10 Methods a Aspect Gig or Enterprise Can Influence Your Taxes
The gig economy is big and getting bigger. According to a 2018 Gallup poll, 36% of American workers participate in the gig economy. And that’s just the tip of the iceberg.
Between income diversification, less dependence on an employer, flexibility, and the chance to develop new and marketable skills, it’s no wonder the gig economy has grown so quickly. But many ignore another critical point: the impact of gig work on income taxes.
Here’s what you need to know about how a side gig changes your tax situation, often for the better.
How a Side Business Affects Your Taxes
Yes, you have to pay taxes on your side gig earnings. If you don’t, you can expect a nasty notice from the IRS, along with penalties and fines on top of any back taxes owed.
However, as a self-employed person or business owner, you get access to tax deductions and benefits not available to most employees. In many cases, these are above-the-line deductions, meaning they come off your adjusted gross income (AGI) before you have to choose between the standard deduction and itemizing. That means you still get the deduction even if you take the standard deduction.
Not all of the tax implications are for the better, but most are, and on balance, the advantages outweigh the disadvantages.
1. You (Probably) Qualify for the 20% Pass-Through Deduction
If you operate using a pass-through legal entity, such as an LLC or S corporation, you’re likely eligible to take the 20% pass-through deduction introduced by the Tax Cuts and Jobs Act of 2017 (TCJA).
As a freelancer or small-business owner, you almost certainly structured your legal entity as a pass-through entity, which means profits “pass through” to you as an individual taxpayer.
The short version of the 20% pass-through deduction is that many businesses can deduct 20% of their qualified business income before adding it to their tax bill. So, if you earned $10,000 in net profit from your side business, you may only have to pay taxes on $8,000 of it.
The long version gets complicated, and fast. To put it simply, if your taxable income is under $157,500 for a single taxpayer ($315,000 for a married couple), you can likely take the full 20% deduction off your qualified business income.
If you earned more than $157,500 ($315,000 for a married couple), then the pass-through deduction becomes subject to a series of restrictions.
Word of Warning
Talk to an accountant, because wading through the minutiae of the IRS tax rules on the pass-through deduction may induce the worst headache of your life.
Pro tip: H&R Block has CPAs and EAs that you can chat with online. They can help answer all of your questions about the pass-through deduction.
2. You Can Deduct More Expenses
As a small-business owner or self-employed person, you can deduct expenses that most employees can’t. For example, you can deduct part of your housing expenses for home office expenses, even after the TCJA added limitations for employees.
Bought a new laptop? Mobile phone? Talk and data plan? Printer? Paper? You may be able to partially deduct those expenses, if you use them primarily for business purposes, under Section 179 of IRS rules.
Business-related travel is another popular tax deduction for small-business owners.
Words of Warning
First, keep every single receipt for business-related expenses, and file them where you can easily find them if the IRS questions you.
Second, be extremely careful not to abuse these deductions. If you take a two-week vacation and have one “dinner meeting with a potential client” who happens to be a friend of yours, don’t expect the IRS to let you write off the vacation as a business travel expense.
Again, talk to your accountant about what they think you can make a defensible case for and what you can’t. The line is sometimes blurry, so tax preparation is often about creating a defensible argument for why you’re justified in deducting this or that expense.
3. You Can Contribute to a SEP IRA
The self-employed have access to a unique type of IRA for retirement planning in the SEP IRA. These can be set up through a broker like E*Trade.
Unlike the normal IRA contribution limit of $6,000 ($7,000 for taxpayers over 50) in the tax year 2021, the SEP IRA has a far higher contribution limit of $58,000. It comes with a catch, though: an additional limit of 25% of your self-employment income.
A taxpayer who earned $30,000 in net income from their self-employed activities can, therefore, contribute $7,500. Their other earnings, such as those from their full-time job, don’t count when calculating the 25% cap on SEP IRA contributions.
If you’re organized as a business, you can also create your own 401(k). But that requires hiring a 401(k) administrator, which comes with fees that leave it unattractive to most side gig business owners.
4. You Probably Need to File Estimated Quarterly Taxes
When you work for someone else, they pull estimated taxes out of your paycheck and pay them to the IRS throughout the year on your behalf.
But when you work for yourself, you have to do that on your own if you’re slated to owe more than $1,000 in total taxes on your self-employment income. You prepay this year’s taxes throughout the year, every quarter, and when you file your return early next year, you either get a refund or owe taxes based on how much you’ve paid, just like a normal employee.
Failure to prepay taxes on your self-employment income means penalties and fines from Uncle Sam.
Here’s a quick guide on how to make estimated quarterly tax payments to the IRS, plus the quarterly tax due date calendar.
5. You Need to Send 1099s to People You Paid (And You May Receive 1099s Yourself)
If you paid someone more than $600 last year, and they’re not an employee of yours, you need to send them a 1099 form.
Your accountant can do this for you, but if you’re handling it on your own, beware that it’s not as simple as downloading a form and mailing it. You must buy original hard copies of 1099 forms issued by the IRS. You then have to send a copy to the payee and a copy to the IRS, which you can do electronically.
The due date for sending 1099s is typically January 31. Failure to do so results in – you guessed it – fines from the IRS. It’s one of the more common tax mistakes made by entrepreneurs and employees alike.
As a self-employed person, you may also receive 1099s from people who paid you. Don’t even think about trying to get away with not declaring self-employment income. The IRS is watching, with a copy of all your 1099s in hand.
6. You Have More Options for Deducting Health Insurance
While traditional employees can deduct health care costs, the costs have to be at least 7.5% of the taxpayer’s AGI, and the taxpayer has to itemize their deductions.
But with the standard deduction so much higher after the TCJA – $12,400 for individuals in the tax year 2020 ($24,800 for married couples) and $12,550 ($25,100 for married couples) in 2021 – far fewer Americans are itemizing, which makes this deduction even less useful.
Self-employed people who own their own businesses have more options.
If you set up your health insurance under your business, you can deduct the cost of coverage for yourself, your spouse, your dependents, and even adult children under 27. The best part? The costs come off your net business earnings, so you can still take the standard deduction.
Your business must show a net profit for the year; you can’t use health insurance to create losses. You can take the deduction if you’re an LLC owner, a partner, more than a 2% shareholder of an S-corp, or if you show self-employment income on Schedule SE.
It’s definitely a perk to keep in mind as you browse health insurance options as a self-employed person.
7. You Can Still Deduct Accounting & Tax Prep Costs
The TCJA removed the deduction for tax preparation and accounting expenses – at least for individuals. For businesses, these expenses are still deductible, and they’re subtracted from taxable net revenue.
Once again, that means self-employed people can still take the standard deduction and deduct their accounting costs from their business revenue.
Talk to your accountant about how much of your total accounting and tax preparation costs you can classify as business accounting costs, rather than personal costs, to legally maximize your deduction.
8. Prepare to Pay Self-Employment Tax
One of the downsides of being self-employed is having to pay double FICA taxes, also known as self-employment taxes.
Employees pay 7.65% in Social Security and Medicare taxes, known as FICA taxes, which is only half of the total tax bill they owe. What many employees don’t realize is that their employer covers the other half, for a total FICA tax bill of 15.3% per employee.
Self-employed people pay both halves.
When you complete your Schedule SE, expect a line for FICA taxes totaling 15.3% of your net self-employment revenue. All that 1099 income you earned is subject to these taxes, as is all net business income if it exceeds $400.
And, yes, you need to prepay this as part of your estimated quarterly tax payments.
As a final thought, the IRS does allow small-business owners to deduct half of their self-employment tax (7.65%) from their total taxable income.
9. You Have More Options for Avoiding FICA Taxes
You have to pay double FICA taxes on self-employment income, but not all of your income has to fall under that category.
As a small-business owner, you can take some of your earnings as wages – and pay self-employment taxes on them – but you can also take some of your earnings as a dividend distribution. Owners of S-corps are not charged self-employment taxes on dividend distributions, only on wages.
With that said, the IRS requires that wages be “reasonable compensation” for your work, a term that leaves plenty of leeway.
Beyond dividend distributions, here are some other types of income you can pursue as a business owner that’s not subject to self-employment taxes:
- Rental income
- Bond income
- Dividend income from equities
- Income from crowdfunding websites and peer-to-peer loans
- Venture debt income
- Private equity income
- Capital gains
In other words, income you earn from passive income sources you invest in to generate diversified, ongoing revenue is not subject to self-employment taxes. As a landlord, one of my side gigs is buying rental properties. I don’t have to pay self-employment taxes on the revenue, and I get plenty of real estate tax deductions into the bargain.
10. Your Tax Return Is More Complicated
When your only income is from a W-2 job, your income tax return tends to be pretty simple. But as you start adding side gigs and become self-employed, your tax filing gets more complicated quickly.
As mentioned above, you need to track every single business expense if you want to be able to deduct it – and defend it in an audit. You need to send 1099s, and you can expect to receive 1099s.
Your tax return gets longer. Sole proprietors must fill out Schedule C to document their business expenses. If you receive rental income, you must fill out Schedule E. If you have partners, you must fill out Schedule K-1s and Form 1065.
It’s lucky for you that accounting and tax preparation costs are still deductible for small-business owners, because you may well find yourself needing an accountant’s services for the first time in your life once you launch your own side business.
There’s an admirable sense of independence in the rise of side gigs, side hustles, and side businesses. More Americans are discovering that they can start their own business while working a full-time job and create multiple streams of income. Some Americans are even turning their hobbies into money-making businesses.
Side gigs cost time, stress, and energy, and they complicate your tax return. But in return, side gigs generate extra income and offer access to tax deductions not available to regular employees.
As a parting word to the newly self-employed, it takes a different mindset to succeed as an entrepreneur than it does as an employee. It starts with full accountability over your own success and continually identifying the work most likely to produce revenue and results, rather than doing work handed to you by a boss.
Try these success tips for new entrepreneurs on for size, and best of luck with your side gig!