It seems there are more and more people becoming self employed these days – or at the very least, many folks are starting a side business, turning a hobby into some extra income or doing some type of independent contractor work.
In my day job, I am actually an independent contractor so I know quite well there are some things to remember if you’re self employed.
Whether you’ve decided to turn your blog into a business, sell a multi-level marketing product or rent a storefront to start selling your homemade jewelry there are some mistakes you will definitely want to avoid.
1. Not Setting Aside Money for Taxes
This seems simple enough, but is probably one of the biggest tax mistakes people make among others. The number of people I talk to that haven’t set aside money for taxes is pretty high. If you are a 1099 contractor, the company you are contracted with does not pull out taxes for you.
At first, this feels great because your paycheck is higher – then reality sets in when it’s time to file your taxes.
Uncle Sam requires you to make quarterly estimated tax payments. If you don’t have enough paid in for your estimated taxes you could face some penalties. I recently talked to someone who didn’t think they really needed to set money aside for his independent contractor work and figured he could just use his savings to pay the taxes.
He ended up making a little more than he thought by the end of the year and couldn’t pay all the tax liability. He got whacked with some stiff penalties and is now making recurring payments to the IRS until his debt is wiped out.
Another thing people fail to realize is the self-employment tax that’s due. This was a stiff kick in the gut to me after my first year of self-employment.
Uncle Sam charges 15.3% tax for self-employed in addition to your regular income tax! This is equivalent to the FICA tax on a regular paycheck. The good news is that you can deduct half of your self-employment tax, but you still have to pay!
What I do to help me throughout the year is any time I get paid, I set aside 20% of my money right away into a separate bank account, which is labeled Uncle Sam’s. Then each quarter I take that money and make a quarterly estimated tax payment.
In the fourth quarter I do a quick assessment of where I am in terms of income and tax payments and adjust accordingly. This has worked well for me the last few years.
2. Not Taking a Look at Incorporating
Many self-employed folks start out as a sole proprietor. They themselves are the business and everything (income, expenses and liabilities) gets funneled through their own personal account.
Not everyone should incorporate. If you’re not planning on going “big time” with your business or you’ve decided you just want your hobby to make enough to cover expenses, it probably doesn’t make sense to pay the fees associated with incorporating.
It does make sense, however, to at least consider whether incorporating is right for you. One benefit of incorporating is that you can get around the self-employment tax.
The biggest benefit however is limited liability. This means that the business, not the owner is personally responsible for its obligations. In other words, if the business gets sued, only the business assets are at risk, not all of your own personal assets like in a sole proprietorship.
3. Not Keeping Track of Income and Expenses
This is one of those mundane tasks that most owners hate, but every business must do in order to maximize deductions as well as protect themselves from an IRS audit.
A business owner should really be organized when it comes to tracking daily expenses and income. Don’t write down your mileage on a napkin each time you travel. Your bookkeeper will thank you for that. Or, if you are acting as bookkeeper you’ll appreciate your organization as your business grows.
Get a notebook, use a spreadsheet or some budgeting or personal finance software to track the amount of your expenses, the category (i.e. office supplies) and a brief explanation of what you purchased etc.
Don’t rely on your memory to come through for you when you need to report an expense. Keep your receipts, develop a system and keep up to date.
I typically store all my receipts in one place for the week and then each Friday I pay bills, track my expenses in a spreadsheet, review my income and take a look at profit and loss statements.
This may be a bit much depending on what type of business you are in, so just be sure you come up with a system that works for you.
Avoiding these mistakes as a self-employed person will help free up time, save you money and protect your business so you can maintain a long and profitable career.
{ 12 comments… read them below or add one }
Be sure to check out the IRS EFTPS program to make those quarterly payments. EFTPS is their ONLINE tax payment system. It’s free. Go to IRS.gov. There is usually an EFTPS logo on the home page. Click on it to see how it works and how to apply.
If you incorporate you end up paying yourself a salary, which is subject to all sorts of fun payroll taxes and forms (I use paycycle.com).
You can’t really avoid the 15.3% SS+Medicare tax unless you pay yourself a salary lower than the business’ income and “dividend” the excess to the “shareholders” (you) periodically. Problem is, the IRS is on to this, and really expects you to pay out all of the income of the business to yourself as a salary.
Jason, excellent article. It’s just what I needed for this point in my life. The IRS is the last agency we want to mess with. They seem to have unlimited power and can ruin one’s life. I pledge to keep my finances in line and business transactions in the books so that come tax time, I won’t be caught off guard. Thanks sir! Oh, and thanks to “CoolHappyGuy” for the great tip on the IRS EFTPS program.
good article. I have a few friends that need to read this.
Thanks for letting us know about these three stupid mistakes…I will definitely share this post with my friends and relatives….
All good points! Especially that first one, not a pleasant mistake to make!
Do you have any advice on Nevada corporation? I have several people ask me but do not have any knowledge about them!
One more common mistake, do not give away your margins to get a sale. You will never get them back with that customer. Exceptions are when you want to close a product out and start a new one, or you can lock a long term contract for your product or service. A discount can be worth it to the business stability.
“Not Setting Aside Money for Taxes”…
I do income taxes in season and this is huge. Even if you don’t make estimates you still get stuck making payments once you file and you have to settle with the IRS. It’s not half bad if you’re a saver by nature, and tend to accumulate the money to pay at filing time, but if you aren’t a saver and you don’t make estimates, it’s a double whammy and you’re socked with penalties and interest to boot.
Cool Happy Guy – thanks for the info on the EFTPS. I wasn’t aware of that site – looks like a great service!
I’ve been freelancing for several years and I’d say put aside 30% actually. I pay in about 25% over the course of the year and that “almost” covers the bill when taxes come due in the spring–I keep hoping for a refund but not yet.
My freelancing is on top of a full time job though, so I might be seeing a higher amount go in….
Jason,
Great post. Those 3 will definitely get a small business in a world of trouble. Any one with a small business or wanting to start a small business need to head these 3 warnings. Take them seriously !
Chris