Deducting confusion from self-employment taxes
Our experts spell out the standards for self-employed individuals, and itemize the differences.
P.D., Dallas, Texas
I told a friend who has only self-employment income in 2007 that he could still take the IRS standard deduction for an individual against his earnings, if their itemized deductions are less. They said their tax preparer told them they could only use any itemized deductions against their self-employed income. Who is correct?
By Shara Rutberg, Fortune Small Business contributor
Dear P.D.: As stated, you are the correct one.
“A self-employed individual can itemize deductions or use the standard deduction,” says Vicki Meyer, a CPA with Thomas Howell Ferguson, P.A. in Tallahassee.
But the question is a little tricky, says Tom Ochsenschlager, vice president of taxation with the Washington, D.C., American Institute of Certified Public Accountants . When you’re self-employed you have to pay two different taxes, not just your income taxes. Self-employed individuals have to attach a Schedule SE (which stands for “self-employment”) to their 1040. The Schedule SE is where you compute your Social Security, Medicare and Federal Unemployment taxes.
For most people, their employer withholds and pays these taxes. When you’re self-employed, you are your own employer. To figure out how much of your income is subject to these payroll taxes, generally you take the net income figure from your form Schedule C on your 1040. This figure is net of only the deductions directly related to your business. You cannot claim the standard deduction on Schedule C.
But, that does not preclude you from taking “either the standard or itemized deductions to compute your income tax on your 1040 if you’re self-employed,” Ochsenschlager says. It’s possible that either your itemized deductions or the standard deduction would completely wipe out your taxable income, but you would still have to file a 1040 to pay the self-employment (payroll) taxes.
Be careful not to confuse business deductions, which are typically allowed only against business income, with itemized deductions, says Meyer.
“Itemized deductions are non-business expenses, such as medical expenses, interest, taxes, charitable contributions, and certain miscellaneous expenses related to being an employee," she says.
Some categories of deductions can be both: for example, taxes can be incurred both in your business and personally. Others relate to your employment status. For example, un-reimbursed travel may be deductible by an employee as an itemized deduction, but may be deducted by a self-employed individual against their self-employment income.
“The key is keeping your deductions in their proper place,” she says. “Your question reflects a common language barrier when it comes to discussing taxes.”
Some of the confusion stems from the fact that when you’re self-employed, you’re actually computing two different kinds of taxes, says Ochsenschlager.
“You’re going to owe self-employment tax covering social security, payroll and Medicare,” says CPA Jerry L. Love, CEO of Davis, Kinard & Co. in Abilene, Texas.
“In addition, you’re going to owe taxes on your taxable income,” says Ochsenschlager.
The best advice? “Have your friend go back to the tax return preparer for clarification,” says Meyer.
This column provides general information only and is not intended to replace the services or legal advice of an attorney. Always consult a lawyer regarding any specific legal concerns, as laws vary from state to state.
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