One of the often overlooked aspects of having a side income is the need to file income taxes. This is especially true if you’ve never had a side income. You may not even be sure that you need to file for a side income, but rest assured that you do.
Virtually any income you earn is taxable
This is easy enough if the side income is paid to you through a W2 where the employer reports your income to the Internal Revenue Service (IRS) and also withholds income taxes for you. It can be less clear if you’re paid by Form 1099 (Miscellaneous income) or from self-employment.
One advantage to income from a 1099 or from self-employment is that you can also deduct any expenses you’ve paid in the process of earning that income. Than can not only reduce the amount of income tax you owe, but it may also eliminate your liability completely if your expenses exceed your income.
If you do have income from a 1099 or from self-employment, you will generally need to file an IRS Schedule C (self-employment income) with your regular income tax return. Schedule C is where you report both self-employment income and expenses.
Type of income tax you may owe
There are at least three types of income tax you will owe if you have a side income. All three will apply if the income is from Form 1099 or from self-employment.
Federal income tax. Any profit from self-employment—after deducting related expenses—is carried forward to page 1 of Form 1040 where it’s added to your income. The net profit will be taxed at your highest marginal tax rate since it’s additional income. If you’re in the 15% tax bracket, the profit will then be taxed at that rate as well. It’s even possible that your self-employment income will push you up into a higher income tax bracket.
FICA tax. This is the tax that surprises new owners of side businesses the most. It’s the tax paid (in addition to Federal income taxes) into the Social Security and Medicare programs. If you’re paid by W2, you will pay 7.65% of your earning, which is the employee portion of the FICA tax. If you’re self-employed however, you’ll also pay the employer’s half, which is also 7.65%. Both numbers are assessed on your net income, not gross. You must pay this tax through Schedule SE, but only if your net business income is $400 or more. (NOTE: for 2012, the employee portion of the tax is reduced by two percentage points, to 5.65%. There is no indication that this tax break will be extended beyond 2012.)
State income tax. Just as the Federal government collects tax on your side income, so will your state—if it has an income tax. Since most states collect income taxes based on your Federal income tax return, you will not have to file any special forms. However the extra income from your side venture will increase your income for state purposes and you’ll be paying taxes to cover that.
Other self-employment or business taxes you may owe
There may be other taxes you’ll have to pay as a result of having a side business. Taxes go by various names, and are for a variety of purposes, but they can be in the form of annual assessments, licensing fees or various reporting fees. Some names for these taxes that you might see include business personal property tax, annual report, unincorporated business tax, county or municipal business license and many, many (many!) more. A few counties and municipalities around the country also have their own income taxes.
Don’t ignore these as penalties for non-compliance can be stiff.
How to file your income tax estimates
If you earn a substantial amount of income from your side income you may be required to pay quarterly or even monthly income tax estimates. Though these have various names for the states, you will generally pay your Federal and FICA tax estimates on Form 1040-ES (estimated tax).
It can be a real nightmare trying to figure out how much you owe in estimates—or even if you owe any at all. The process will be simplified if you work with an accountant so that either he can determine your liability for you, or provide you with a simple formula that will allow you to do it yourself.
Don’t forget sales tax!
In some jurisdictions, and on certain income from the sale of products or services you may also be required to collect and pay sales tax. This is a tax that you must collect and pay on a more ongoing basis. Depending on how much you collect, you may be required to pay the tax either quarterly or monthly.
The good part is that this isn’t a tax on your income, but one that you collect over and above your income from your customers. That makes it more of a hassle than a financial burden to pay.
So now that you know about the taxes that need to be filed on a side income, are you sure you want to have your own business?