Q: Tax Playa, I received a small amount of money (several thousand dollars) for writing some op-eds this year. Do I have to pay taxes on that?
Dan, Arlington VA
A: The tax code considers such "side income" to be sole-proprietor business income, and you must pay taxes on it. The bad news is that you will owe both income and self-employment (Social Security and Medicare) tax on this money. The good news is that you can claim business expenses against the income.
First, the basics.
Any income received from whatever source is usually taxable. Income can take many forms--wages being the most prevalent. However, all other types of income are also taxable and have their own rules.
By whatever name it is called--side income, contract income, etc.--business income is fully-taxable to the individual. To enforce this taxation, the IRS requires payers of business income to individuals to issue a 1099-MISC if the total amount of contract payments for the year exceed $600.
The individual then reports this income on a Schedule C of a Form 1040. Business expenses (travel, subscriptions, meals and entertainment, etc.) can then be deducted from this income. The expenses must both be "ordinary" (usual and customary for this type of business) and "necessary" (needed to complete the work). In lieu of listing expenses, a taxpayer can take a deduction for the lesser of business expenses or $5000 by filing a Schedule C-EZ (assuming that the taxpayer actually has this much in expenses).
A taxpayer can take a loss on business income (expenses exceed income). However, a taxpayer who does this in three years out of five is liable for the IRS to re-constitute the activity as a hobby, canceling out all losses and resulting in a back tax and interest/penalty bill.
Once net business income is determined, the self-employment tax (Social Security and Medicare) is calculated. Just as wages have two levels of tax (income and FICA), self-employment income is liable for both income tax and self-employment tax, or SECA. Adding insult to injury, the self-employed person is both the employer and the employee and must pay both halves of Social Security and Medicare (15.3% total). In many cases, the self-employment tax is bigger than the income tax on net income from self employment.
The net income from self-employment is then transferred to the 1040. Three special adjustments are then allowed to this income:
- 1/2 of the self-employment tax. The "employer" hat of the taxpayer gets to deduct his half of Social Security and Medicare tax.
- Self-employed health premiums. If you paid for health care premiums for yourself, your spouse, and/or your dependents while you were self-employed, you can normally deduct them here.
- SEP, Simple, and qualified plans. Self-employed people are allowed to set up their own retirement plans. The simplest of these is the SEP, or simplified employee pension. Self-employed people can put in 20% of their net income from self-employment (minus the deduction for 1/2 of the self-employment tax) into these IRA-like accounts as late as the filing deadline plus extensions.
In order to make sure that a taxpayer with self-employment income has enough taxes paid in by the end of the year, they have a choice:
- Make quarterly estimated tax payments by filing Form 1040-ES
- Increase payroll withholding at your regular job
A good rule of thumb is to pay 15% of your gross self-employment income in taxes to the federal government. Netting out all deductions and self-employment taxes, this is about right.
If you don't pay enough in estimated taxes or have enough taxes withheld, you could be hit with penalties and interest.