November 23, 2020
Taxes the Self-Employed Need to Pay
You’ve heard the adage “Pay yourself first.” As the proud owner of an S-Corporation, paying yourself first is a requirement. Paying yourself a salary means that you are responsible for payroll taxes, in addition to other taxes imposed on you or your business. Being self-employed means that you may pay self-employment tax, federal income tax, state income tax, sales tax, taxes imposed by your city or county, special business taxes specific to your industry, and payroll taxes. You may need to submit quarterly estimated payments to the IRS to avoid potential penalties at tax-filing time. We recognize that this can seem overwhelming and confusing. The experts at Formations are ready to take the worry out of taxes.
Self-employment tax, referred to as FICA, is how you pay into Social Security and Medicare. If you are not an S-Corporation you are paying self-employment taxes at a rate of 15.3% of your total profit in addition to ordinary income tax. As an S-Corporation, you are only paying self-employment taxes on your salary. The remainder of your profit is a distribution and is not subject to self-employment taxes. This can lead to huge tax savings.
As an employee, you split this tax with your employer. The employer pays 7.65% and you pay your share at 7.65% as withholding from your wages. As a self-employed individual, you are responsible for paying both shares. 12.4% of this goes to Social Security, capped on wages of $137,700 for 2020 and 2.9% goes to Medicare. With Medicare, you may pay an additional 0.9% if your income exceeds a certain threshold; $200,000 for a single individual in 2020.
Federal Taxes, Payroll Withholding, and Estimated Payments
At Formations, we believe the best way for S-Corporation owners to pay their federal income taxes is to have those taxes withheld from their payroll. This reduces paperwork, eliminates the need for estimated payments, and ensures that your tax liability is covered.
Your federal taxes as a self-employed individual are based on your current tax bracket. Your income for the year, which includes wages, distributions from your S-Corporation (or the profits of your business if you are not currently an S-Corporation), interest and investment income, etc. are added together and then reduced by allowed exemptions and deductions for the year. Tax on this amount is determined using your tax bracket percentage, which ranges from 10% to 37%. You are taxed at a marginal tax rate, meaning that your first dollar earned is taxed at the lowest bracket, and as your income increases, the money you earn is taxed at a higher bracket. If, in 2020, you are a single individual that makes $150,000 you would fall into the 24% tax bracket. But, because income taxes are assessed progressively, your income will be taxed at a variety of rates, up to that 24%. Your first $9,875 will be taxed at 10%, amounts from $9,875 to $40,125 at 12%, income from $40,125 to $85,525 at 22%, and income from $85,525 to $150,000 will be taxed at a 24% tax rate.
An S-Corporation is a pass-through entity, meaning that all the profits (or losses) pass through to the shareholders. The S-Corporation does not pay a federal tax on its overall profits. You will receive a Schedule K-1 Shareholder’s Share of Income and report your share of those profits (or losses) on your personal tax return. This is reported as part of your overall taxable income and is taxed at your current personal tax rate.
One of the services we provide at Formations is to project your federal tax liability. We look at your overall forecasted income from all sources, determine the withholdings from your W-2 wages, and calculate any potential shortfalls in covering your estimated annual tax liability. We recommend tax withholding amounts on your payroll and assist you in budgeting for any additional payments. The IRS does require that anyone with a tax liability of more than $1,000 make payments as you go through estimated payments or payroll withholding to avoid potential penalties.
In addition to your federal tax responsibilities, you need to be aware of the taxing requirements within your state. Most states have a personal income tax on income earned in that state for the year. Seven states do not have an income tax; Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming, so if you are lucky enough to call one of these states home you do not have to file and pay a separate state tax return. New Hampshire and Tennessee charge a state tax on tax investment and interest income, not on wages, and both states are moving towards changing this taxation of personal income.
When determining state tax, eleven states have a flat tax rate and the remainder of states have progressive tax rates, meaning the rate of tax you pay increases as your income increases. The tax rates vary by state, ranging from as little as 0% to 12.3%. If you live and work in one state, you need to file a return for that state. However, if you live in one state and work in another, or generate income in more than one state, you may be subject to filing and paying taxes in multiple states.
In addition to the taxes paid at a state level, some cities and counties may charge a local income tax. These local income taxes generally apply to someone who lives or works in that specific locality. Some taxes are withholding taxes, withheld through an employee’s wages with payroll, while others are imposed on income, like the state income tax. There are 16 states that have some form of local income tax. These include Alabama, Arkansas, Colorado, Delaware, Indiana, Iowa, Kentucky, Maryland, Michigan, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, and West Virginia.
Industry-Specific Business Taxes
Some industries pay additional taxes, generally at the state level. These may include a Use Tax, Sales Taxes, or Business and Occupation Taxes which are separate from all other previously mentioned taxes and vary based upon specific state regulations and the specific industry. It is important to know all your tax responsibilities. We are here to help ensure your continued compliance so give us a call today.
Sales and Use Taxes
Currently, 45 states collect some form of statewide sales tax; Alaska, Delaware, Montana, New Hampshire, and Oregon do not collect statewide sales taxes, although Alaska does allow the collection of local sales taxes. 38 states charge an additional sales tax at the local level. Sales tax is generally charged on the retail sales of goods, but some states charge a sales or use tax on services. You should understand your responsibilities for collecting any sales taxes and paying the appropriate departments. If you are in the retail industry, the payment of sales tax is not an actual expense, as you are collecting the taxes when you sell your goods, holding the funds until it is time to report your sales, and then passing on the monies you have collected to the Revenue Department for that state or locality.
If you have additional employees, you will be responsible for collecting and paying payroll taxes. For each employee, there will be federal withholdings and the employee’s share of Social Security and Medicare at 7.65% withheld from their wages. You will have the employer’s portion of Social Security and Medicare at 7.65% of total wages as a business expense. You may need to withhold state taxes, city taxes, local taxes, and school district taxes from the employee’s wages, depending upon various state regulations. And, depending upon state regulations, you may have to pay state unemployment, worker’s compensation, and some form of medical leave for your employees. These may be withheld from the employee’s wages, an employer expense, or a combination of the two.
Not a Formations customer?
We recognize that this may be overwhelming to think about and plan for. At Formations, we take care of all the necessary tax filings as well as assist you in budgeting for the various tax expenses. Contact us today to discuss your options and how we can help