Side hustle nation: How to help self-employed clients with IRS rules

It's no secret that inflation-strapped Americans have been seeking out alternative ways to make ends meet in recent years.

A combination of higher inflation and sluggish wage growth has resulted in significantly less purchasing power for the average working person. The result: Two-thirds of Americans reported living paycheck to paycheck in a recent MarketWatch Guides study, and more than half of those (54%) reported adopting "side hustles" — a supplementary source of income outside of their primary workplace — to combat rising costs. 

These individuals usually earn extra income through contract work and receive 1099s, and they are considered "self-employed" for tax purposes when reporting the income and expenses related to the side hustle. For example, a person who is employed and receives a salary may also drive for a ride-sharing company in the evenings and on weekends. The income earned and expenses incurred related to the ride-sharing work, such as costs for gas and depreciation on the car, would be subject to the self-employment rules for taxation. 

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Additional wages are almost always beneficial regardless of a person's economic standing, and clients in higher tax brackets may seek self employment in addition to (or instead of) traditional employment for a variety of reasons. For example, an individual who creates art pieces to sell online may form an LLC or operate as a sole proprietorship through which they purchase materials, market their work and ship their goods to purchasers.

As every client has a different approach to their side hustles, this column should serve as a brief background for what to expect when it comes to taxation. Many clients may not be fully aware of the intricacies of navigating their income tax when it comes to being self-employed. 

It's essential that financial advisors brief clients on IRS rules regarding the downsides — and the potential benefits — related to earning extra cash on the side.

Estimated taxes

Most side hustles are not exempt from taxation. Any net income that is generated over the amount of $400 must be reported, whether through a 1099 form as an independent contractor, or on  a business income schedule such as a Schedule C for sole proprietors. 

Clients should also make estimated quarterly tax payments — around 25% to 30% for federal and state taxes — if they are expected to owe more than $1,000 in taxes after deducting federal income tax withholding. 

As a general rule, advise clients to keep a separate checking account for income and expenses related to the side hustle for clearer recordkeeping and to manage expectations and ease frustrations. Commingling income from the business with salaried income and personal expenses can make tax preparation much more difficult.

While it's always wise to err on the side of caution, clients reporting under a sole proprietorship, or other pass-through business owners, have additional significant tax advantages available to them as business owners. Clients are eligible for business deductions if they meet a certain set of qualifying requirements (more on that below) — up to as much of 20% of business income, even if they take the standard deduction.

Dedicated work space, travel

For clients using a dedicated space within their homes to conduct business, not only are home office deductions available for direct expenses, but a certain amount of indirect expenses related to the home, like depreciation or utilities, can also be eligible deductions. A simple calculation method allows a deduction of $5 for every square foot used, but it should be noted that this deduction amount is capped for home offices larger than 300 square feet. 

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Clients upgrading their home offices or commercial buildings to increase energy efficiency can qualify for a deduction of up to $1 per square foot if energy usage is reduced by 50%. If the taxpayer uses their car for business, many expenses related to the vehicle can be deducted, such as the cost of the car or car payments, repairs or insurance and even indirect expenses such as depreciation and mileage, which creates a tax benefit even though there is no actual cash outlay by the taxpayer.

However, there is a catch. Simply "working from home" doesn't mean the taxpayer can take the deduction. This deduction is only allowed if the home office serves as a primary place of business, meaning that if your client has an employer with a physical workspace outside of their home, a home office deduction is not permitted. And double-dipping is not allowed — direct expenses cannot be claimed as both itemized deductions and business expenses. As an example, any portion of an individual's mortgage interest that's used as an indirect expense to help calculate their home office deduction must be subtracted from their overall mortgage interest when calculating their itemized deductions. Moreover, when an individual goes to sell their home, depreciation will be recaptured.

Meals and travel expenses are also eligible for deduction if the primary purpose of a trip or outing is business oriented. Many taxpayers piggyback on this advantage by combining work events with personal vacations. For instance, if an individual is visiting a sales prospect near Disneyland, the whole family can travel to the site, and the individual can deduct the cost of their own plane ticket. Meals provided for direct employees are fully deductible, while meals for other business purposes, such as taking sales prospects out to dinner, is only 50% deductible.

Retirement plans

As a business owner, there are even more significant tax advantages if there are employees. If the business is formed as an S-Corp, and the business owner pays themself a salary, the employee portion of the self-employment tax is a deductible expense. 

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By comparison, if the business is formed as a sole proprietorship or LLC, the self-employment tax is not a deductible expense. With regards to retirement, the owner can always contribute to their own IRA, but setting up an employment-sponsored retirement plan can be particularly effective, since these plans allow higher contribution amounts compared to traditional or Roth IRAs. 

A 401(k) plan can be set up even if there are no employees, which allows greater contributions than an IRA, and if there are employees, both parties can make contributions to the plans. SIMPLE IRAs are an efficient solution if the owner wants employees to contribute but does not want to make contributions to employees' plans. 

SEP IRAs may be most effective for making more contributions in an organization where the owner earns significantly more than the employees. This is because while employer contributions are required, if the owner makes significantly more than the employees, the contributions will proportionally benefit the owner.