Holy Crap! I’m Self-Employed! - What’s My Tax Liability?!

This series is aimed at helping self-employed individuals navigate commonly encountered complex accounting issues. Issues regarding corporations or other fictitious entities fall outside the scope of this article and this series.

While the IRS and the FTB have their own instructions on each of these topics, some of which are referenced herein, it has been communicated by multitudes of clients that such instructions are woefully unclear, convoluted, and extremely difficult to navigate. This series is intended to address this issue.

For every self-employed person, it becomes necessary to calculate their tax liability throughout the year, and not just during tax time, because of the requirement to pay one’s taxes ratably throughout the year, known infamously as “quarterlies.”

To begin estimating one’s tax liability, one must annualize their income before any other step. This simply means estimating one’s income for the entire year based on a sample of income from part of that year, assuming such income remains relatively constant.

To annualize one’s income:

1^st, record the total amount of every paycheck and cash payment received throughout the year so far. A simple way to do this would be to total one’s year-to-date deposits into their bank account(s), assuming they do not have any deposits comprised of something other than revenue from self-employment. This is your “gross” income.

2^nd, take the total and divide it by the number of months in the year that have passed. For this upcoming quarterly payment in September, you would use the number “9”.

3^rd, multiply that quotient by 12; the number of months in a year. This is your “annualized” income.

If one has been diligent in keeping track of their expenses, subtract your total expenses for the year from your “annualized” income. This is your annualized adjusted gross income (AGI).

Then, from your annualized AGI, subtract your standard deduction. As of 2018, if you’re single, this is $12,000. Married and filing jointly, $24,000; filing separately, $12,000 to each spouse. If you’re not married but you financially support more than 50% of the expenses of a qualifying child or qualifying relative, also known as a dependent, this is $18,000.

Some tax payers may itemize their deductions instead of taking their standard deduction. If it can be estimated, absolutely use your itemized deduction estimate instead.

Subtracting your standard or itemized deduction from your AGI yields one’s taxable income, in this case annualized based on a projection of what’s been earned so far throughout the year.

Once taxable income is determined, one must figure their tax liability, which is how much of one’s taxable income is actually owed to the tax authority.

Self-Employment Tax:

Unfortunately for most self-employed taxpayers, this is not the end of the nightmare. The other side of taxation that one must worry about when self-employed is the dreaded self-employment tax. If one earns more than $400 in self-employment income in the year, this tax becomes applicable as well.

One may find the IRS’ primer on the topic here (https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes), and their actual form (Sch. SE) for figuring the number here (https://www.irs.gov/pub/irs-pdf/f1040sse.pdf).

Self-employment tax is the tax for Social Security, Medicare, Unemployment Insurance, its applicable increase due to state indebtedness, etc. While that calculation can be more complicated, the simplest way to estimate self-employment tax liability is as follows, assuming one’s annual income does not exceed $127,200, in which case other instructions, linked above, apply.

To illustrate the material so far, let’s assume a single taxpayer, Mr. White, has $36,000 of income evenly throughout the year, he has $4,500 of expenses by September of 2018, and he is looking to make their quarterly payment on September 17^th. Let's also assume Mr. White contributed $1,000 to a traditional IRA.

$36,000 divided by 9 is $4,000 per month. For 12 months in the year, $4,000 multiplied by 12 is $48,000 in annualized income. We could do the same with the expense figure; $4,500 divided by 9 is $500 / month, multiplied by 12 is $6,000 of annualized expenses.

Mr. White's net annual income would be $42,000, or $48,000 estimated annual income less $6,000 of estimated annual expenses.

Because of his $1,000 contribution to his traditional IRA, Mr. White’s Adjusted Gross Income (AGI) would be $41,000, deducting $1,000 from his net annual income of $42,000. 

 To measure the effect of self-employment tax up to this point,multiply the net annual income $42,000, by 0.9235, as specified on the IRS form’s instructions. This yields $38,787.

Multiply this amount by 15.3%, which yields $5,934.41.

Half of this amount is deductible from taxable income.

Mr. White's AGI is $41,000. Assuming he does not itemize expenses, his standard deduction would be $12,000, and assuming no tax credits apply, his preliminary taxable income would be $29,000, taking $12,000 of standard deduction away from $41,000 of AGI.

Mr. White’s preliminary taxable income, before the tax liability calculation, was $29,000. This amount is reduced further by the self-employment tax deduction of half of the SE Tax amount, or $2,967.21, yielding a new taxable income of $26,032.79. 

What remains is to calculate Mr. White's tax liability, and then determine his quarterly estimated payment.

Using tax tables:

Tax authorities use a system of reference tables to calculate the final amount of tax due. This process is horrendously convoluted, but it can be simplified. For reference, the IRS’ tax tables can be found here (https://www.irs.gov/irb/2018-10_IRB#RR-2018-06).

For purposes of this study, we will use only the individual tax table, which is as follows:

TABLE 3 - Section 1(c) – Unmarried Individuals (other than Surviving Spouses and Heads of Households)
If Taxable Income Is:	The Tax Is:
Not over $9,525	10% of the taxable income
Over $9,525 but not over $38,700	$952.50 plus 12% of the excess over $9,525
Over $38,700 but not over $82,500	$4,453.50 plus 22% of the excess over $38,700
Over $82,500 but not over $157,500	$14,089.50 plus 24% of the excess over $82,500
Over $157,500 but not over $200,000	$32,089.50 plus 32% of the excess over $157,500
Over $200,000 but not over $500,000	$45,689.50 plus 35% of the excess over $200,000
Over $500,000	$150,689.50 plus 37% of the excess over $500,000

This is the total amount the IRS should have, in theory, by the time the final quarterly payment is made on January 15^th of the following year.

For California, the applicable tax table for individuals and heads of households can be found here (RTC Div. 2 Part 10 Ch. 2 Paragraph 17041).

If the taxable income is:	The tax is:
Not over $3,650  ........................	1% of the taxable income
Over $3,650 but not over $8,650  ........................	$36.50 plus 2% of the excess over $3,650
Over $8,650 but not over $13,650  ........................	$136.50 plus 4% of the excess over $8,650
Over $13,650 but not over $18,950  ........................	$336.50 plus 6% of the excess over $13,650
Over $18,950 but not over $23,950  ........................	$654.50 plus 8% of the excess over $18,950
Over $23,950  ........................	$1,054.50 plus 9.3% of the excess over $23,950

Mr. White's taxable income of $26,033 falls in the 2^nd tax bracket on the federal table, between $9,525 and $38,700. The first $9,525 is taxed at 10%, and any amount after that threshold is taxed at 12%, so one would subtract the first $9,525 of his income from his $26,033 to find the amount taxed at 12%, which is $16,508. 12% of $16,508 is $1,980.96.

As previously mentioned, the first $9,525 of earnings is taxed as 10%, or $952.50. $1,980.96. added to $952.50 yields $2933.46, or a preliminary total income tax liability to the IRS of $2,933.

Using the same process for California, one sees that Mr. White falls into the highest tax bracket for the State of California; surprise surprise. $23,950 subtracted from $29,000 yields $5,050, 9.3% of which is $469.65. As the table instructs, adding $1,054.50 to $469.65 yields $1,524 in preliminary income tax liability to the FTB. 

Notice how the deduction for self employment tax only applies to the federal return. The state of California has no such similar provision because the self employment tax is specifically for Social Security, Medicare, and associated programs under federal, not state, jurisdiction. 

Now, adding the self-employment tax liability to the income tax liability, $2,933 and $5,934.41 yields $8,867.41 of total tax liability.

California tax liability does not change based on self-employment taxes, and remains at $1,524, for a combined state and federal tax liability of $10,391

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To contrast the self-employed experience with someone who is employed with a company, if Mr. White were employed at a regular job making the same amount of money, his withholding for Social Security and Medicare, mandated by the Federal Insurance Contributions Act (FICA), would be 7.65% of earnings, and his employer would be responsible for the other 7.65%. For Mr. White, this would be a total of $3,672 withheld for FICA.  

Mr. White would not be able to deduct his regular business expenses in 2018 since the Tax Cuts and Jobs Act removed such deductions, known as employee-business expenses. Instead of contributing to an IRA, his $1,000 contribution to a 401(K) retirement plan with his employer is paid with pre-tax dollars, so it doesn't get counted. His AGI would be $47,000, and his taxable income after his standard deduction would be $35,000. 

Applying the tax tables, his tax on that money would be $4,009.50. His California tax liability would remain $1,524, for a total; adding $4,010 to the IRS, $1,509 to the FTB, and $3,672 for FICA, resulting in a combined liability of $9,206. 

This amount would be withheld, along with a few other amounts, from his paycheck throughout the year, and any excess withheld would be returned in the form a tax refund.

The same amount of money made between two different employment schemes yields a de facto penalty of 12.9% in this specific example, or $1,186 for the year for no other reason than for having been self-employed.

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When one is done reeling from the shock of their tax liability, the task of figuring out their quarterly estimate remains as the final step to this arduous process.

To figure how much should be sent to the IRS to avoid (or minimize) one’s penalty, do the following:

1)      take the number of months in the year already passed (in September, it would be 9)

2)      divide it by 12 (9 divided by 12)

3)      Multiply that subsequent proportion by the tax liability figure calculated in the previous paragraph. 

4)      Next, subtract from that subtotal any estimated payments already made for the current tax year (do not include the Jan. 15^th payment for last year’s taxes if one was made).

To figure the amount to send to the FTB, please refer to the instructions here. Essentially, California specifies how much of one’s annual tax liability must be sent with each quarterly estimate depending on the timing of the receipt of one’s income.

In Mr. White’s case, let’s assume he earns his income evenly throughout the year and he made his timely quarterly payments in April and in June. In September, to the IRS, he would begin with his federal tax liability, $10,391.

9 months have passed throughout the year, so 9 divided by 12 is 75%, multiplied by the tax liability yields about $7,793.

From that amount, we subtract the amounts paid in April ($2,598) and in June ($2,598), yielding a total quarterly estimate of $2,597, $7,793 due so far less $5,196 already paid.

For the state of California, no quarterly estimate is due in September for Mr. White.

 

If he were to have received all of his $36,000 after June, then California mandates that 70% of his liability be paid in the estimate due in September, so his quarterly estimate for September in this specific case would be $1,067.


The federal quarterly estimate would be made on the corresponding month's Form 1040-ES, found here (https://www.irs.gov/pub/irs-pdf/f1040esn.pdf)

The California quarterly estimate is made on Form 540-ES found here (https://www.ftb.ca.gov/forms/2018/18_540es.pdf).

Most of the methodology discussed so far disregards any tax credits or other reductions to taxable income not included in standard, itemized, or business related deductions, nor does this methodology consider the effects of the Alternative Minimum Tax. For such situations, please consult your CPA, or…

If this quick guide is insufficient for your specific situation, or if you would like more information, please contact the author at fmachado@soapaccounting.com.

Sources:
26 U.S. Code Section 6654
Internal Revenue Bulletin: 2018-10Internal Revenue Bulletin: 2018-06
https://taxfoundation.org/2018-tax-brackets/
https://www.ftb.ca.gov/individuals/faq/ivr/208.shtml
https://www.ftb.ca.gov/forms/2018/18-540ES-instructions.shtml
RTC Div. 2 Part 10.2 Ch. 4 Paragraph 19025
RTC Div. 2 Part 10 Ch. 2 Paragraph 17041


Disclaimer: None of the above is intended as specific tax advice and should not be construed as such. Any actions taken based on the above information is taken at your own risk.

Please contact the author directly for any inquiries regarding one's own specific situation.