Chapter 1
Working for Yourself: The Good, the Bad, and the Ugly
Working for Yourself: The Good................................................................. 4
Independence........................................................................................... 4
Higher Earnings........................................................................................ 4
Tax Benefits............................................................................................... 5
Working for Yourself: The Bad................................................................... 6
No Job Security......................................................................................... 6
No Free Benefits....................................................................................... 6
No Unemployment Insurance................................................................. 6
No Workers’ Compensation.................................................................... 6
No Free Office Space or Equipment...................................................... 6
Few or No Labor Law Protections.......................................................... 6
Complete Business Responsibility........................................................ 7
Others May Discriminate.......................................................................... 7
Working for Yourself: The Ugly.................................................................. 7
Double Social Security Tax..................................................................... 7
Personal Liability for Debts..................................................................... 7
Deadbeat Clients...................................................................................... 7
How to Use This Book.................................................................................. 8
Starting Up Your Business...................................................................... 8
Ongoing Legal and Tax Issues............................................................... 8
Working for yourself can be both financially and spiritually satisfying. But the lot of the self-employed is not always an easy one. You have to make the often difficult transition from having an employer take care of the details to handling everything on your own. For example, you won’t have a company payroll department to withhold and pay your taxes for you.
Many self-employed people (including those with plenty of clients) get into trouble because they don’t run their operations in a businesslike manner. Spending a few hours now to learn the nuts and bolts of self-employment law and taxes can save you countless headaches—not to mention substantial time and money—later on. You don’t have to start wearing a green visor and bow tie, but you do need to learn a few rudiments of business and tax law.
Before you delve into the details of the following chapters, read this chapter for an overview of the pros and cons of being self-employed as compared to being an employee. It may help you make an informed decision if you’re thinking about striking out on your own—or help confirm that you made the right decision if you’re already working for yourself.
Working for Yourself: The Good
Being self-employed can give you more freedom and privacy than working for an employer. It can also result in substantial tax benefits.
Independence
When you’re self-employed, you are your own boss—with all the risks and rewards that entails. Most self-employed people bask in the freedom that comes from being in business for themselves. They would doubtless agree with the following sentiment expressed by one self-employed person: “I can choose how, when, and where to work, for as much or as little time as I want. In short, I enjoy working for myself.”
The self-employed are masters of their own economic fates. The amount of money they make is directly related to the quantity and quality of their work, which is not necessarily the case for employees. The self-employed don’t have to ask their bosses for a raise; they go out and find more work.
Likewise, if you’re self-employed, you’re normally not dependent upon a single company for your livelihood, so the hiring or firing decisions of any one company won’t have the same impact on you as on that company’s employees. One self-employed person explains: “I was laid off six years ago and chose to start my own company rather than sign on for another ride on someone else’s roller coaster. It’s scary at first, but I’m now no longer at someone else’s mercy.”
Higher Earnings
You can often earn more when you’re self-employed than as an employee for someone else’s business. For example, an employee in a public relations firm decided to go out on her own when she learned that the firm billed her time out to clients at $125 per hour while paying her only $17 per hour. She now charges $75 per hour and makes a far better living than she ever did as an employee.
According to the Wall Street Journal, self-employed people who provide services are usually paid at least 20% to 40% more per hour than employees performing the same work. This is because companies that hire self-employed workers (referred to throughout this book as “hiring firms”) don’t have to pay half of the self-employed worker’s Social Security taxes, or pay for unemployment compensation taxes, workers’ compensation coverage, or employee benefits like health insurance and sick leave for workers who are not their employees. Of course, how much you’re paid is a matter for negotiation between you and your clients. Self-employed people whose skills are in great demand may receive far more than employees doing similar work.
Tax Benefits
Self-employment also provides many tax benefits that aren’t available to employees. For example, no federal or state taxes are withheld from your paychecks by an employer as they must be for employees. Instead, the self-employed normally pay their own estimated taxes directly to the IRS four times a year. This means you can hold on to your hard-earned money longer. It’s up to you to decide how much estimated tax to pay (although there are penalties if you underpay). The lack of withholding combined with control over estimated tax payments can result in improved cash flow for the self-employed.
More important, you can take advantage of many tax deductions that are limited or unavailable for employees. When you’re self-employed, you can deduct any necessary expenses related to your business from your taxable income as long as they are reasonable in amount and ordinarily incurred by businesses of your type. This may include, for example, office expenses (including those for home offices), travel expenses, entertainment and meal expenses, equipment costs, and insurance payments. These are covered in greater detail in Chapter 4.
In contrast to the numerous deductions available to the self-employed, an employee’s work-related deductions are severely limited. Some deductions available to the self-employed may not be taken by employees—for example, an employee may not deduct the cost of commuting to and from work, but a self-employed person traveling from his or her office to that of a client may ordinarily deduct this expense. And, even those expenses that are deductible for an employee may be deducted only to the extent they add up to more than 2% of the employee’s adjusted gross income. This means that most of an employee’s expenses related to employment cannot be deducted fully.
In addition, the self-employed can establish retirement plans, such as SEP-IRAs and solo 401(k) plans, that have tax advantages. These plans also allow them to shelter a substantial amount of their incomes until they retire.
Because of these tax benefits, the self-employed often ultimately pay less in taxes than employees who earn similar incomes.
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Six Things You May Not Know About the Self-Employed
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1. There are lots of them. 16% of all workers in the United States are self-employed.
2. Rich people are more likely to work for themselves. Self-employed people account for two-thirds of all American millionaires.
3. Lots of them are older. More people become self-employed at age 50 or above than in younger age groups (16.4% versus 10.2%).
4. They tend to be happier. Self-employed people are more likely to be completely satisfied with their jobs than are employees: 42% of self-employed Americans are completely satisfied with their jobs compared with just 31% of employees who are equally satisfied.
5. They work more hours. Nearly half of all self-employed Americans (49%) work more than 44 hours in a typical workweek, compared to 39% of American workers overall, 38% in government and in private business, and 30% in nonprofit organizations.
6. They tend to be born in the U.S.A. In the past, immigrants were self-employed at greater rates than native-born Americans. However, this is no longer the case. By 1997, native-born Americans had higher self-employment rates than immigrants.
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Working for Yourself: The Bad
Despite its advantages, being self-employed is no bed of roses. Here are some of the major drawbacks.
No Job Security
As discussed above, one of the best things about being self-employed is that you’re on your own. On the other hand, this can be one of the worst things about it too.
When you’re an employee, you must be paid as long as you have your job, even if your employer’s business is slow. This is not the case when you’re self-employed. If you don’t have business, you don’t make money. As one self-employed person says: “If I fail, I don’t eat. I don’t have the comfort of punching a time clock and knowing the check will be there on payday.”
No Free Benefits
Although not always required by law, employers often provide their employees with health insurance, paid vacations, and paid sick leave. More generous employers may also provide retirement benefits, bonuses, and even employee profit sharing.
When you’re self-employed, you get no such benefits. You must pay for your own health insurance, often at higher rates than employers pay. Time lost due to vacations and illness comes directly out of your bottom line. And you must fund your own retirement. If you don’t earn enough money to purchase or create these benefits for yourself, you will have to forgo some or all of them.
No Unemployment Insurance
The self-employed also don’t have the safety net provided by unemployment insurance. Because hiring firms (companies that hire self-employed people) do not pay unemployment compensation taxes for the self-employed, these people cannot collect unemployment benefits when their work for a firm ends.
No Workers’ Compensation
Employers must generally provide workers’ compensation coverage for their employees. Employees are entitled to collect workers’ compensation benefits for injuries that occur on the job even if the injury was their own fault.
Hiring firms usually do not provide workers’ compensation coverage for the self-employed people they hire. If a work-related injury is a self-employed person’s fault, he or she has no recourse against the hiring firm. (See Chapter 6.) And even if it’s the hiring firm’s responsibility, the self-employed person will have to deal with the expense and hassle of a lawsuit.
No Free Office Space or Equipment
Employers normally provide their employees with an office or space in which to work and the equipment they need to do the job. This is not usually the case when a company hires a self-employed person, who must normally provide his or her own workplace and equipment.
Few or No Labor Law Protections
A wide array of federal and state laws protect employees from unfair exploitation by employers. Among other things, these laws:
• impose a minimum wage
• require many employees to be paid time and a half for overtime
• prohibit discrimination and harassment
• require employers to provide family and medical leave, leave for military service, or time off to vote or serve on a jury, and
• protect employees who wish to unionize.
Few such legal protections apply to the self-employed.
Complete Business Responsibility
When you’re self-employed, you must run your own business. This means, for example, that you’ll need to have at least a rudimentary record-keeping system or hire someone to keep your records for you. (See Chapter 14.) You’ll also likely have to file a far more complex tax return than you did when you were an employee. (See Chapter 8.)
Others May Discriminate
Because you don’t have a guaranteed annual income as employees do, insurers, lenders, and other businesses may refuse to provide you with services or may charge you more than employees for similar services. It can be difficult, for example, for a self-employed person to obtain disability insurance, particularly one who works at home. Health insurance may be easier to get, but the premium payments could cost you an arm and a leg without the benefit of an employer’s group rate.
Also, it may be more difficult to buy a house because lenders are often wary of self-employed borrowers. To prove you can afford a loan, you’ll likely have to provide a prospective lender with copies of your recent tax returns and a profit and loss statement for your business.
Working for Yourself: The Ugly
Unfortunately, the bad aspects of self-employment discussed above do not end the litany of potential woes. Being self-employed can, in some respects, get downright ugly.
Double Social Security Tax
For many, the ugliest and most unfair thing about being self-employed is that they must pay twice as much Social Security and Medicare taxes as employees. Employees pay a 7.65% tax on their salaries, up to a salary amount capped by the Social Security tax limit ($106,800 in 2010). Employers pay a matching amount. In contrast, self-employed people must pay the entire tax themselves—a whopping 15.3% on their income up to the amount capped by the Social Security tax limit. This is in addition to federal and state income taxes. In practice, the Social Security tax comes to less than 15.3% because of certain deductions, but it still takes a big bite out of what you earn from self-employment. (See Chapter 10.)
Personal Liability for Debts
Employees are not liable for the debts incurred by their employers. An employee may lose his or her job if the employer’s business fails but will owe nothing to the employer’s creditors.
This is not necessarily the case when you’re self-employed. If you’re a sole proprietor or partner in a partnership, you are personally liable for your business debts. You could lose much of what you own if your business fails. However, there are ways to decrease your personal exposure, such as obtaining insurance. (See Chapter 6.)
Deadbeat Clients
Ugliest of all, you could do lots of business and still fail to earn a living. Many self-employed people have great difficulty getting their clients to pay them on time or at all. When you’re self-employed, you bear the risk of loss from deadbeat clients. Neither the government nor anyone else is going to help you collect on your clients’ unpaid bills.
Clients who pay late or don’t pay at all have driven many self-employed people back to the ranks of those working for the boss. However, there are many strategies you can use to help alleviate payment problems. (See Chapter 7.)
How to Use This Book
This book will help you make what’s good about self-employment even better, make the bad aspects less daunting, and—hopefully—make the ugly aspects a little more attractive.
Exactly which portions of the book you’ll need to read depends on whether you’re already self-employed or just starting out.
Starting Up Your Business
If you’re just starting out, there are a number of tasks you’ll need to complete before or soon after you start doing business. These include:
• choosing the legal form for your business (see Chapter 2)
• choosing a name for your business (see Chapter 3)
• deciding where to set up your office (see Chapter 4)
• obtaining business licenses and permits
and a federal taxpayer ID number (see Chapter 5)
• obtaining insurance for your business and yourself (see Chapter 6), and
• setting up at least a rudimentary bookkeeping system (see Chapter 14).
You should read the chapters discussing these tasks first.
Ongoing Legal and Tax Issues
Once your business is up and running, there are a number of ongoing legal and tax issues you may have to tackle. These include:
• deciding how to price your services and taking steps to ensure you get paid (see Chapter 7)
• understanding basic tax rules (see Chapter 8)
• paying estimated taxes (see Chapter 11)
• keeping track of your tax-deductible business expenses (see Chapters 9 and 14)
• dealing with taxes for any employees or
independent contractors you hire (see Chapter 13)
• taking steps to ensure that the IRS doesn’t view you as an employee if you’re audited (see Chapter 15)
• deciding how to fund your retirement (see Chapter 16)
• using written client agreements (see Chapters 18, 19, and 20), and
• dealing with ownership of the copyrights, patents, and trade secrets you create (see Chapter 17).
You can read the appropriate chapters when a problem arises or read them in advance to help you avoid problems from the outset.
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