Self Employed: At first glance, self-employment and small business ownership may appear quite similar, both offering the allure of being your own boss. However, when it comes to dealing with the IRS and managing taxes, these two entrepreneurial journeys diverge significantly. In this article, we’ll delve into the distinctions between self-employment and small business ownership and explore how they can impact your tax responsibilities.
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Differentiating Self Employed from Small Business Ownership
To distinguish between self-employment and small business ownership, it’s essential to consider how you run your enterprise. If you’re a small business owner, you oversee a business that may have other individuals working for you. In contrast, if you’re self-employed, you are essentially the business itself.
Self Employed Scenarios
1. Sole Proprietor
As a sole proprietor, your business is essentially an extension of yourself. You make all the decisions, work for yourself, and consider your business profits as personal income.
2. Independent Contractor
Independent contractors, often referred to as freelancers, offer services to others while maintaining their autonomy. They work on a contractual basis with clients they choose, all without being classified as employees.
In a partnership, you retain the characteristics of a sole proprietorship, but you share business ownership with two or more individuals who are your partners.
Small Business Owner Traits
1. Employing Workers
Small business owners hire employees or engage self-employed workers as independent contractors to help with their business operations.
2. Separate Entity
Your business can be classified as a separate legal entity, providing you with reduced personal liability.
3. Tax and Insurance Responsibility
If you have part-time or full-time employees, you are responsible for handling their taxes and securing workers’ compensation insurance.
Taxation: The Key Difference
The most significant disparity between self-employed individuals and small business owners lies in how they manage income and taxes, subsequently affecting their tax obligations.
Self Employed Taxation
1. Personal Reporting
Self-employed individuals report their business deductions, profits, and losses on their personal income tax returns, utilizing Schedule C.
2. Self Employment Tax
If your earnings exceed $400 annually, you are required to pay self-employment tax, covering Medicare and Social Security contributions. To avoid penalties or a substantial year-end tax bill, you may need to make quarterly estimated tax payments.
Small Business Owner Taxation
1. Business Type Specific
Small businesses are taxed differently depending on their legal structure. For instance, limited liability companies (LLCs) may pass taxes through to the owners, or they can elect to be taxed as a corporation.
2. Corporate Taxes
When taxed as a corporation, you’ll pay taxes on your business profits, calculated as revenue minus the cost of goods sold and other operating expenses.
3. Employee Reporting
Small business owners use Form W-2 to report employees’ incomes and the amount of federal, state, or local income tax withheld. When hiring independent contractors, payments of $600 or more must be reported using Form 1099-MISC or Form 1099-NEC.
Transitioning from Self Employed to Small Business Owner
As your business evolves, you may contemplate transitioning from self-employment to small business ownership. Here are some situations where such a transition might be beneficial:
Reducing Personal Liability(Self Employed)
If you’re a sole proprietor and your business expenses are increasing, structuring your business as a single-member LLC for tax purposes can be a wise move. This separation safeguards your business from your personal assets, offering increased liability protection. You can further choose to tax your business as an S corporation and report profits and losses using Form 1120-S.
Adding Owners or Employees(Self Employed)
If you’ve been a sole proprietor and are thinking of introducing new owners or employees, such as in a partnership or LLC, changing your business structure may be necessary. The inclusion of more individuals in your business often triggers a change in the business’s structure.
In conclusion, the decision to alter your business structure should align with your specific needs and the growth of your enterprise. Whether you choose to remain self-employed or transition into a small business owner, understanding the distinctions between these two paths is essential for making informed decisions that will impact your financial and tax responsibilities.