There is one major difference according to the IRS between an employee and employer and who pays what portion of tax on earned income. Self-employed persons are required to pay all of the tax on earned income. Tax from earned income is labeled as a pay-as-you-go tax meaning you pay as you earn it.
When you earn income from running your own business you are considered self-employed. The IRS requires self-employed persons to pay self-employment tax for any year they are self-employed. Most people do not realize that this is the same tax that is taken from their paychecks each pay period under the various columns such as social security, Medicare and federal and state taxes.
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Self-employed persons have a minimum limit to reach before payment of estimated tax is required. If you are expecting to earn more than $400 in net income (after taxes) you are required to remit taxes according to the IRS.
To calculate self-employment tax, you must use the current tax rate. As of 2010 the rate is 15.3 percent of net earnings. The rate is separated into two parts says the IRS: 12.4 percent applies to social security; while 2.9 percent applies to Medicare. There is a maximum earnings limit of $106,800 for 2010. This includes combined wages, tips and net earnings.
How to Remit Taxes
When you are self-employed, knowing how to pay taxes as you go becomes important. You will need either an SSN (individual social security number) or an ITIN (individual tax identification number). To apply for an SSN use Form SS-5; this is the application for the Social Security Card. To apply for an Individual Taxpayer Number, use Form W-7. ITIN numbers are reserved for nonresident or resident aliens or for persons who are not eligible for an SSN.
File Schedule SE when you file your annual Form 1040 to calculate how much tax you are required to pay. This number will either be larger or smaller than your estimated payments during the year.
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Types and Methods
When you are self-employed how you pay taxes as you go depends on how your business is set up. There are two methods of paying self-employment taxes: quarterly payments and paying taxes as if you are an employee of the business. Either method requires the business to send payments in a timely fashion to the Internal Revenue Service.
Quarterly tax payments are estimated payments sent every three months to the IRS. These payments are held in escrow until you file the annual Schedule SE with your 1040. If these payments are deemed to be over the amount calculated, you will be issued a refund. If these payments are deemed to be less than the calculated amount you are required to submit payment with the tax forms.
This type of tax payment is more complicated than quarterly payments and requires an accountant to determine the proper amounts per paycheck. This is also the more efficient form of payment because it treats the self-employed person like an employee of the business where the business withholds the correct amount of taxes each pay period. For this method, you need to set up the business as a corporation with an EIN (Employer Identification Number).
For the self-employed, misunderstanding of how to pay taxes as you go can lead to penalties. According to the IRS, failure to remit the correct amount of tax will make a business or individual liable for the original tax amount, interest and late penalties. These penalties and interest charges can continue to increase as long as any portion of the original tax amount is still owed.
IRS: Self-employment Tax retrieved at - http://www.irs.gov/businesses/small/article/0,,id=98846,00.html
IRS: Penalty for Underpayment of Estimated Tax retrieved at - http://www.irs.gov/taxtopics/tc306.html