There are several parallels between being self-employed and owning a small business. For instance, both empower you to be your own boss! However, when it concerns filing taxes and reporting company revenue, your official business classification might signify quite different things to the IRS.
Here’s how to figure out what group you fit into as an entrepreneur and how it affects your taxes.
Self-employed vs small business owner: understanding the difference
The easiest way to tell the difference between being self-employed and owning a small business is to observe how you conduct your work. You manage a business as a small business owner, and you often hire others. If you work for yourself, you yourself are the business.
Examples of Self employment:
- Sole proprietor: You are your company as a solo proprietor. You make the decisions, operate the company yourself, and keep the proceeds from your business as personal income.
- Independent contractor: Sometimes known as a freelancer, you generate work for others while remaining your own boss. You operate on a contract basis with customers of your choice, but you are not an employee of those clients.
- Partnership: A partnership has all of the characteristics of a sole proprietorship, but you share joint ownership of the firm with two or more “partners.”
Characteristics of small business ownership:
- You hire staff or recruit self-employed individuals to work for you as independent contractors.
- Your company might be designated as a distinct entity, which means you will have less personal accountability.
- You are accountable for collecting taxes and acquiring workers’ compensation insurance whether you have part-time or full-time staff.
How are taxes handled differently?
The most important distinction between small company owners and self-employed people is how you compensate yourself. Naturally, this has an impact on how each individual pays their taxes.
If you are self-employed:
- Your business tax deductions, earnings, and losses are recorded on Schedule C of your personal income tax return.
- If you earn more than $400 per year, you must pay self-employment tax to fund Medicare and Social Security obligations.
- To prevent fines or a big tax payment at the end of the year, you may pay quarterly anticipated taxes throughout the year.
If you own a small business:
- Small businesses are subject to taxation in different ways depending on their business type; for example, LLC taxes can be transferred to the owners, or you can decide to be taxed as a corporation.
- If you are taxed as a company, you must pay corporate taxes, which are a tax on your earnings (revenue minus the price of products sold and other business running costs).
- Form W-2 is used to record your employees’ earnings and the amount of federal, state, or local income tax withheld.
- If you engage independent contractors, you must use Form 1099-MISC or Form 1099-NEC to record any payments of $600 or more.
When should I transition from being self-employed to being a small business owner?
Many self-employed individuals wonder when they ought to set up a formal company structure as their firm expands.
You should think about altering your business structure if:
- You desire to reduce your own liability.
Imagine you are a sole proprietor who uses Schedule C to record your business costs. Your company’s costs have just increased. When filing, you find yourself adding more assets to Schedule C.
In this scenario, organizing your firm as a single-member LLC for tax reasons may be a good option to reduce your personal exposure. You are incorporating a distinct business entity from yourself, which provides more liability protection.
After that, you can decide to tax your company as a S corporation and begin utilizing Form 1120-S to record business earnings and losses.
- You are appointing new owners or staff.
Perhaps you’ve been riding alone as a single proprietor and are thinking about expanding to become a partnership or LLC. Or maybe you’ve been in a partnership with someone who has decided to depart. In any event, a change in ownership can frequently result in a change in corporate structure.
Similarly, increasing staff might increase your responsibility, giving you still more incentive to change your business type. In the end, changing your business structure is about what is best for you – and your business!