My Top Advice for People New to Self-Employment Income: Learn About Quarterly Estimated Taxes, Don’t Sweat the LLC
Hi Friendos,
People who are first starting with self-employment income run into all kinds of advice, good and bad. Typical advice includes “Choose the Right Business Structure.” People focus their energy on researching how to establish an LLC, something they can typically skip, and have nothing left in tank to learn about paying quarterly estimated taxes, which is a must. Some professions have their own special legal needs (hello medical professionals!) but most do not. Here is my top advice for most people with self-employment income.
- Get an Employer Identification Number (“EIN”) from the IRS. You can do this online in 5 minutes. It’s like a Social Security number for your business and is not a required-to-have item, but I am sensitive to identity protection and think this is best practice to use. You can keep your Social Security number to yourself and provide your business EIN instead when doing things like establishing a business bank account and filling out W-9 forms if you’ll be paid as a contractor.
- Identify any local regulatory requirements for your state or city, such as required business licenses, and follow them. If you want to establish a “doing business as” name that is different from your personal name, you can do that.
- Establish a business bank account that has a debit card. Have all the money related to your business flow into and out of that account. You get paid, the $ goes into your business account. You pay a business expense, the $ comes out of your business account. This will make tax prep much easier and help you claim all the deductions you are entitled to (minimize your taxes owed) because your monthly bank account statements will help you remember all your transactions.
- Learn about quarterly estimated taxes; I wrote about them here. The U.S. has a pay-as-you-go system which means all of us are expected to pay income taxes all year long as we earn income. When you have a W-2 job, your employer does this for you – withholding money for taxes and sending it in on your behalf. When you are self-employed, you must do it yourself.
- Set money aside for quarterly estimated taxes each time you are paid. I highly recommend a separate checking or savings account that you use solely for this purpose, because co-mingled funds meant for taxes vs other purposes can be tricky to separate out. If you have many small transactions where customers pay you, you can set aside for taxes every week, every two weeks, or even every month — the point is to ensure you have ready cash to make quarterly tax payments when they are due. A good rule of thumb is to set aside 25% -30% of business profit (pick 30% if your state imposes income taxes). This might sound like a high % considering the levels of the federal income tax brackets, but self-employed people also have to pay employer and employee portions of Social Security (12.4%) and Medicare tax (2.9%) (15.3% total, payroll taxes). Remember: business profit is revenue less expenses; you only have to pay taxes on your profits, not your entire revenue.
- Have a regular time for administrative tasks, every week or every month. Develop a checklist or administrative calendar and refine it over time. The checklist/calendar should include making actual payments of quarterly income taxes. It should also include regularly updating your business records and gathering backup documents, like receipts for expenses, into one central location. Digital copies are great – you can scan items or take a picture with your phone and save a copy of the picture. The IRS doesn’t care how you keep your records, just that you keep them.
- Set money aside for your future self, like by having a fully funded emergency fund and putting money into an IRA and investing it in low-cost, diversified index funds. I wrote about emergency funds here and about IRA’s (individual retirement accounts) here.
You’ll see that my advice does not include identifying your ideal business structure. Most people starting out with self-employment income are working on their own. If they pay other people, they pay them as contractors, not employees. And they usually do not start out with a ton of profits (e.g., more than, say, $70k/year). And they usually do not face a big risk of being sued. All this means that setting up shop as a sole proprietorship works very well.
Next week I’ll write more about why an LLC is typically not necessary and debunk the myth that “an LLC saves money on taxes.”
-Stephanie
Frequently Taxed Questions 