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:
1st, 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.
2nd, 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”.
3rd, 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.
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 17th. 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 15th of the following year.
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 2nd 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
<feel free to skip the following rant>---------------------------------------------------------------------
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.
<end
rant>------------------------------------------------------------------------------------------------------
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. 15th
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.
