Important tax terms that self-employed business owners must know, and more importantly, why they're critical to understand.
When you first decided to start your own business, friends and family members might have made comments like, “Wow, you’re going to be able to take so many tax deductions!” or, “You’ll be able to write-off a fancy car.” Do they, or you, even know what tax terms like tax deductions and write-off even mean?
For the new entrepreneur, the promise of significant tax savings when it comes time to pay taxes can be exciting or tempting. If only it were that simple!
The truth is, there are some important differences between filing taxes as a self-employed freelancer, independent contractor, or solopreneur and filing taxes as an employee. To minimize your tax bill as a business owner, you’ve got to understand a few key tax terms and concepts.
In this blog post, I’ll define some important tax terms that self-employed business owners must know, and more importantly, why these tax terms are critical to understand.
Table of Contents
1. Taxable Income
Your taxable income is the total amount of income that’s subject to taxes (eg. income tax).
As an employee, you fill out a W-4 form that tells your employer how much of your wages to withhold for tax purposes. Employers withhold federal income taxes and Federal Insurance Contribution Act (FICA) taxes, including Social Security and Medicare contributions. Different states also have their own withholding rules.
As an independent contractor or freelancer, there is no employer to withhold these taxes for you. Instead, you’ll need to calculate and pay self-employment tax (a Social Security and Medicare tax for the self-employed), as well as federal and state income taxes.
If you expect to owe $1,000 or more on your federal income taxes and own a sole proprietorship, partnership, LLC, or S corporation, you don’t wait until the tax deadline to pay your taxes in full. Instead, you make estimated income tax payments each quarter. Use Form 1040-ES to calculate your estimated tax, and make your payments on April 15, June 15, September 15, and January 15 (or the next business day if that date falls on a holiday or weekend).
An adjustment to your income is any expense that legitimately reduces your total (gross) income. These are reported on Schedule 1 of your IRS Form 1040 and subtracted from your gross income to arrive at your adjusted gross income (AGI). A tax deduction is a type of adjustment.
4. Audit Potential
Audit potential refers to the risk that tax returns may be unusual or incorrect. The IRS has several ways to determine whether your returns have audit potential. For example, taxpayers who fill out Schedule C forms (that is, self-employed entrepreneurs), taxpayers who claim excessive deductions relative to their business income or above the average for their industry, and tax returns with errors may be flagged for an audit.
You also have higher audit potential if your business has a lot of cash income, such as a bar or restaurant, vending machine business, or laundromat. This is because many such business owners don’t report all of their cash income.
5. Tax Exemption
Tax exemptions are given to specific types of organizations, such as nonprofits. To get a tax exemption as a self-employed person, you need to be an ordained clergy member or a member of certain religious communities that object to receiving money from the government. You can apply for a tax exemption using IRS Form 4361. While one of the most attractive tax benefits, a tax exemption only applies to a specific few instances.
6. Tax Deductions vs. Tax Credits
One of the biggest misconceptions about taxes is that tax deductions and tax credits are interchangeable terms.
A tax deduction is deducted from your taxable income. A tax credit is deducted from your tax bill. What’s the difference? It can be substantial. For example, suppose your taxable income is $100,000, and you qualify for a $2,000 tax deduction. This reduces your taxable income to $98,000, which may also reduce your tax bill, but probably not by much.
However, suppose your taxable income is $100,000, and you owe $10,000 in taxes, but you qualify for a $2,000 tax credit. Since the tax credit is subtracted directly from your tax bill, your tax bill is reduced to $8,000.
While both have an effect on your federal income tax, the difference between tax credits and tax deductions is important to understand before making purchases or investments that are tax-deductible.
7. Types of Tax Deductions
The IRS sets standard deductions that everyone can claim. These deductions are subtracted from your AGI. The government’s goal here is to exempt a certain base level of income from taxation. The Tax Cuts and Jobs Act passed in 2017 increased the standard deduction. For the 2021 tax year, the standard deduction is $12,550 for single filers, $25,100 for married couples filing jointly, and $18,800 for heads of household.
Using our previous example, suppose you are a single freelancer with an AGI of $100,000. The most straightforward approach to filing taxes would be to take the standard deduction of $12,550, reducing your taxable income to $87,450.
But what if you spent $20,000 on tax-deductible mortgage interest, real estate taxes, and charitable contributions? In that case, itemizing your expenses (listing them on Schedule A attached to your Form 1040) would allow you to subtract these deductions from your AGI, reducing your taxable income to just $80,000.
You can either take a standard deduction or itemize your deductions; you can’t do both.
The Tax Cuts and Jobs Act made some significant changes to business deductions. Some of the most popular business tax deductions, such as costs for entertaining clients, have been reduced or eliminated altogether.
However, it added a new deduction for owners of pass-through businesses. Sole proprietorships, LLCs, partnerships, and S corporation shareholders may be able to simply deduct 20% of their qualified business income. This is in addition to the standard deduction.
Go back to our example of the freelancer with AGI of $100,000 who takes the standard $12,550 deduction and has a taxable income of $87,450. By taking a deduction of 20% of $100,000 ($20,000), his or her taxable income shrinks to $67,450.
Get Help When You Need It
Understanding these essential tax terms will help you get a head start on your business taxes in order to file your tax return as a freelancer.
If you’re worried about being able to pay your bills come tax time, and you’re currently financially stable, you might consider applying for a business line of credit now. Hence, you have a cushion of funds ready when you need them.
If you are confused about taxes, it’s always helpful to seek professional advice from an accountant, bookkeeper, or tax preparer specializing in freelancers or small businesses like yours. With many new changes to the tax laws, getting professional help can really pay off this year.
And there are so many more confusing tax terms like tax liability, adjusted gross income, capital gains, etc. Looking them up and getting an understanding of their meaning is a great start, but when it comes to dealing with the Internal Revenue Service, it’s best to have your ducks in a row.
This post was updated in November 2021.