Taxing the gig economy, Part 3: The unintended consequences of being a small business
More tax responsibilities and potentially more IRS problems
Editor’s note: The changing definition of work is often referred to as the gig economy, the sharing economy, and the on-demand economy. For taxpayers and tax professionals, it isn't always easy to apply traditional tax law to less clear-cut scenarios that arise in the new economy. In Part 3 of this series, we’ll look at the aspects of owning a small business that may surprise the newly self-employed.
The Small Business Administration reports that there are more than 28 million small businesses in the United States. With new business opportunities from companies such as Uber, Airbnb, and Lyft, more taxpayers are finding it easier than ever before to work for themselves. Some gig economy workers may not realize that they are now small-business owners – or that they are now a primary target for IRS audits and notices.
Small businesses have always represented a problem for the IRS
Every year, the U.S. Treasury loses almost a half-trillion dollars to taxpayers who file inaccurate returns, owe back taxes, or don’t file required returns at all. This amount is called the tax gap.
IRS statistics show that small businesses are the largest segment of noncompliant taxpayers, potentially shortchanging the government about half of the total tax gap. This is largely because small businesses voluntarily report business income and deductions on their tax returns. Small businesses also have more complex tax responsibilities.
Small business taxes get complicated
Small businesses typically have more filing and payment obligations than the average taxpayer, including:
- Quarterly estimated tax payments
- Payroll tax deposits and filings
- Reporting payments to contractors each year
- Sales tax reporting
- State and local licensing requirements
Because of their tax responsibilities, small businesses frequently interact with the IRS and state departments of revenue. They are also much more likely to be questioned by taxing authorities.
The six most common tax-problem traps for small businesses
Here are the most common problems that small-business owners find themselves in:
1. I didn’t know I had to pay my own Social Security and Medicare taxes.
This is a common miss among people who are newly self-employed. They may be surprised when they file a return and find that, in addition to income taxes, they owe another 15.3 percent tax. This is called self-employment tax, and it can result in a significant tax bill.
The 15.3 percent self-employment tax is the self-employment version of Social Security and Medicare taxes that an employer would pay if the individual were a traditional employee. On the bright side, these taxpayers can deduct half of their self-employment tax to directly offset their income.
2. I didn’t know I had to pay throughout the year.
Self-employed people don’t withhold taxes from a paycheck like traditional employees. They’re responsible for voluntarily sending in tax payments each quarter.
Not knowing or forgetting about quarterly estimated tax payments can result in a significant tax balance and penalties when filing. If the self-employed person can’t pay, he or she can set up a payment arrangement with the IRS at filing.
3. I keep getting behind.
Self-employed people sometimes find themselves continuously behind in estimated tax payments, resulting in an annual tax bill due at filing that they can’t pay. Repetitive new balances result in defaulted installment agreements, more payment plan setup fees, additional penalties and interest, and more interaction with the IRS. If the balances accumulate to more than $50,000, taxpayers can face increased financial disclosure to the IRS, as well as tax liens, which jeopardize taxpayers’ ability to get credit.
4. I didn’t report cash payments.
Statistics show that self-employed taxpayers report the proper amount of income only 42 percent of the time. Most small businesses, especially cash-intensive businesses, are on the honor system for declaring their income.
And with cash-intensive businesses, the IRS has few, if any, Forms 1099 to validate the income. Therefore, every IRS audit of small businesses starts with scrutiny about whether the business reported all of its income.
5. I “wrote off” personal expenses.
This is another major area of IRS scrutiny in a small-business audit. New small-business owners may find themselves deducting certain expenses, such as cars, cell phones, in-home offices, and travel and entertainment expenses. The IRS perceives many of these expenses to be personal in nature (and therefore not deductible) unless taxpayers can prove that the expenses were business-related. Good recordkeeping is essential.
6. I didn’t file on time (or, at all).
Many small businesses put off filing because they don’t have the money to pay their tax balances. This procrastination causes many businesses to run up large tax bills and penalties, including a 25 percent failure to file penalty for filing more than five months late.
In recent years, the IRS has found many of these nonfilers with the Form 1099-K, Payment Card and Third-party Network Transactions. Form 1099-K reports payments that the business receives from debit/credit cards and third-party processors, such as PayPal.
Many online-retail small businesses in particular are now having to reconcile their revenues to this new form. Businesses that don’t file and receive this form are experiencing IRS delinquent-filing notices and enforcement actions.
For the small business owner, taxes are not a once-a-year obligation
Business owners, including independent contractors in the gig economy, must embrace a year-round relationship with tax responsibilities. That starts with keeping good records throughout the year, continues with making estimated tax payments to limit the tax balance at filing, and culminates with filing an accurate return at the end of the year.
Small-business owners will continue to see more of the IRS after filing. Recognizing their requirements and preparing for more IRS interaction (and potentially scrutiny) is the key to making taxes less taxing for the small-business owner.
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
More in this series:
- Taxing the gig economy, Part 1: ‘Interesting tax situations’ create gray areas for on-demand drivers
- Taxing the gig economy, Part 2: Nontraditional home rentals aren’t always a perfect fit with the tax law
- Taxing the gig economy, Part 4: Artists, musicians, and makers who cross borders should be proactive to avoid major tax pitfalls