Tax planning strategies for the self employed

Marguerita M. Cheng CFP® for Marketing Intelligence Center writes: Self-employment represents the opportunity to control your income and your schedule. An added bonus of your newfound freedom and flexibility is more regular interaction with your tax advisor.  If you're self-employed, you must also pay both the employer and employee share of FICA taxes, not to mention assume responsibility for your own retirement plan.

However, self-employed individuals can deduct half of this self-employment tax as a business expense.

Now that the 2013 tax filing season is behind us, here are some tax planning strategies that you can implement for the remainder of 2014. As always, be certain to consult a qualified tax advisor to discuss your specific situation.

(1) Understand self-employment tax 

It is critical that you understand and comply with your federal tax responsibilities. The federal government uses self-employment tax to fund Social Security and Medicare benefits. You must pay this tax even if you earn a modest amount of self-employment income. If you file a Schedule C as a sole proprietor, independent contractor, or statutory employee, the net profit listed on your Schedule C (or Schedule C-EZ) represents your self-employment income and must be included on Schedule SE, which is filed with your federal Form 1040. Schedule SE is used to calculate and report the amount of self-employment tax. In 2014, the maximum amount of income subject to Social Security taxes, otherwise referred to as the “wage base” increased by 2.9% to $117,000 from $113,700. For 2014, the Social Security tax rate, which is shared equally between employers and employees, remains 12.4%.  In other words, individuals at the highest income level will pay $7,254 in Social Security taxes in 2014 as compared to $7,049.40 in 2013. As mentioned above, although self-employed individuals pay both the employer and employee tax for a maximum Social Security tax of $14,508, they can deduct half of their FICA taxes as a business expense on their federal income tax return.

It is important not to overlook Medicare taxes. Employees and employers also each pay a 1.45% Medicare tax on all wages with no cap on earnings or income. Self-employed individuals pay a combined Medicare tax of 2.9%

(2) Make your timely estimated tax payments 

Employees typically have income tax, Social Security tax, and Medicare tax withheld from their paychecks. However, for self-employed individuals, odds are that no one is withholding federal and state taxes from your income. Consequently, you'll need to send quarterly estimated tax payments (using IRS Form 1040-ES) to satisfy your federal income tax and self-employment tax obligations. You may have to make state estimated tax payments, as well. If you neglect to send quarterly estimated tax payments, you may be subject to penalties, interest, and a big tax bill at the end of the year. For more information regarding estimated tax payments, refer to IRS Publication 505.

(3) Employ family members to save taxes

Hiring a family member to work for your business can result in tax savings by shifting business income to a relative. Reasonable compensation paid to an employee is a tax-deductible business expense, which can reduce the amount of taxable business income attributed to you. The IRS can question compensation paid to a family member, especially if the amount seems unreasonable or inconsistent, considering the services actually performed. Also, prior to hiring a family member who's a minor, verify that your business complies with child labor laws.

As a business owner, you're responsible for paying FICA (Social Security and Medicare) taxes on wages paid to your employees. The payment of these taxes will be a tax-deductible business expense.  However, if your business is a sole proprietorship and you hire your child who is under age 18, the wages that you pay your child won't be subject to FICA taxes.

As is the case with wages paid to all employees, wages paid to family members are subject to withholding of federal income and employment taxes, as well as certain other taxes in some states.

 (4) Establish an employer-sponsored retirement plan for tax (and nontax) reasons

Just because you're self-employed does not mean you skimp on retirement savings. You can establish an employer-sponsored retirement plan. With such a plan, your business may be allowed an immediate federal income tax deduction for contributing pretax dollars into a retirement account. Contributions and earnings will not be subject to federal income tax until withdrawn (as a tradeoff, tax-deferred funds withdrawn from these plans prior to age 59½ are generally subject to a 10% premature distribution penalty tax--as well as ordinary income tax--unless an exception applies). You can also establish a 401(k) plan that allows Roth contributions. With Roth contributions, there is no immediate tax benefit (after-tax dollars are contributed), but future qualified distributions may be free from federal income tax, provided certain criteria are satisfied. Consider evaluating the following retirement plan options:

• Simplified employee pension (SEP) IRA
• SIMPLE IRA
• SIMPLE 401(k)
• Individual 401(k), Single 401(k) or Solo 401(k)

The type of retirement plan that you should establish depends on your specific situation. Explore all of your options and consider the complexity of each plan. Please note that if your business has employees, you may have to provide retirement plan contributions for them. For additional information about retirement plan options, consult your qualified tax advisor or refer to IRS Publication 560.

(4) Take full advantage of all business deductions to lower taxable income

Because deductions lower your taxable income, confirm that your business is taking advantage of any business deductions to which it is entitled.  You may be able to deduct rent or home office expenses, as well as office equipment, furniture, supplies, and utilities. For business expenses to qualify as deductible, they must be considered both ordinary (common and accepted in your trade or business) and necessary (appropriate and helpful for your trade or business).

If you're concerned about lowering your taxable income this year, consider the following options:

• Deduct the business expenses associated with your motor vehicle, using either the standard mileage allowance or your actual business-related vehicle expenses to calculate your deduction
• Purchase supplies for your business late this year that you would normally order early next year
• Purchase depreciable business equipment, furnishings, and vehicles this year
• Deduct the appropriate portion of business meals, travel, and entertainment expenses
• Write off any bad business debts

(5) Deduct health-care related expenses

If you qualify, you may be able to benefit from the self-employed health insurance deduction, which would allow you to deduct up to 100% of the cost of health insurance that you provide for yourself, your spouse, and your dependents. This deduction is an “above-the-line” deductible expense. In other words, it is taken on the front of federal Form 1040 when calculating adjusted gross income, so it is available to all self-employed individuals regardless of whether or not they itemize.

Contributions to a health savings account (HSA) are also an "above-the-line” deductible expense. An HSA is a tax-exempt trust or custodial account established with a high-deductible health plan to earmark funds for health-care expenses. If you withdraw funds to pay for the qualified medical expenses of you, your spouse, or your dependents, the funds are not included in your adjusted gross income. Distributions from an HSA not used to pay for qualified medical expenses are included in your adjusted gross income, and are subject to an additional 20% penalty tax unless an exception applies.

About the author: Marguerita M. Cheng is the Chief Executive Officer at Blue Ocean Global Wealth. Marguerita has been quoted and featured in numerous national publications. Marguerita is a monthly columnist for the Washington Business Journal and Be Inkandescent Magazine. She is a CFP® professional, a Chartered Retirement Planning CounselorSM, and a Certified Divorce Financial Analyst.