Self-employment offers immense benefits: In addition to the flexibility to work on your own schedule and never having to answer to a boss, you have the freedom to choose where you work, what you choose to outsource to others, and which projects most spark your passion and are worthy of being taken on.
For workers who go out on their own however, the path to self-employment can present some surprising twists at tax time. Nearly 16 million Americans are self-employed, and they must navigate significant hurdles to make sure their wages are accurately reported to the IRS and they don’t lose out on valuable cash in the process.
Here are 10 tips to avoid the most common pitfalls that trip up self-employed workers, so you can avoid them and maximize your take-home income.
1. Keep ’em separated.
If you’re considering becoming a full-time, self-employed professional, the first thing you should do is create separation between you and your business by setting up a legal business entity. Many self-employed workers opt to form LLCs, which are simple to establish and provide a freelance worker with a level of cache that helps them stand out from the pack when applying for jobs.
These are effective in reducing personal liability, but In most cases, forming an S-corporation is the best move. This is a business that’s completely separate from you, the worker — it has its own bank account and payroll, and it establishes a legal separation between you as the business owner and you as an employee, so that only the w2 salary you pay yourself is subject to self-employment tax. That’s often quite an advantage over an LLC, where your entire net income is subject to self-employment tax of 15.3%. S-Corps provide you with limited liability protection as well as a special tax classification that allows you to put any income not paid out as part of your w2 salary back into the business. From there it can be reinvested or paid out as distributions.
2. Get an EIN Number from the IRS.
Employer Identification Numbers, or EINs, are free and act as the golden ticket to creating separation. With an EIN, you can open a business bank account, which will make it easy to track business expenses and keep them separate from personal expenses.
3. Put your savings to work with a Roth IRA or Solo 401K.
The days of counting on social security are as much in the past as the days of rotary phones and dial-up internet. To protect yourself in the modern world as a self-employed worker, put your savings into a Roth IRA or Solo 401K. Not only do these moves secure your future, but they also lower your tax liability. And as the icing on the cake, they can also be used to take out loans — it’s always good to have a safety net in place, and one that safeguards your future is especially beneficial.
4. Make it a family affair.
If you’re a parent, bring your kids into the family business by paying them to work for you rather than providing a handout like an allowance. Such a move produces the ultimate win-win: your kids will gain valuable acumen and responsibility while you’ll be able to delegate tasks. And while they’re earning money through their own labor, they can also help contribute to their own Roth IRA.
5. Don’t overlook the HSA and FSA.
Healthcare is a huge chunk of every employers’ budget, and when you’re self-employed and carrying the burden of paying for your own healthcare, the costs can quickly become daunting. HSAs, or Health Savings Accounts, as well as FSAs, or Flexible Spending Accounts, can help. By opening an HSA or FSA, you’ll be entitled to tax-free out-of-pocket medical expenses. FSAs can also be used to pay for childcare and summer camps, which will significantly reduce your tax burden. Educate yourself with the spending limit for both of these types of accounts, and make sure to max them out so you are using them to their full potential.
6. Claim all non-cash donations.
Taking that old couch to Goodwill? Dropping off packages of baby clothes at a nearby orphanage? Don’t forget to claim the benefits of your good deed. All non-cash donations under $5000, like those of small furniture to organizations like Goodwill, can result in a $1500 tax reduction. But don’t forget to claim, and don’t fret if you didn’t ask for a receipt. The chance of an audit for these small deductions is very low.
7. Leverage your expenses.
The list of industry-standard business expenses that will help you generate income is long. There’s your car, and the mileage you put on it while commuting to jobs. There’s your phone, your internet, the price of advertising across any number of platforms, even a portion of your rent or mortgage if you use a home office. Leverage your business to pay for all of these expenses, and track them so you can deduct them from your income at year’s end to lower your tax burden. Even the mileage on your car is tax-deductible, so don’t forget to keep an eye on it and note whenever you drive for work!
8. Make it a working lunch.
In 2022, all of your business meals are 100 percent deductible. So if you’re going to grab lunch, breakfast or even coffee, consider grabbing it with a client or colleague and turn your meal into a working one. Just don’t forget to save the receipt.
9. Pay yourself!
Now that you’ve applied for an EIN and opened a separate business account, don’t forget to give yourself a salary. At any given moment, you should have about three to six months’ worth of business expenses in your operating account. When you have more than that, invest the excess back into your business, or distribute it in the form of payment in order to keep your money safe from business liabilities.
10. You don’t have to do this alone.
Yes, you’ve branched out to work yourself, but that doesn’t mean you don’t have to work without a support network. Indeed, if you want to reach your true potential as a small-business owner, you’ll need a trusted advisor that will bring your focus back to growing your business. So seek out a network of colleagues and mentors that you admire, and lean on them to help you grow. Even when you work alone, it takes a village.
Shahar Plinner is a tax and accounting expert with over 15 years of experience in the field. He is the CEO and Co-Founder of Formations and an advocate for the self-employed on a mission to help them achieve financial well-being. As the founder and former CEO of GPL, a tax and accounting firm, he served thousands of business owners and perfected the S-Corp management process. Shahar is a passionate advocate for the self-employed, and is widely known as the “tax guru” of the west coast.