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A self-employed person works for himself/herself instead of as an employee of another person or organization, drawing income from a trade or business. This is less stable than working as an employee but tends to earn a higher hourly income or rate.
In its simplest form, the individual and his business are one and the same entity. This makes the owner personally liable for all the debts of the business. To avoid this, he may choose to incorporate his business, protecting his personal assets from creditors or others taking legal action against the business.
Self-employed workers cannot contribute to a 401K plan, unless they self-incorporate and set up a 401K plan for the company, but this requires some significant paperwork. Most self employed set up a Self Employment Plan (SEP) IRA, which allows them to contribute up to 20% of their income, up to $40,000 in contributions, to the SEP per year. This is significantly higher than 401K plans.
If a self-employed person's client goes bankrupt, the bankrupt company's actual employees usually have first rights to whatever cash the company had. Next is the IRS, and then all the external creditors, including the self employed worker.
Self-employed workers are paid directly by clients or by their business, and some proportion of these payments will be due to the government as income tax. Unlike an employee of a company, a self-employed person must pay tax after receiving his taxable income.
In order to avoid resulting interest payments to the IRS for paying taxes in arrears, self-employed workers in the United States usually pay estimated taxes quarterly, and at the end of the year, the tax return determines if these estimated payments were enough. Another tax implication is that a self-employed worker must pay both the employee and employer portions of the FICA tax (so instead of 6.2%, they must pay 12.4% until they make enough that FICA is no longer paid). Self-employed workers must also pay 2.9% instead of 1.45% for Medicare on all income.
On the other side, self-employed workers can take far more deductions than an ordinary employee. Anytime a self-employed worker visits a client, the trip expenses are deductible (the deduction for driving any car is $0.385 per mile plus any tolls incurred).
Other expenses such as uniforms, computer equipment, cell phones, etc. can be deducted if there is a legitimate business use for these items. Since the chances of being audited by the Internal Revenue Service are relatively slim, many self-employed workers likely overstate their deductions. One deduction that has a reputation for raising a "red flag" at the IRS is the deduction for a home office.
Many people would simply put a desk in an attic, perhaps with an old computer on it, and try to take a deduction (for depreciation). Home office deductions are legitimate, although it has to be a legitimate office. The IRS will also overrule other flagrant deductions, such as buying a Yacht and naming it after your company. If you're an accountant or dentist, such a deduction likely won't be valid.
If someone is self-employed, but works for only one client, and is otherwise indistinguishable from a regular employee, then the IRS will probably require the company to treat him as a regular employee.
The US Internal Revenue Service provideds Schedule C and SE of Form 1040 to assist self-employed workers in payment of the proper amount of tax.
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