your financial assets.

A Form 1099-DIV is a great window into your taxable investments. By learning how to read the major boxes of your 1099-DIV, you can gain valuable insights about your investments and their tax efficiency.

VTSAX Form 1099-DIV 2024 Update

The Basics

Form 1099-DIV exists so that taxpayers and the IRS know the income generated by financial assets in dividend paying accounts. These include stocks, mutual funds, and exchange traded funds (“ETFs”). The financial institution prepares the Form 1099-DIV and submits a copy to the IRS and a copy to the taxpayer. 

Let’s be clear about what we are talking about. We are not talking about assets in retirement accounts (401(k)s, IRAs, Roth accounts, HSAs, etc.). You do not receive a Form 1099-DIV from a retirement regardless of how much money the account earned during the year. This is one of the advantages of saving through a retirement account. Dividends and other income generated by assets in a retirement account are not taxable to the account holder when generated (so long as the funds stay in the retirement account).

Dividends

Corporations pay dividends to their shareholders as a return to the shareholders of their portion of some or all of the earnings of the corporation. The corporation’s Board of Directors vote from time to time to pay dividends to the shareholders. Boards determine dividends based on a variety of factors, including the company’s profitability, industry, stage in the corporate life cycle, and business cash needs.

All shareholders of a corporation receive dividends. Some of those shareholders are themselves mutual funds or ETFs. Mutual funds and ETFs distribute out dividends and certain other income they receive (such as interest) to their shareholders as dividends.

Box 1a and Box 1b

Box 1a lists the so-called “total ordinary dividends” received from the account. That is all of the dividends paid by the stocks, mutual funds, and ETFs in the account. 

Box 1a should be understood as the entire pie. It represents all of the dividends received in the taxable account. The amounts in Box 1a are reported on line 3b of the Form 1040 (and on Schedule B if required).

Box 1b qualified dividends should be understood as a slice of the pie. It represents the portion of the total ordinary dividends that qualify for the long-term capital gains rates. Dividends create “ordinary income” for U.S. federal income tax purposes. However, certain “qualified dividends” (referred to as “QDI”) are taxed at preferential long term capital gains rates. As I have previously written, “[g]enerally, two requirements apply for the dividend to qualify for favorable QDI tax treatment. Very generally stated, they are:

  • The shareholder must own the stock for 60 of the 121 days around the “ex-dividend” date (the first date on which the stock sells without the right to receive the upcoming dividend); and,
  • The paying corporation must be incorporated either in the United States or in a foreign country with which the United States has a comprehensive income tax treaty.

Shareholders can obtain QDI treatment for stock owned through mutual funds and ETFs.

It may be that your qualified dividend slice is the entire pie. In most cases, there are usually some dividends that do not qualify for QDI treatment. 

Amounts reported in Box 1b are reported on line 3a of the Form 1040.

Box 2a Capital Gain Distributions

Box 2a is the danger zone of the Form 1099-DIV. In a way, it is unavoidable to recognize dividends (even if such dividends are QDI) if one wants to invest in a broad based portfolio of equities in a taxable account. Eventually corporations pay out dividends. While younger companies tend not to pay dividends, as companies mature they tend to start paying dividends.

What are much more avoidable (at least to a degree) are capital gain distributions. Capital gain distributions come from mutual funds and ETFs (they do not come from individual stocks).

Capital gain distributions occur when fund managers sell individual holdings at a gain. The fund is required to (usually toward year end) pay out those gains to the shareholders. The paid out gains are reported in Box 2a.

Three things tend to increase capital gain distributions: 1) active management; 2) a bull market; and 3) fund redemptions.

Active Management

Usually, this is the most significant factor in capital gain distributions. In order to actively manage a mutual fund or ETF, fund managers generally need to buy and sell different holdings. The selling of holdings is what creates capital gain distributions.

Frequent trading can make certain actively managed mutual funds and ETFs very tax inefficient, because they trigger capital gain distributions that are currently taxed to the owner at capital gains rates. 

From this, we can deduce the secret tax advantage of index funds. Index mutual funds and ETFs seek to simply replicate a widely known index. Other than occasional mergers and acquisitions of companies in the index, index fund managers rarely need to sell a holding to meet an investment objective. Thus, in many cases holding index funds in taxable accounts is tax efficient and will be better from a tax perspective than holding an actively managed fund.

Bull Market

Mutual funds and ETFs pass out capital gain distributions, not capital loss distributions. But in order for the shareholders to have a capital gain distribution, the mutual fund or ETF must (a) sell a holding and (b) must realize a gain on that sale.

In bear markets, it is often the case that the second requirement is not satisfied. The fund often realizes a loss on the sale of holding, meaning that the portfolio turnover does not generate a capital gain distribution reported in Box 2a. However, bear markets don’t always mean there will be no capital gain distributions, as active management and fund redemptions can still trigger capital gain distributions.

Fund Redemptions

There is an important distinction between mutual funds and ETFs in this regard. ETFs trade like public company stock — other than IPOs and secondary offerings, generally you buy and sell the stock of a public company and an ETF with an unrelated party that is not the issuer itself. 

Mutual funds, on the other hand, are bought and sold from the issuer. If I own 100 shares of the XYZ mutual fund issued by Acme Financial, when I redeem my 100 shares, Acme Financial buys out my 100 shares.

In order to buy out mutual fund shares, the mutual fund must have cash on hand. If it runs out of cash from incoming investments into the fund, it will have to sell some of its underlying holdings to generate the cash to fund shareholder redemptions. This creates capital gain distributions for the remaining shareholders. 

Interestingly, Vanguard has created a method to reduce the tax impact of mutual fund redemptions. Further, in recent times, fund redemptions have not caused significant capital gain distributions in many cases because in this current bull market mutual fund inflows often exceed outflows. 

Box 3 Nondividend Distributions

There are occasions where corporations make distributions to shareholders during a time where the corporation does not have retained earnings (i.e., it either has not made net income or it has previously distributed out is net income). Such distributions are not taxable as dividends. Rather, such dividends first reduce the shareholder’s basis in their stock holding. Once the basis has been exhausted, the distribution causes a capital gain.

Box 5 Section 199A Dividends

Section 199A dividends are dividends from domestic real estate investment trusts (“REITs”) and mutual funds that own domestic REITs. These dividends are reported on Form 8995 or Form 8995-A and qualify for the Section 199A QBI deduction. The good news is that the taxpayer (generally) gets a federal income tax deduction equal to 20 percent of the amount in Box 5. This deduction does not reduce adjusted gross income but does reduce taxable income.

Section 199A dividends are another slice of the pie of Box 1a ordinary dividends.

Watch me explain Section 199A dividends

Box 7 Foreign Tax Paid

An amount in Box 7 is generally good news from a federal income tax perspective. Many countries impose a tax on the shareholder when the corporation pays a dividend is a non-resident shareholder. The corporation withholds a percentage of the dividend and then remits the net amount of the dividend to the shareholder. 

The amount in Box 7 usually creates a foreign tax credit that reduces federal income tax dollar for dollar. If you have $300 or less in foreign tax credits ($600 or less if married filing joint) you can simply claim the foreign tax credit on your Form 1040 without any additional work. If your foreign tax credits exceed these amounts, you will also need to file a Form 1116 to claim the foreign tax credit.

The ability to claim foreign tax credits is a reason to hold international equities in taxable accounts.

Watch me discuss how VTIAX might generate a foreign tax credit on a US income tax return.

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Box 11 represents all of the tax-exempt dividends received in the taxable account. Typically this is generated by state and municipal bond interest received by the mutual fund or ETF and passed out to the shareholders. This income is tax-exempt for federal income tax purposes.

This income may not be tax-exempt for state tax purposes. For example, in my home state of California, this income is taxable unless it is established that 50 percent or more of the funds assets are invested in California state and municipal bonds. In that case, the exempt-interest dividend attributable to California state and municipal bonds is tax-exempt for California purposes. The financial institution must separately provide the percentage of income attributable to California bonds to the shareholder in order to compute the amount of exempt-interest dividend exempt from California income tax. 

Box 12 is a subset of Box 11 (Box 11 is the whole pie, Box 12 is a slice). Box 12 dividends are those attributable to private activity bonds. The significance is for alternative minimum tax (“AMT”) purposes. While this income is tax-exempt for regular federal income tax purposes, it is not tax-exempt for AMT purposes (and thus is subject to the AMT). After the December 2017 tax reform bill this issue still exists, though it affects far fewer taxpayers.

Conclusion

The Form 1099-DIV conveys important information, all of which must be properly assessed in order to correctly prepare your tax return. It can also provide valuable insights into the tax-efficiency of your investments. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.