A Quick Guide to Managing Tax Liability for Side Businesses
Discover how to navigate tax obligations for side businesses and freelancers. Track income, make estimated payments, and maximize deductions. Stay compliant with IRS guidelines.
The humble side hustle is having a moment, with more Americans turning to additional sources of income to meet their financial needs.
According to a recent LendingTree survey, 44 percent of Americans report having a side hustle, representing a 13-percent increase from the previous year.
This surge in side hustles can be attributed, in part, to the impact of inflation and the need to supplement primary income. Hey, sometimes you have to do what you have to do. And, frankly, owning a side business that could become your primary business is a great way to build wealth.
However, individuals with side businesses must understand the tax implications and ensure compliance with the Internal Revenue Service (IRS).
Tracking Income and Reporting
For folks with side businesses, keeping accurate records of all income received is crucial. In this case, record keeping includes earnings from freelancing, independent contracting, or any form of self-employment.
The IRS requires self-employed individuals (and yes, having a side hustle is a form of self-employment) to report their income on a Schedule C, Sole Proprietor, or a similar form depending on the type of business entity involved as part of an annual tax return. Whether income is documented through Form 1099-MISC, Form 1099-K, or received as cash payments, it must be reported and included in the tax return.
It's worth noting that if an individual has multiple W-2 forms, they should ensure they do not overpay Social Security taxes. There is a maximum amount of Social Security taxes an individual needs to pay each year. If working for a single employer, they should stop withholding Social Security taxes once the maximum threshold is reached. However, if working for multiple employers, any excess Social Security taxes paid can be claimed when filing the tax return.
We recommend visiting the "what are my self-employment tax obligations" section of the IRS's Self-employed Individuals Tax Center online for U.S. taxpayers.
Tax Implications and Considerations
Working a second job, having a side gig, or running a side hustle can impact an individual's tax situation.
When income increases, so does the potential tax liability. It is essential to adjust withholdings to account for the additional income, particularly if it is the first time engaging in a side business due to circumstances like the COVID-19 pandemic. Self-employed individuals must keep track of expenses related to their side businesses, such as receipts and mileage records, as these can be used to offset taxable income.
Regardless of the amount earned, it is crucial to report all income accurately. Even if an individual earns less than $400 from a side gig, it should still be reported on the tax return. Failure to report income can result in penalties and fines from the IRS. Additionally, individuals who receive 1099 forms for non-employee compensation should ensure that they include this income on their tax return to avoid penalties for underreporting.
Self-Employment Tax and Estimated Payments
Self-employed individuals are subject to self-employment tax, which encompasses Social Security and Medicare taxes. Unlike traditional employees, self-employed individuals are responsible for paying these taxes themselves. Additionally, they must also pay income tax on their self-employment earnings.
To fulfill tax obligations, self-employed individuals are required to make estimated tax payments on a quarterly basis. It is important to accurately estimate earnings for the year to avoid overpayment or underpayment of taxes. Failure to make estimated tax payments can result in penalties and interest charges.
Deductions for Self-Employed Individuals
One advantage of being self-employed or having a side business is the ability to deduct certain business-related expenses, reducing taxable income. Common deductible expenses for self-employed individuals include:
- Business mileage.
- Dues and subscriptions.
- Necessary tools and equipment.
- Work-related education and training costs.
Tracking and documenting these expenses can significantly impact the overall tax liability.
Additionally, self-employed individuals may be eligible for the home office deduction. However, it is important to understand the specific criteria for claiming this deduction, as there have been changes in recent years. The IRS requires exclusivity and regular use of a specific area in the home for conducting business activities to qualify for the home office deduction.
Engaging in a side business or having a freelance gig can provide financial stability and additional income. However, it is crucial to understand and comply with the tax obligations associated with self-employment. Tracking income accurately, reporting all earnings, making estimated tax payments, and maximizing deductions are essential for managing tax liability effectively. By staying informed and adhering to IRS guidelines, individuals can navigate the tax implications of their side businesses and maintain financial peace of mind.