If you’re a self-employed freelancer or a small business owner, you are responsible for calculating your tax liability and sending in your quarterly tax payments throughout the year. If this is your first foray into owning a business or self-employment, this process can be stressful. Not to worry; you’ll get the hang of it with practice and some research.
In this guide, we’ll discuss the tax filing process for small business owners and independent contractors. We’ll also explore how to calculate your tax liability amount and offer ways to reduce it.
What is tax liability?
Your tax liability is the amount you owe to a tax authority, most likely the Internal Revenue Service (IRS). You may also have tax liabilities from your state and local governments. Your total tax liability will include amounts you owe from your federal income tax, capital gains tax, self-employment tax, taxes from previous years, plus any penalties or interest you’ve incurred. To put it simply, if you think you’ll owe taxes on it, it’s a tax liability.
When filing your United States Individual Income Tax Return (IRS Form 1040), line 24 is your total tax liability. Note that this number will look large at first, but it doesn’t include tax withholdings.
As a small business owner, you’re responsible for calculating your own tax liability (whether you do it yourself or use an accountant) and sending quarterly tax payments throughout the year.
If you do not send one or many quarterly tax payments, send a late payment, or send insufficient funds, the IRS will charge a penalty. The IRS might give you a break on penalties depending on events like personal circumstances, disasters, age, or disability, but it is not guaranteed. For business owners not currently making any revenue, you may still owe quarterly payments due to your total personal income.
Your tax liability is dependent on your business structure, including but not limited to a limited liability company (LLC), corporation, and sole proprietorship.
You can learn more about the advantages of specific business structures and your responsibilities and tax obligations as a self-employed individual in this IRS publication.
Examples of Tax Liability
Below, we’ll take a look at a few different scenarios when it comes to tax liability.
Scenario 1: A marketing consultant who made less than $10,000 during the last year
Many people create LLCs as consultants. In this first scenario, you are a marketing consultant with your own LLC. As a single-member LLC, you will be taxed similar to a sole proprietorship. This means you will pay taxes on your profits, whether you withdraw the money for personal use or keep it in business for capital purposes. Because you’ll be filing your income tax return as an individual and not a corporation, how much you owe will depend on the profits or losses of your business, your other income outside of the business (if any), filing status, and tax bracket.
Your tax liabilities will include federal income tax liability, state income tax, self-employment taxes, and if you expect to owe at least $1,000 in taxes when you file your return, you are also required to remit quarterly estimated taxes. This can be done through the IRS online or through the mail, or you may consult with a tax professional who can submit the forms on your behalf.
Scenario 2: A graphic designer who made $20,000 from a side gig in addition to a full-time job
Thinking about turning your side gig into a legitimate LLC? In this scenario, you might be a freelance graphic designer outside of your traditional 9-to-5 job. Your employer will be withholding taxes to cover income tax and Social Security and Medicare contributions from your employment income, and should provide you with a W-2.
However, you will be responsible for paying self-employment taxes and income taxes on your business profits through your single-member LLC, which would require you to fill out a Form 1040 or 1040-SR Schedule C. You will also be required to remit estimated tax payments quarterly, which can be done online or via mail through the IRS.
Scenario 3: A plumber running a single-member LLC with a gross income of $45,000 in the current year
Forming an LLC around your skilled trade? In this final scenario, imagine you own a plumbing service. As a small business owner who actively works in your business, you will need to pay income taxes and self-employment tax (Social Security and Medicare) on your profits. You will need to remit your quarterly payments through the IRS online or through the mail.
How to Calculate Your Tax Liability
If you’re a sole proprietor or a single-member LLC, you report your business income and losses on Schedule C with your Form 1040. If you’re a partner on a partnership, you submit an Information Return. Remember to set aside funds to pay your tax bill because you will be taxed on all profits for the year, even if you’ve retained the money for future business use.
Aside from income taxes, you’re also obligated to pay self-employment tax. This is your contribution to the Social Security and Medicare programs, which provides you with retirement benefits, disability benefits, and hospital insurance benefits. Self-employment tax is a flat rate of 15.3%, where 12.4% goes to Social Security, and 2.9% goes toward Medicare. The only time you don’t have to pay self-employment tax is if you earned less than $400.
As a small business owner, you generally need to make estimated tax payments. Because the IRS expects you to pay taxes as you earn income during the year, you are required to remit estimated tax payments if you expect to owe at least $1,000 when you file your tax return. Any amount you pay also covers your self-employment tax.
The IRS Form 1040-ES can help you figure out how much you owe in quarterly taxes. These tax payments should be remitted on the 15th of April, June, September, and January.
Since sole proprietorships, partnerships, and LLCs are flow-through entities, your tax liability will depend on your taxable income, tax rate, and tax filing status. But before you can calculate your total income tax liability, you have to determine the following first:
- Your taxable income: This is the total amount of self-employment income and additional employment you earned during a tax year.
- Your gross tax liability: Subtract your tax deductions from your total taxable income.
- Your deductions: These are eligible expenses you incurred during the year, e.g., business expenses and property tax.
So, as a self-employed individual, your total income tax liability is equal to your gross tax liability minus tax credits and the total estimated tax remittance you’ve made during the year.
Ultimately, your tax rate will depend on your taxable income and your filing status. Check the IRS website for income tax rates and tax laws, because changes are made from year to year.
Example: Again, let’s think about the tax liability of a plumbing business registered as a single-member LLC with a gross income of $45,000 in the current year. If the owner is a married man filing jointly with his wife, their tax rate will fall into two income brackets. Without accounting for deductions and tax credits, for the 2021 tax year, this business owner will owe 10% taxes from the first $19,900 and 12% for the remaining $25,100, per the info available from the IRS.
Gross tax liability of $45,000 = ($19,900 x 10%) + ($25,100 x 12%)
Total tax due = $1,990 + $3,012 = $5,002
How to Reduce Your Tax Liability
There are two common approaches that you can use to reduce your tax bill:
- Tax credits: A tax credit is a dollar-for-dollar reduction in your actual tax bill. Examples of tax credits are the child tax credit and the earned income tax credit.
- Tax deductions: Deductions reduce your taxable income by the percentage of your highest federal income tax bracket. So, if you have substantial tax deductions or exemptions, you can potentially lower your tax bracket, as well. As a taxpayer, you have the choice to apply standard deduction or itemized deductions every year.
For example, suppose you’re a freelancer who uses a room in your home regularly and exclusively as an office. In that case, the IRS lets you write off the corresponding rent, utilities, real estate taxes, repairs, and maintenance expenses.
Here are a few examples of eligible tax deductions you can claim as a small business owner:
- Self-employment taxes
- Home office deductions
- Internet and phone bills
- Health insurance premiums
- Meals when traveling or meeting clients
- Business travel expenses
- Vehicle use
- Interest paid on business loans
- Continuing education expenses
- Business insurance premiums
- Startup costs
- Marketing expenses
- Retirement plan contributions, e.g., IRA contributions
Given that businesses may be subject to multiple types of taxes, and you may need to remit payments throughout the year, it’s important to determine your tax obligations. Speaking with a tax professional in your network can help take away the burden and stress of filing taxes. For additional help, ZenBusiness can help you focus on growing your business.
Tax Liability FAQs
- What are federal income tax liabilities?
Your federal income tax liability is the total amount of taxes you owe to the IRS. This amount depends on how much you earn and your filing status. You can reduce your tax bill if you are eligible for tax credits and have allowable deductions.
- Is tax liability the same as tax due?
No, your tax liability is not the amount you would need to pay. Your quarterly payments plus eligible deductions and credits will be subtracted from your tax liability, and the difference will be your tax due.
- Are taxes assets or liabilities?
Since taxes are money owed to tax authorities, they’re generally considered liabilities.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.