CHAPTER 1
Being Self-Employed and On Your Own

1. What Does Self-Employment Mean?
2. Legal Consequences of Self-Employment
3. Practical Issues in Self-Employment
4. Tax Terminology
5. Being 1099ed
6. What's Ahead

Being self-employed is an awesome thing. You control your destiny and your earning potential is limitless. You can set your hours, subject to the demands of the project or activity you're working on. If you're an employee satisfied with your job, you can supplement your income with a side hustle. And, as a self-employed individual-full or part time-you can achieve a work-life balance that enables you to attend to your other interests and responsibilities. Be a mompreneur or dadpreneur. Care for an elderly parent. Take time to train for a marathon. Travel.

Of course, you have many obligations that come along with being self-employed. Whether your business makes or loses money, you have to report your income and expenses to the federal government if you are otherwise required to file a tax return. Depending on the state you reside in, you'll also have to report your business activities to your state.

In order to report your income and expenses, you need to understand how being self-employed affects your taxes. If you are just starting out in business and formerly were an employee, things are very different as a self-employed individual. Instead of receiving a W-2 from your employer telling you exactly what you must report as income for the year, it's now up to you to track what flows in and out of your business coffers so you can report this at tax time. You may receive 1099s from businesses for which you perform services, but these forms may not tell the whole story of your revenue for the year.

You also must become familiar with tax terminology and rules that affect your tax responsibilities. And you should think about matters beyond taxes that become your responsibility as a business owner, including your health coverage (Chapter 8), retirement savings (Chapter 8), and insurance protection.

What Does Self-Employment Mean?

Solopreneur, independent contractor, platform worker, direct seller of skills,  freelancer, consultant-whatever term you apply to yourself, you are a self-employed person if you have not formed a corporation for your business activities. If you have no co-owners, then you are automatically treated for tax purposes as a sole proprietor and are required to file Schedule C with your personal federal income tax return, Form 1040. If you are age 65 or older, you can file Form 1040-SR instead of Form 1040. If so, then attach a Schedule C to this return.

Self-employed farmers file Schedule F; that is not discussed in this book even though many of the deductions and strategies in this book apply to farmers. Suppose you set up a limited liability company (LLC) to achieve personal liability protection (explained later). If you are the only owner (technically called a member), then you, too, file Schedule C unless you take steps to be taxed in another manner.

Being self-employed means that you are taxed on the net result of your efforts for the year, regardless of what you have left in the bank, what you spend on your personal needs, or what you reinvest in your business.

Example

If the revenue you take in is $78,000 and your deductible expenses are $22,000, your net income (essentially your profit) is $56,000. You pay federal income tax on $56,000, regardless of whether you've withdrawn $56,000 from your business bank account, spent it on your family, or used it to purchase realty for your business.

Strategies for Your Living Expenses

If you're like most self-employed individuals, you need money from your business to pay your personal rent or mortgage, buy food, make car payments, have a subscription to Netflix, take a trip once in a while, and pay other personal expenses. You can take out as little or as much money from the business as you wish for this purpose. Your use of business funds for personal expenses has no impact on taxation. You can't deduct the business's payments of your personal expenses. The amount of money you take from the business (often referred to as a draw) is entirely up to you. It is based on what the business can afford and what you need, rather than on any tax consideration.

You'll probably want to do a budget for your personal needs as well as your business expenses. This will help you figure the amount to take from your business bank account each week or month, depending on how you want to arrange withdrawals.

If you have a significant other with whom you share living expenses, factor in contributions toward household expenses from this person. During the period in which you are just starting your self-employed business, the other person may need to bear a greater share of expenses until your business activities start to bear fruit. Or you may need to live with a parent or someone else willing to put you up. Discuss your personal financial situation to make sure the person you live with is supportive, not only in the time you devote to your business, but also for your financial needs.

Greater IRS Scrutiny

Being self-employed and filing Schedule C puts you under the IRS's microscope. Audit rates for Schedule C filers are higher than for other individuals because the IRS believes that self-employed individuals have a greater opportunity to underreport income, overstate deductions, and fail to pay self-employment tax (this tax is covered in Chapter 9).

If you have a loss on a Schedule C but also have significant other income from a job or investments, you risk being questioned about whether your activities are really a business or are merely a hobby (see Chapter 4).

At the other extreme, the better you do in your business, statistics show the greater the likelihood you will be audited, as shown in Table 1.1.

IRS Action

If the IRS believes you have underreported your income, it can reconstruct income using bank deposits and other methods. You can, of course, contest this IRS action by appealing within the IRS or by going to court, which is a timely and usually expensive endeavor.

Take this real-life situation: An enterprising couple owned a number of businesses, including a trucking business that the husband ran and a daycare business that the wife ran. His business reported gross receipts on his Schedule C of $8,000; her Schedule C showed a profit of $6,000. The IRS found $151,564 in taxable deposits, including $72,125 in cash, into the trucking business account and $11,168 in deposits, including $6,410 in cash, into the daycare business account. Once the IRS questioned their income, the burden was on them to show they properly reported all their income, something they failed to do. So the IRS, with the Tax Court's approval, increased the income from their businesses based on their bank deposits.

Table 1.1 Audit Rates for Schedule C Filers

Source: 2018 IRS Data Book.

Legal Consequences of Self-Employment

There are important non-tax results from being self-employed as a sole proprietor. You are personally liable for all of the debts of the business. If, for example, someone is injured on your business premises and your business insurance doesn't cover the claim, your personal assets-the home you own, your car, your savings account, and other personally owned property-can be taken to satisfy the claim.

Personal liability probably isn't a significant issue for many types of sole proprietors. What's your exposure to liability if, for example, you're a freelance writer? However, for other sole proprietors, such as daycare owners, liability can be an issue. Fortunately, it can be addressed satisfactorily by having adequate insurance. Whatever type of business you're in, be sure to discuss your liability coverage with an insurance expert to cover your bases.

When you start a business, the farthest thing from your mind is failing. You are optimistic, confident of your business idea and abilities, and expect to achieve success. Of course, the reality is that nearly as many businesses go under each year as start up. Being a sole proprietor means that if business debts mount and you're going under, your only bankruptcy option is to file as an individual. Your business cannot go bankrupt separately from your personal affairs.

Keep in mind that you don't have to stay self-employed forever. If your business takes off and you want to expand, you may change your business organization from a sole proprietorship to something else, such as a corporation or a limited liability company. At that time you'll base your decision for which entity to use on a number of...