Being your own boss can be fabulous. You set your own hours, choose your own projects, pick your working conditions. There are tax benefits, too. If you have a home office, for example, you can deduct part of your mortgage interest and property taxes as a business expense. Of course, there are a few tax drawbacks too.
Self-Employment Tax
As an employee, you pay half your Social Security and Medicare taxes and your boss contributes the other half. When you're self-employed, you pay the whole thing. As of 2012, self-employment tax is 13.3 percent, levied on your net self-employment income in any year it's $400 or more. You calculate the tax before subtracting the standard deduction and personal exemptions on your 1040.
Audit Risk
As an independent contractor, it's easier for you to hide income than when you work 9-to-5 for someone else. The IRS knows that, so your tax return may get extra scrutiny. Deductions for travel, business dinners and entertainment expenses can draw an auditor's eye, as does writing off a home office. The base risk of an audit is 1 percent so even if self-employment doubled the risk, the odds are against an audit. There's no reason to turn down a deduction you're legitimately entitled to -- you just need to keep the records, in case the IRS ever asks you to prove it.
Estimated Taxes
Instead of tax withholding, you must typically file quarterly estimated tax payments. This is intended to cover what you owe in both self-employment and income tax. It requires you sit down, total your taxable income and figure your tax four times a year, unless your income is so steady you can make four equal payments. If you underestimate by too much, the government can slap a penalty payment on you to teach you a lesson for next time.
Paperwork
Estimated tax is only the beginning of the paperwork. When your business sells anything subject to sales tax, you have to file with the state to collect it, then collect and submit regular payments. If you have employees, you're the one responsible for figuring their payroll taxes and withholding the right amount, unless you pay someone to handle the work for you. Even if you're a one-person shop, you need to track payments, receipts and expenses to keep your taxes accurate.
